1. How do regular Treasury bonds work? How does inflation affect them?

How are TIPS

different? Why do TIPS (out) underperform regular treasuries?

A treasury bond is a marketable, fixed-interest U.S. government debt security with a maturity of
more than 10 years paying interest payments semi-annually and taxed only at the federal level.
Treasury bonds are issued with a minimum denomination of $1,000

 Treasury bonds are available directly to the general public and transactions with the
government are usually conducted through a limited number of primary dealers who bid for
the bonds in an auction.
 These dealers then make the bonds available on an open market, where prices and yields
are determined by market forces.

Buying Treasury bonds is not risk free. Bonds typically trade for less than their face value or par,
which creates the yield for the bondholder. The total yield is the difference between the purchase
price and the par value and the interest to be paid up to maturity. As the price of purchasing a bond
increases, the yield to maturity decreases. Most bonds are not held to maturity, but are traded to
generate profits on fluctuating market conditions. Thus the interest rate risk is the principle danger
to the buyer.

United States Treasury inflation-protected securities (TIPS) are a simple and effective way to
eliminate inflation risk while providing a real rate of return guaranteed by the United States
government. They are securities whose principal is tied to the Consumer Price Index. With inflation,
the principal increases and it decreases with deflation. When the security matures, the U.S. Treasury
pays the original or adjusted principal, whichever is greater.

TIPS can provide an economic benefit in the event that future inflation in the United States turns out
to be higher than the bond market currently anticipates. If actual inflation is lower than the BEI rate,
nominal bonds may outperform over the life of the bonds. In the long run, nominal returns should
surpass the returns of TIPS by an amount equal to the cost of the inflation risk premium. The
premium is the reward earned by investors in nominal .Treasury bonds for bearing inflation. Thus,
the total return on a Treasury bond portfolio has tended to be slightly more volatile than that of a
similar-maturity TIPS portfolio.

2. How can we combine regular (nominal) Treasuries and TIPS to build a hedge portfolio that
has exposure to inflation risk but not to real interest risk?

In order to achieve the desired hedge effect of inflation risk exposure and real interest rate
neutrality, one needs to take a long position in the inflation indexed TIPS issue with a given duration
and at the same time take a short position in the ordinary nominal T-Bond with exactly the same
duration.
 In order to test this hedge portfolio upon its effectiveness, one needs to investigate how a change in
one of the two variables affecting nominal interest rates (real rate or inflation rate) would affect the
overall payoff for the investor. Starting with a given change in the real interest rate, one could
actually observe that the two securities will offset each other through its long/short positions (the
directional effect does not play any role as TIPS and nominal bonds both represent a “short position
in the real interest rate) and leave the overall portfolio payoff profile unaffected by ensuring a
“hedged” real interest rate position. Next, by the moment the variable of inflation is changed as
well, the inflation protected issue will by its inherent nature still compensate for any change in the
price level. Here, one could as well observe some kind of hedge and inflation neutrality. However,
due to the short position taken for the nominal bond, which is indeed still exposed to the inflation
factor, the portfolio becomes effectively exposed with regards to price changes here. Finally,
summing up all the effect from above, one could indeed achieve exactly the desired hedge portfolio
of being exposed to inflation risk but not to real interest risk at the same time.

5. How does HMC develop its capital market assumptions?

HMC develop its capital market assumptions by means of investigating the risk and return
characteristics of the asset classes, its standard deviations, and correlations/covariance with each
other HMC tries to come up with a systematic asset allocation which optimizes the trade-off
between portfolio return variance minimization and given expected portfolio returns.

For this purpose the company retrieves data based upon real, inflation adjusted measures over a
long-run time horizon in order to gain statistical significant results for further analysis. The rates of
return are adjusted for the change in an economy’s price level as the real rate of return better
reflects dynamics of the underlying security, filtered from any external, merely inflation caused
returns – this in turn further enhances the comparability of the international asset classes in the
portfolio with each other due to the fact that HMC is invested on a global basis.

Within the sample, global securities (e.g. Foreign Equity, Emerging Markets, and Foreign Bonds)
might be affected by different macroeconomics variables and trends and therefore could underlie
different actual or expected inflation rate assumptions. Based upon this dataset HMC then conducts
a portfolio optimization analysis and constructs a so called efficient frontier, which shows the set of
portfolio asset combinations with the lowest risk for a given level of return an investor would be
willing to hold.

7. What are HMC's assumptions about expected return, volatility, inflation and interest rate risk
about TIPS?

While conducting its research, Harvard Business Company noted that for the period from 1997 to
late 1999, TIPS experienced a real yield within the range of 3, 2% to 4, 25%. Taking into account the
overall positive growth trend of these securities since their market introduction in 1997, HMC
assumed an average real return of 4% for long-term investments. Moreover, they estimated the
instruments volatility and correlation with all other asset classes, obtaining the following results: the
estimated standard deviation of 3% was incomparably lower than standard deviations of other
assets (median of 12%), thus providing the portfolio with a risk-decreasing factor. A second reason
why TIPS were a reasonable candidate for the company’s diversified portfolio were low correlations
with almost all other asset classes. The highest, 50% correlation between domestic bonds and
inflation indexed bonds was caused by the structure of both instruments: both have the same
underlying security.

9.Do TIPS have advantages / disadvantages beyond their mean-variance properties that make them
attractive class for investors with long investment horizons

 TIPS is that they do not bear any inflation risk, as op-posed to common Treasury Bonds.
 They are also protected against deflation, since the face value that is redeemed at maturity
will never be less than the initial face value, even though the nominal value of money has
decreased.
 In the long term, stocks have outperformed bonds in the past century. The reason for this
has been attributed to the unprecedented and unexpectedly high inflation rates in U.S.
during the 70’s. By holding TIPS, it is possible to maintain an acceptable degree of
performance for long term investments.
 Low correlation coefficients make them an attractive tool to diversify a portfolio. Their low
risk profile, even compared with standard Treasury Bonds, make them a good asset class for
a long term horizon, in which safe returns are often considered a priority.

Disadvantages

 TIPS can be counterproductive if the actual Inflation rate remains below the Break Even
Inflation rate (BEI). This usually happens if the actual inflation is far below the expected
inflation. In such a circumstance, an investor can be better off by holding normal bonds,
which already allocate a part of the yield to compensate investors for the inflation.
 TIPS have less liquidity than normal Treasury Bonds as they are traded less often.
 Long term TIPS may be unavailable at a certain point of time. Due to the risk for the issuer,
extremely long term TIPS can be hard to obtain, and having shorter maturities can alter the
portfolio structure of a long term investor.