Which to Hold Indexed or Conventional Bonds

Accepting that developed, liquid markets, such as that for Treasuries, are efficient, with near-perfect information available to most if not all participants, then the inflation expectation is built into the conventional Treasury yield. If the inflation premium understates what certain market participants expect, investors will start buying more of the index-linked bond in preference to the conventional bond. This activity will force the indexed yield down (or the conventional yield up). If, on the other hand, investors think that the implied inflation rate overstates expectations, they will buy more of the conventional bond. 

The higher yields of the conventional bonds compared with those of the index-linked bonds represent compensation for the effects of inflation. Bondholders will choose to hold index-linked bonds instead of conventional ones if they are worried about unexpected inflation. An individual s view on future inflation will depend on several factors, including the current macroeconomic environment and the credibility of the monetary authorities, be they the central bank or the government. Fund manj ers take their views of inflation, among other factors, into account in deciding how much of the TIPS and how much of the conventional Treasury to hold. Investment managers often hold indexed bonds in a portfolio j ainst 

In certain countries, such as the United Kingdom and New Zealand, the central bank has explicit infiation targets, and investors may believe that over the long term those targets will be met. If the monetary authorities have good track records, investors may further believe that inflation is not a significant issue. In such situations, the case for holding index-linked bonds is weakened. 

Indexed bonds real yields in other markets are also a factor in investors decisions. The integration of markets around the world in the past 20 years has increased global capital mobility, enabling investors to shun markets where infiation is high. Over time, therefore, expected returns should be roughly equal around the world, at least in developed and liquid markets, and so should real yields. Accordingly, index-linked bonds should have roughly similar real yields, whatever market they are traded in. 

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