Pricing treasury inflation protected securities

Abstract

Essay 1: Academics and practitioners perceive Treasury Inflation-Protected Securities (TIPS) to be tax disadvantaged relative to their nominal counterparts because the tax code requires investors to pay annual income taxes on the inflation adjustments made to the principal. The only caveat is if the investor holds the inflation-protected security in a nontaxable account. This paper investigates the price of TIPS for a positive income tax rate to see if the marginal investor considers the tax consequences of owning the security. From 2002 to 2004, I find some evidence of a positive marginal tax rate in the price of TIPS. From 2005 to 2010, I show that the price of TIPS and nominal Treasury notes and bonds do not include economically meaningful marginal tax rates. Although differences may exist in the tax code, the findings suggest the marginal investor does not price the unique tax treatment.

Essay 2: Treasury Inflation-Protected Securities (TIPS) are distinctive assets that compensate investors for inflation by adjusting the principal value, and subsequently interest payments, for changes in the non-seasonally adjusted urban Consumer Price Index. In this essay, I propose the addition of a constant term, “alpha,” to the theoretical bond pricing equation. The objective is to test for a significant alpha in the monthly cross-section of TIPS prices from January 2002 to December 2010. The results suggest a significant alpha exists in the price of TIPS. For comparison, I also investigate the price of nominal Treasury notes and bonds for a significant alpha. I find evidence of a significant alpha in the price of nominal securities, but the parameter estimates are not economically meaningful. The empirical findings suggest that the inclusion of an alpha is necessary when modeling TIPS prices.