Case Study 2

The Harvard Management Company

and Inflation Linked Bonds (2001)
HMC's Mission Statement

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
HMC Background
• The organisation that actively manages the assets of
Harvard University.
• HMC manages 68% of endowment assets internally
• Employs 180 with 38 as investment professionals
• Endowment, pension assets, working capital,
other: total $19 billion
• Last 10 years HMC provided real return of 11.3%
• Over same period U.S treasury bills: 2.2%, U.S equities:
15.8%

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
Policy Portfolio (goals)
• Determined by board, but management allowed to
make short run tactical adjustments

• Designed to fulfill growth goals of the endowment.

• Estimated, to achieve these goals, they need an

average real return on the endowment of between 6% &
7%

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
Policy Portfolio (components)
• Consists of 11 wide asset classes
Type of Asset Policy
Domestic Equity 32
Foreign Equity 15
Emerging Markets 9
Private Equity 15
Absolute Return 4
High Yield 2
Commodities 5
Real Estate 7
Domestic Bonds 11
Foreign Bonds 5
Cash -5

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
Policy portfolio (analysis)
• HMC determined relevance of each asset by
considering: expected future returns, volatilty of real
return, correlation of real returns on each asset class
with the real returns on all other asset classes.

• Used historical data to estimate this.

• Determined portfolio implications using mean-variance

analyses: which combinations of assets lower risk &
increase return (ie, are on the efficient frontier)

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
TIPS performance
See exhibit 3: (from handout)
• HMC used data based on the last 3 years and also
compared TIPS to similar assets like commodities
(which also offer protection against inflation)
Since 1997:
o Real return rate of between 3.2% and 4.25%
o Real yields on treasury bills have only been around
2%Treasury nominal bills around 3%

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
HMC’s final Recommendations

•HMC evaluated TIPS using mean-variance analyses

based on estimated data.
•Also reviewed how other Universities were allocating their
portfolios
•HMC recommended a new Policy Portfolio with a new

position of TIPS 7%

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
Recommended Policy Portfolio
Type of Asset Old Policy Portfolio New Policy Portfolio
Domestic Equity 32 22
Foreign Equity 15 15
Emerging Markets 9 9
Private Euqity 15 15
Absolute Return 4 5
High Yield 2 3
Commodities 5 6
Real Estate 7 7
Domestic Bonds 11 7
Foreign Bonds 5 4
Inflation-Indexed 0 7
Cash -5 0

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
What are TIPS?

• Inflation linked bonds issued by the US treasury

• First issued in 1997
• Around US$500 billion on issue
• Offered on 5, 10 and 20, year terms
• Are marketable securities
• Principal is marked to CPI
• Pay coupons semi-annually

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
What are Inflation Linked Bonds?

• Total of US$1.5 trillion on issue

• Mainly issued by governments
• Principal is indexed to inflation
• Removes exposure to inflation
• Fairly low correlation with other asset classes

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
Associated Risks
• Perform poorly with sharp interest rates rises
• Potential difference with CPI and actual inflation
• Return declines in deflationary environment
• Possible, but highly unlikely default risk

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
How do TIPS work?
• Yields are linked to inflationary expectation
• If the yield on treasuries is 2.5%, and the yield on
TIPS is 2%, inflation the TIPS duration is
expected to be 0.5%.
• Coupon payment changes with principal value
• i.e. CP = Principal x Coupon Rate
• At maturity the higher of original or adjusted face
value is returned to investor

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
How do TIPS work?
Lets say a:
• Principal value is $1,000
• The coupon rate is 2%
• Thus the coupon payment would be $20
• However, if the CPI increased by 5% the principal
value would increase to $1,050
• The coupon rate remains at 2%, however the
interest payment is inflated to $21 ($1,050 * 2%)

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
How do TIPS work? - Principal

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
How do TIPS work? - Coupon Payment

Case Study 2: The Harvard Management

Company and Inflation Linked Bonds (2001)
When would TIPS OUTperform/
UNDERperform regular Treasuries?
what is a regular US treasury security?
• Govt Debt
• Provides a Fixed interest payment until maturity
• Carry different maturities based on T-Bills, T-Notes, T-
Bonds
• Very Liquid
• No Credit or Default risk- (backed by the Govt.)
• Subject to high Inflation and Interest Rate risk
• Avoid long-term maturity unless you trust that the inflation
rates and the interest in the market will be lower.
 Regular Treasuries vs. TIPS

• If inflation is lower than expected, regular Treasuries will be

a better investment than TIPS.
• If inflation is higher than expected, TIPS will be better.
• Inflation can erode the value of regular Treasuries
• if inflation remains low, TIPS holders receive lower returns
than what they could receive with regular Treasury notes
and bonds for the same maturity period.
• TIPS principal is adjusted strictly- with CPI changes, the
value of the principal can go down from a peak it's already
reached but never will go below original face value
SO..What happens to TIPS if deflation
occurs?

The principal is adjusted downward, and your interest

payments are less than they would be if inflation occurred or
if the Consumer Price Index remained the same. You have
this safeguard: at maturity, if the adjusted principal is less
than the security's original principal, you are paid the original
principal.

In a period of substantial inflation uncertainty (e.g., now), TIPS

are an attractive bet. You get inflation protection if prices rise,
but you get your full nominal principal back at maturity if prices
fall.
example

You have a Billion Bucks (BB) and you are thinking about
buying either regular treasuries or TIPS Today? Treasury
yields are 3% and TIPS is 3.5%? where do you want to put
your BB is you expect a expect CPI inflation at 3%, .5%, or
-2%?
There are 4 criteria for determining an
asset class:
• The asset class should be relatively independent of other
asset classes already in the portfolio
• An asset class should be comprised of homogeneous
investments
• An asset class should have the capitalization capacity to
absorb a meaningful fraction of the investor’s portfolio
• An asset class should be expected to raise the utility of the
investor's portfolio without selection skill on the part of the
investor
Correlation between TIPS and the other
securities in the portfolio
 But why doesn't TIPS satisfy the 4th
criterion of asset class categorization?
Sharpe Ratio = Rp - Rf
σ
Asset class effect on Sharpe ratio
New portfolio

– Foreign Equity
– Commodities
– Foreign Bonds
– TIPS

• In this new portfolio, when TIPS is removed, the

Standard Deviation (Volatility) increases and the
Sharpe ratio falls from .21 to .17
>>> A decrease of 23.5%