The Harvard Management Company and Inflation-Protected Bonds

Group 1

Case Study 1 “The Harvard Management Company and Inflation-Protected Bonds”

Group members:

Name                 NetID

Weijia Pan         weijiap2

Nianfan Tang    nianfan2

Ningxin Ma       ningxin5

Hao Shi              haoshi4

1. Describe how TIPS are structured, in particular, how do coupons and principal vary with inflation/deflation and how are they taxed? Are they taxed more heavily than nominal bonds?

The TIPS’s structure: TIPS’s structure requires the principal and coupon of the bond to change based on the monthly level of inflation as determined by the CPI.

1. The principal value on any date equals the product of the stated value at issuance or par amount, times the index ration applicable to that date. The index ration is the reference CPI applicable to a particular valuation date divided by the reference CPI applicable to the original issue date.
2. Interest payments for a particular security are determined by multiplying the inflation-adjusted principal by one-half of the stated rate of interest on each semi-annual interest payment date.

Taxation: The taxation structure is similar to that of Treasury zero-coupon bonds. Any inflation adjustment that causes an accretion to principal is taxed in the period in which it is made. Therefore, when inflation occurs, TIPS are taxed more heavily than nominal bonds; when deflation occurs, TIPS are taxed less heavily than nominal bonds. Specially, when deflation occurs, the interest can be deductible, causing an investment tax credit.

2. If a TIPS bond was issued on December 15, 2001 with a principal amount of $1,000, what would be its accrued principal on December 15, 2017? Note that when a bond is issued in the middle of the month, the relevant lagged CPI is an average of CPIs for two prior months since CPIs reflect price levels at the beginning of a month. See http://research.stlouisfed.org/fred2/series/CPIAUCNS?cid=9 to answer this question.

Sep. 2001: CPI=178.300

Oct. 2001: CPI=177.700

Sep.15 2001 Average CPI= (178.300+177.700)/2=178

Sep. 2017: CPI=246.819

Oct. 2017: CPI=246.663

Sep.15 2017 Average CPI= 246.741

Inflation-accrued principal= F* 1000*246.741/178=1386.185[pic 1]

3. What is the rationale for investing Harvard University’s endowment fund in TIPS? Consider evidence in http://research.stlouisfed.org/fred2/series/CUUR0000SAE1?cid=32421 when giving an answer.

The historical data presents an upward trend of CPI, so TIPS have higher yield than U.S. nominal bonds. In details, TIPS had offered a real yield that ranged from 3.2% to 4.25%, while real yields on Treasury bills had been historically around 2%, and real yields on Treasury nominal bonds had been around 3%. In view of this relatively high yield on TIPS, and their inflation-protection characteristics, the mean-variance optimizations suggested that inflation-protected bonds were an attractive asset to hold in a portfolio. The analysis also suggested long positions in private equity commodities, real estate and emerging markets, at the expense of domestic equities and domestic bonds. Thus, the results of the analysis supported a move away from domestic equities and nominal bonds toward inflation-protected bonds.