Inflation-Linked Bonds for Strategic Asset Allocation

If one believes in a more sustained economic recovery in the near term than the more volatile one we have been witnessing over the past few years, and hence the inherent risk of accelerating inflation, Treasury inflation-protected securities (TIPS) could provide inflation protection to institutional investors as a diversifier and a hedging instrument. In this paper, we show that TIPS offer excellent diversification benefits to different types of investors. Given the expectations for the economy in coming years, and the diversification benefits that TIPS offer, we recommend that institutional as well as individual investors allocate approximately 20 percent of portfolios to inflation-linked bonds. There are four apparent reasons for this recommendation: (1) low and sometimes negative correlations with major asset classes, (2) expectation for higher probabilities of inflation surprises, (3) robust risk/return profiles of TIPS, and (4) an inherent need to match liabilities that increase in value as inflation rises