An Analysis of the Determinants of Inflation‐linked Bond Prices in Korea

• Author: Jangkoo Kang,Soonhee Lee
• DOI: http://doi.org/10.1111/ajfs.12232
• Published date: 01 October 2018
• Date: 01 October 2018

An Analysis of the Determinants of

Inflation-linked Bond Prices in Korea*

Jangkoo Kang

College of Business, KAIST, Republic of Korea

Soonhee Lee**

School of Business Administration, Kyungpook National University, Republic of Korea

Received 28 August 2015; Accepted 16 December 2017

Abstract

We estimate term structure using Korean financial data such as nominal spot rates, monthly

inflation rates, and a survey of inflation forecasts, and examine the factors affecting Korean

inflation-linked bond prices. Inflation-linked bond market yields are higher than the model

yields generated using the term structure and the market-model yield differential is explained

by the expected inflation rate, on-the-run/off-the-run spread, trading volume, and bond fund

cash flows. This shows that inflation-linked bond investors understand the additional benefit

of the tax exemption on the notional amount increment caused by inflation that the term

structure model ignores, and the inflation-linked bond price is also affected by liquidity and

supply–demand pressure.

Keywords Inflation-linked bond (IL bond); Inflation risk; Liquidity risk; Tax exemption

JEL Classification: E43, E44, G12

1. Introduction

Among government-issued securities, inflation-linked bonds (IL bonds) are unique

because they provide protection against inflation.

1

For a plain nominal Treasury

bond, the principal and coupons are fixed for the bond’s life. In contrast, the

principal and coupons of an IL bond vary depending on the price level, so that IL

bond investors are protected against inflation. As IL bonds and nominal bonds are

*The work reported in this paper was supported by the Korea Exchange in 2017.

**Corresponding author: Kyungpook National University, 80 Daehakro, Bukgu, Daegu

41566 Korea. Tel: +82-53-950-5436, Fax: +82-53-950-6247, email: soon0573@gmail.com.

1

The bonds protecting against inflation risk are commonly called inflation-linked bonds.

They may have other names, such as Treasury-inflation Protected Securities (TIPS) in the

United States; Inflation Linked Gilts (ILGs) in the United Kingdom; and Real Return Bonds

(RRBs) in Canada. In Korea, IL bonds are called Inflation-linked Korea Treasury Bonds

(KTBi). In this study, we use the term Inflation-linked bonds (IL bonds).

Asia-Pacific Journal of Financial Studies (2018) 47, 605–633 doi:10.1111/ajfs.12232

©2018 Korean Securities Association 605

financial instruments giving real and nominal returns, respectively, market partici-

pants such as policy-makers or finance professionals seek to get information on real

interest rates and future expected inflation from the prices of these assets. However,

making an inference about future expected inflation by using these bonds is a non-

trivial exercise. The reason is that the difference between nominal and IL yields of

comparable maturities —also known as inflation compensation or break-even

inflation rate —does not represent a clean measure of future inflation expectations

due to the inflation risk premium and distinctive features of IL bonds, such as the

indexation lag of the IL cash flows and the liquidity differential relative to nominal

bonds. Numerous studies have examined these issues, which can be broadly catego-

rized into two lines of research.

The first line of research focuses on the estimation of risk premium. These stud-

ies predefine risk components priced in bonds and examine the risk premium using

data such as IL bonds, nominal government bonds or rate of inflation, assuming IL

bonds and nominal government bonds are fairly priced. Chen et al. (2010) estimate

the inflation risk premium using the modified quadratic term structure model and

show that the premium is related to the shape of the term structure of nominal

interest rates. Christensen et al. (2010) also estimate the inflation risk premium

using the no-arbitrage Nelsen–Siegel model and show that the expected inflation

calculated by subtracting the inflation risk premium from the break-even inflation

rate predicts future inflation even better than the break-even inflation rate. Grish-

chenko and Huang (2013) estimate the inflation risk premium, taking into account

liquidity and find that the premium does not exceed 10 basis points.

The second line of research examines the technical factors that affect IL bond

prices and, consequently, inferences about real rates and expected inflation. Evans

(1998) and Grishchenko and Huang (2013) show that the indexation lag may dis-

tort the reading of the real rates implied by IL bond prices for UK gilts or United

States Treasury-inflation Protected Securities (TIPS), respectively. Bardong and

Lehnert (2008), Haubrich et al. (2012), and Fleckenstein et al. (2014) show that the

United States TIPS are considerably underpriced, compared with the nominal Trea-

sury bonds. Fleckenstein et al. (2014) explain TIPS mispricing using the factors that

capture availability of funding and liquidity risk. Grishchenko and Huang (2013)

and D’Amico et al. (2016) show that the liquidity premium embedded in TIPS

prices can be substantial, as was the case during the initial years of the TIPS market

and during the financial crisis of 2008–2009. G€

urkaynak et al. (2010) and Kajuth

and Watzka (2011) show that the nominal-TIPS yield differential is related to liq-

uidity factors such as on-the-run/off-the-run spread, trading volume, and the

spread between Resolution Funding Corporation (REFCO) and Treasury STRIPS.

Pflueger and Viceira (2013) show that TIPS prices are affected by real and liquidity

risk premiums while nominal Treasuries are affected by inflation and real risk

premiums. Huang and Shi (2016) find an additional factor explaining TIPS prices

that is orthogonal to the information contained in cross-sectional TIPS yields —

similar to the hidden factor in Duffee (2011).

J. Kang and S. Lee

606 ©2018 Korean Securities Association