Case Study the Harvard Mgt Company and Inflation - Protected Bonds

Case Study 1

The Harvard Management Company and Inflation-Protected Bonds

1. TIPS are treasury securities that adjust for inflation. Coupons and principals change proportionately to the changes of CPI. Thus, principal and coupon of a TIPS increase with inflation and decrease with deflation. TIPS pay interest (coupon) semi-annually at a constant rate based on the adjusted principal due to the inflation. When a TIPS matures, investors are paid the adjusted principal or original principal, whichever is greater.

Treasury securities including TIPS are exempt from state/local taxes and interests are taxed at the federal level. However, for TIPS, accretion to principal due to inflation is taxed when it is made. Income from corporate bonds is generally subject to federal, state and/or local taxes. Therefore, the taxation imposed on TIPS is higher than other treasury securities but lower than corporate bonds.

1. CPI in December 2001 is 176.700 (CPI at issuance), CPI in December 2014 is 234.812:

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1.  A short observation period from 2/1/1997 to 3/12/2001 saw TIPS performing well, providing a real yield ranging from 3.2% to 4.25% (Exhibit 3 in article). Since 2000s, CPI is rising at an increased rate, making it urgent to include TIPS that could guard the portfolio against inflation. Based on the mean-variance analysis conducted by the HMC team, the proposed portfolio including TIPS does improve the sharp ratio from 0.28 to 0.32 (+14.29%). This is mainly due to decreased volatility by 13.97%, partially offset by slightly decrease in the expected return.

Therefore, the rationale in TIPS is their inflation protection characteristics, and their low correlation with other assets in the portfolio to reduce the unsystematic risk.

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