PrefBlog

Here’s an interesting paper partly about TIPS liqudity, titled The Microstructure of the TIPS Market by Michael J. Fleming and Neel Krishnan:

• • The potential advantages of Treasury inflationprotected securities have yet to be fully realized, mainly because TIPS are not as liquid as nominal Treasury securities.
• • The less liquid nature of TIPS may adversely affect prices relative to those of nominal securities, offsetting the benefits of TIPS having no inflation risk.
• • A study of TIPS, using novel tick data from the interdealer market, provides new evidence on the liquidity of the securities and how liquidity differs from that of nominal securities.
• • Analysis of various liquidity measures suggests that trading activity and the incidence of posted quotes may be better cross-sectional gauges of TIPS liquidity than bid-ask spreads or quoted depth.
• • Differences in intraday trading patterns and announcement effects between TIPS and nominal securities likely reflect the different use, ownership, and cash-flow attributes of the securities

…
These potential benefits have not been fully realized, mainly because TIPS lack market liquidity compared with nominal securities.{2} This lack of liquidity is thought to result in TIPS yields having a liquidity premium relative to nominal securities, which offsets the inflation risk premium.{3} Similarly, the presence of a liquidity premium in TIPS yields complicates inferences of inflation expectations, particularly if the premium changes over time. However, despite the importance of TIPS liquidity and the market’s large size ($728 billion as of November 30, 2011), there has been virtually no quantitative evidence on the securities’ liquidity.

Footnote 2: Market liquidity is defined here as the cost of executing a trade, which can depend on the trade’s size, timing, venue, and counterparties. It is often gauged by various measures, including the bid-ask spread, the price impact of trades, quoted depth, and trading activity.

Footnote 3: D’Amico, Kim, and Wei (2008) estimate that the liquidity premium was about 1 percent in the early years of the TIPS program. Pflueger and Viceira (2011) find that the liquidity premium is around 40 to 70 basis points during normal times, but was more during the early years of TIPS and during the 2008-09 financial crisis. Sack and Elsasser (2004) argue that TIPS have not reduced the Treasury’s financing costs because of several factors, including lower liquidity. Roush (2008) finds that TIPS have saved the government money, except during the early years of the program. Dudley, Roush, and Ezer (2009) show that the ex ante costs of TIPS issuance are about equal to the costs of nominal securities issuance.
…
Our study proceeds as follows. Section 2 discusses institutional features of the market for TIPS. In Section 3, we describe the tick data used in our empirical analysis. Section 4 reports our empirical results, including trading activity by sector, the liquidity of on-the-run and off-the-run securities, price impact estimates, intraday patterns in trading activity and liquidity, and the effects of major announcements. Section 5 concludes.
…
Our analysis of the TIPS market identifies several microstructure features also present in the nominal Treasury securities market, but several unique features as well. As in the nominal market, there is a marked difference in trading activity between on-the-run and off-the-run TIPS, as trading drops sharply when securities go off the run. In contrast to the nominal market, there is little difference in bid-ask spreads or quoted depth between these securities, but there is a difference in the incidence of posted quotes. The results suggest that trading activity and quote incidence may be better crosssectional measures of liquidity in the TIPS market than bid-ask spreads or quoted depth.

Intraday patterns of trading activity are broadly similar in the TIPS and nominal markets, but TIPS activity peaks somewhat later, likely indicating differences in the use and ownership of these securities. Announcement effects are also different, probably reflecting the types of information most important to the particular securities. The employment report is the most important announcement in the nominal market, but it elicits relatively little response in the TIPS market in terms of trading activity. In contrast, announcements of the consumer price index and the results of TIPS auctions precipitate significant increases in TIPS trading activity, likely indicating these announcements’ particular importance to TIPS valuation

There’s also Trading Activity and Price Transparency in the Inflation Swap Market by Michael J. Fleming and John R. Sporn:

• • Liquidity and price transparency in derivatives markets have become increasingly important concerns, yet a lack of transaction data has made it hard to fully understand how the inflation swap and other derivatives markets work.
• • This study uses novel transaction data to shed light on trading activity and price transparency in the rapidly growing U.S. inflation swap market.
• • It reveals that the market is reasonably liquid and transparent, despite its over-the-counter nature and low level of trading activity. Transaction prices are typically near widely available end-of-day quoted prices and realized bid-ask spreads are modest.
• • The authors also identify concentrations of activity in certain tenors and trade sizes and among certain market participants as well as point to various attributes that explain trade sizes and price deviations.

