In the previous work Inflation-Protected Bond Rotation Strategy. We introduce an inflation indicator to form a bond allocation strategy under different environments, and we recommend holding inflation-protected treasuries in high inflation situations. However, during 2021, although the CPI index rises from 1.3% in January to 5.4% in July and has stayed at a high standard since then, the year-to-date return of the Treasury Inflation-Protected Security (TIPS) performs relatively flat compared to the increase in CPI index. In this report, we will discuss the reason behind it and provide a better operation to conquer the low return situation.
The driving factors of TIPS’ return are both interest rate and inflation. In our research, the correlation between mid-term inflation-protected Treasury ETF (TIP) return and 7-Year interest rate variation is -0.83 while the correlation between TIP’s return and mid-term inflation proxy is 0.21. The interest rate variation has more influence than the inflation part in TIP’s return.
Based on the findings, we try to develop a way to eliminate the interest rate risk. Using the idea of duration, which represents interest rate risk, and duration matching, a strategy is used to manage interest rate risk. We present a simple strategy that long the inflation-protected Treasury ETF and short the normal Treasury ETF with a similar duration. The strategy has two combinations: the combined-long-term strategy and the combined-mid-term strategy. Below we show the performance of the two combined strategies and the ETFs in 2021. The combined strategy has a higher and more stable return than inflation-protected treasury only, and both approaches bring a superior Sharpe ratio compared to individual ETFs.
AVP of Quantitative Finance, Gamma Paradigm Research