Liquidity Premium and Return Predictability in U.S. Inflation-Linked Bonds Market

This paper discusses the predictive role of alternative measures of the liquidity premium of TIPS relative to Treasury bonds for government excess bond returns. The results show that the liquidity premium predicts positive (negative) TIPS (nominal Treasury) excess returns. The explanatory power of the TIPS liquidity premium is statistically significant and economically meaningful for short-term excess TIPS maturities and for long-term nominal Treasury bonds. I also find that the out-of-sample forecasting power of liquidity for nominal Treasury excess returns appears to have been addressed by the events during the recent financial crisis. By contrast, I have evidence of out-of-sample forecasting ability during both normal and bad times for TIPS' excess returns