Can treasury inflation-protected securities safeguard investors from outward risk spillovers?

What is it about?

Documenting the interlinkages among assets that are widely used to hedge against inflation is crucial for investors, as the necessity to protect the investment portfolio is stronger under inflationary conditions. For this purpose, we investigate the volatility spillovers between Treasury Inflation Protected Securities (TIPS) and a battery of other assets perceived as inflation hedges, including bonds, gold, real estate, oil and equities. The applied methodology comprehends the time-varying parameter vector autoregressive (TVP-VAR) extension of the Diebold and Yilmaz (2012) approach for the period 1/1/2010-3/31/2022. Our results indicate that the assets under consideration are moderately interconnected and subjected to several exogenous shocks, such as the US-China trade war, the COVID-19 pandemic and the Russia-Ukraine war. Furthermore, we assess the hedging effectiveness of TIPS against each asset by estimating hedge ratios and optimal portfolios weights, before and after the spread of COVID-19 pandemic, by using conditional variance estimations (DCC-GARCH). The empirical findings show that the short position in the volatility of TIPS is proved to be an excellent hedge for all the sampled assets, with the exception of short-term Treasury bonds, and their hedging ability was improved during COVID-19.

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Why is it important?

This study investigates the connectedness between TIPS and various financial assets that are assumed to offset the effects of inflation, such as short-term (1-3 years), medium-term (7-10 years), long-term (20+ years) Treasury bonds, gold, real estate, oil and equities. We also encompass basic macroeconomic and financial variables within the system which might have affected the channel of the diffused shocks. Volatility spillovers are analyzed by implementing the time-varying parameter vector autoregressive (TVP-VAR) model of Antonakakis et al. (2020), which is based on the framework of Diebold and Yilmaz (2012), for the period 1/1/2010-3/31/2022. This framework has recently been applied in the works of Balcilar et al. (2021), Bouri et al. (2021) and Zhang et al. (2021). Moreover, we provide portfolio strategies with TIPS in order to quantify the diversification benefits that can be added to portfolios consisting of the remaining sampled assets. For this reason, we construct hedge ratios and optimal portfolio weights, by using conditional variance estimations (DCC-GARCH), in the spirit of Guhathakurta et al. (2020). As the COVID-19 pandemic heavily influenced asset price volatilities, we divide the sample period into pre-COVID-19 (1/1/2010-12/31/2019) and COVID-19 (1/1/2020-3/31/2022) periods and shed light on the ability of TIPS to perform as a hedging instrument against the risk deriving from volatility diffusion. In this way, investors would be aware of possible changes in their asset allocation in order to maximize portfolio effectiveness.

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