…
Several recent studies have compared the inflation swap rate with breakeven inflation as calculated from Treasury inflationprotected securities (TIPS) and nominal Treasury bonds.1 The two market-based measures of expected inflation should be equal in the absence of market frictions. In practice, inflation swap rates are almost always higher, with the spread exceeding 100 basis points during the recent financial crisis.
…
Our data set contains 144 U.S. dollar zero-coupon inflation swap transactions, or an average of 2.2 transactions over the 65 trading days in our sample.9 Daily notional trading volume is estimated to average $65 million. Three-quarters (108/144) of the transactions are new trades, 24 percent (35/144) are assignments of existing transactions (whereby one counterparty to a swap steps out of the deal and assigns its position to a new counterparty), and 1 percent (1/144) are cancelations. One new transaction has a forward start date, for which the accrual period begins two years after the trade date, with the remaining 107 new transactions starting two or three business days after the trade date.
…
We also identify a concentration of activity among certain market participants. In particular, 54 percent (78/144) of our trades are between G14 dealers, 39 percent (56/144) are between G14 dealers and customers, and 7 percent (10/144) are between customers. Of the new trades between G14 dealers and customers, the G14 dealer receives fixed 63 percent (19/30) of the time and pays fixed 37 percent (11/30) of the time.11 New trades in which dealers receive fixed are larger, so that dealers receive fixed for 81 percent of new contract volume. That is, dealers are largely paying inflation and receiving fixed in their interactions with customers.
…
Our analysis of a novel transaction data set uncovers relatively few trades—just over two per day –in the U.S. zero-coupon inflation swap market. Trade sizes, however, are large, averaging almost $30 million. Sizes are generally larger for new trades, especially if they are bulk and allocated across subaccounts, and tend to decrease with contract tenor. We also identify concentrations of activity—with 45 percent of trades at the ten-year tenor, and 36 percent of all trades (and 48 percent of new ones) for a notional amount of $25 million. Over half the trades (54 percent) are between G14 dealers, 39 percent are between G14 dealers and other market participants, and 7 percent are between other market participants. We identify just eighteen market participants during our study’s sample period, made up of nine G14 dealers and nine other market participants.

Despite the low level of activity in this over-the-counter market, we find that transaction prices are quite close to widely available end-of-day quoted prices. The differential between transaction prices and end-of-day quoted prices tends to decrease with tenor and increase with trade size and for customer trades. By comparing trades for which customers pay fixed with trades for which they receive fixed, we are able to infer a realized bid-ask spread for customers of 3 basis points, which is consistent with the quoted bid-ask spreads reported by dealers.

In sum, the U.S. inflation swap market appears reasonably liquid and transparent despite the market’s over-the-counter nature and modest activity. This likely reflects the fact that the market is part of a larger market for transferring inflation risk that includes TIPS and nominal Treasury securities. As a result, inflation swap positions can be hedged quickly and with low transaction costs using other instruments, and prices of these other instruments can be used to efficiently price inflation swaps, despite modest swap activity

Not exactly the world’s biggest market! I looked up inflation swaps because I was interested in the question “Who the hell pays inflation”, which came to mind due to this article in the Globe, The government ditched inflation-protected bonds – companies should start issuing their own by JOHN H. COCHRANE AND JON HARTLEY:

If the government won’t do it, corporations, banks and financial institutions should issue these bonds themselves rather than just complain. Not every asset must be provided by the government.
…
If the government won’t do it, however, there is no reason that the government’s critics can’t issue them. Companies can issue real return bonds, as they already issue U.S. dollar bonds. Banks can offer real return accounts and certificates of deposit.

If the government steps out of the market, there’s all the more demand for private issuers to step in. Pension funds desperate to replace vanishing inflation-indexed government bonds are natural clients. Company profits rise and fall with inflation, so they have a natural incentive to issue bonds whose payments rise and fall with inflation. Even mortgage rates could rise and fall with an index of wages.

Why not? Broadly, this reluctance seems one more symptom of an overleveraged, overregulated, government-dependent and not very competitive or innovative banking and financial system. Banks and other financial institutions only want to issue or expand a new product if they can quickly lay off the risk onto the government, and earn steady fees. The model of issuing equity to bear risk and then offering a profitable innovative product to consumers is too out of fashion.

Frankly, I thought the article was naive, but thought: “Who the hell would issue these things? Who’s got a natural hedge against inflation that they might want to offload? Assuming they can recover the ultra-massive liquidity premium there’s gonna be on a, say, 1-billion long-term linker issue from a corporation, that is.” All I could think of was utility companies who have long-term assets currently financed by long-term nominal bonds, with the assets producing commodity-linked revenue. Maybe they could finance with linkers instead? Maybe pipelines? So, I started looking for information on inflation swaps …

I can’t answer the question definitively. The authors of the swaps paper didn’t investigate where the open interest is lodged. But there is enough information in the paper that I’m willing to bet a nickel (a full nickel, mind you, not just a few pennies) that it’s the dealers. The dealers will pay inflation and they buy TIPS to hedge. BORRRRRRR-ING! And it doesn’t work without government-issued linkers.