Asset Allocation with Inflation-Protected Bonds

In the study reported here, we set out to examine whether and how the availability of indexed bonds might affect investors' asset allocation decisions. We used historical yields on conventional U.S. T-bonds and an inflation-forecasting model to create a series of hypothetical indexed bond returns. We found that the real (inflation-adjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation among stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio. These conclusions are generally supported by analysis of the history of actual returns on U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) for February 1997 through July 2003.