How do I construct an inflation-linked bond portfolio for real return objectives?

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AcadiFi · Accepted Answer

Inflation-linked bonds (TIPS in the US, linkers abroad) preserve purchasing power by indexing principal to CPI. Portfolio design for Featherstone Endowment's $250M real-return sleeve. Sizing. Inflation-sensitive liabilities (spending growth at CPI + 2%) justify 20-40% of fixed income in TIPS depending on inflation hedging priority. For $1B total fixed income with high inflation concern, 30% = $300M TIPS. Maturity selection. TIPS available at 5, 10, 20, 30-year auctions. Match to liability horizon: endowment with 15-30 year payout period weights intermediate and long TIPS. Ladder: 20% 5-year, 40% 10-year, 30% 20-year, 10% 30-year gives real duration ~11 years. Real vs nominal duration. TIPS have real duration (sensitivity to real yield changes) similar to nominal bond duration at same maturity. A 10-year TIPS has real duration ~9 years, meaning a 100 bp real yield increase drops price ~9%. TIPS also have implicit negative duration to inflation expectations: rising breakevens hurt nominals but not TIPS. Breakeven inflation. 10Y breakeven = 10Y nominal yield - 10Y TIPS real yield. Currently ~2.3% means market expects 2.3% average CPI. Buy TIPS when you believe realized inflation will exceed breakeven. Liquidity. TIPS market is ~$2T but 10-30x less liquid than nominal Treasuries; bid-ask 5-15 bps on benchmarks, wider on off-the-run. Avoid selling in stressed markets (March 2020 TIPS bid-ask widened to 100+ bps). Global diversification. Consider UK gilts, French OATi, German Bundei, Japanese JGBi for 20-30% of the sleeve to diversify inflation risk across jurisdictions; currency-hedge to base. Overall real return target 1.5-2.5% above CPI net of fees.

How do I construct an inflation-linked bond portfolio for real return objectives?

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