Harvard Management Co and Inflation Protected Bonds free essay sample

The Harvard Management Company is an entity wholly owned by Harvard University and it is responsible for managing Harvard’s endowment and pension assets. At the end of the second quarter of 2000, Harvard Management Co. oversaw the management of $19 billion, the majority of it managed internally by Harvard’s investment professionals. The endowment’s goal is to provide a real return of 6%-7%, of which 4%-5% would be distributed annually to the university and the balance of returns would remain to allow for a real growth rate of spending. As of the second quarter of 2000, Harvard was actively considering creating an allocation to Treasury Inflation Protected Securities (TIPS) in its Policy Portfolio. Harvard believed the portfolio weights should be changed due to changes in capital market assumptions and the rise of TIPS as an institutional-level investment. TIPS Versus Nominal Treasury Bonds Like many institutional portfolios, Harvard’s portfolio contained an 11% target allocation to domestic bonds. We will write a custom essay sample on Harvard Management Co and Inflation Protected Bonds or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Including US Treasury securities as substantial portion of this allocation would allow Harvard to earn a market return on a fixed income instrument without having to worry the credit risk. However, investing in Treasuries carries significant risks such as interest rate risk and inflation risk. Traditional Treasury securities consist of a par value of a bond and a state coupon rate, which is paid semiannually. The payments are fixed throughout the life of the bond, but the real value of the principal at maturity can be significantly different that the beginning of the investment due to inflation, or a loss in the purchasing power of money. Traditional Treasuries do not adjust their principal and interest payments due to changes in the inflation rate. TIPS are different in that their principal value adjusts to increases in the Consumer Price Index (CPI). The CPI is a measure that examines the weighted average of prices of a basket of consumer goods and services. Changes in the CPI are used to assess price changes associated with the cost of living, and it is an indicator of the level of inflation. The coupon payments naturally adjust to inflation since the coupon payment is always based on the inflation adjusted principal of TIPS. Harvard views TIPS as a favorable investment because they would provide an inflation adjusted return, which is a central focus of Harvard’s investment strategy. TIPS will outperform regular Treasuries in an environment where inflation is greater than expected. Expected inflation is measured by the nominal Treasury yield of a given maturity minus the TIPS yield of the same maturity. If real inflation is greater than this expected inflation, then TIPS would end up a higher return than the corresponding nominal Treasury bond. Harvard seeks to add value to its portfolio by protecting part of its fixed income exposure against inflation risk. Comparing Interest Rate Risk and Inflation Risk of TIPS and Nominal Treasuries A rise in real interest rates would drive the price of TIPS down. A rise in real interest rates would imply a rise in nominal rates holding inflation constant or a fall in inflation holding nominal rates constant. A rise in real rates would drive the price of TIPS down just as a rise in rates drives the price of nominal Treasuries down; the present value of the bond’s cash flows would be driven down by higher interest rates. A fall in inflation or outright deflation would lower the expected value of cash flows from a TIPS investment, resulting in lower prices. Additionally, increases in realized inflation will not affect the market value of TIPS, all else equal. This is because markets are forward looking and would have already priced in the increase in the principle value of TIPS. Increases in expected inflation will increase the value of TIPS as investors bid up prices in anticipation of higher realized inflation in the future. In contrast, nominal Treasuries will fall in value as inflation expectations increase. Nominal Treasuries fall in value because investors demand higher yields so that they can earn a return above inflation. As the market perceives inflation risk to be higher, investors will seek the safety of inflation protected securities (TIPS) thus driving their prices higher. Nominal Treasury bond prices fall due to increases in actual inflation, expected inflation, and heightened inflation risk. . The chart below shows the average annual inflation over several decades. As you can see, inflation over the long term has been approximately 3. 24%.