The Harvard Management Company and Inflation-Protected Bonds

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The Harvard Management Company (HMC) is the organization that actively manages the assets of Harvard University. Overseeing a total of $19 billion in assets, HMC had managed to achieve an average real return of 11.3% during the 90’s, 9.1% above the average return of US T-Bills and 3.6% below US equities. With a target of 6%-7% average real return, HMC’s goals are to correctly measure Harvard University’s financial requirements and to provide investment opportunities that will accurately meet or exceed them with the lowest amount of risk assumed by the institution. In order to determine the relevance of each asset on its diversified portfolio, HMC is considering three factors: expected future returns, volatility of real returns and correlation of real returns on each asset class with those on all other asset classes. In Exhibit 1 of the report we observe the portfolio composition of Harvard’s portfolio from 1984 until 2010.

Through the use of historical data and mean-variance analysis, HMC was in a position to identify the portfolio that best suits its needs and considers making changes to it only in response to (1) changes in the goals or risk tolerance of the university as an institution, (2) changes in capital market assumptions, or (3) the appearance of a new asset class in the market. The 1997 introduction of TIPS in the US market seemed to satisfy both conditions 2 and 3, as described next.

Treasury Inflation-Protected Securities (TIPS)

TIPS are inflation indexed bonds issued by the US treasury. While such bonds had been issued before 1990 in other countries (Exhibit 2), they made their first appearance in the US in 1997. They are designed to approximate real bonds with payouts that are constant despite inflation surprises. They are quoted in terms of a real interest rate and are issued mostly at long maturities greater than 10 years. The principal on these bonds grows with a pre-specified price index, which in the U.S. is the Consumer Price Index (CPI-U), while the coupons are equal to the inflation-adjusted principal on the bond times a fixed coupon rate. Thus the coupons on these bonds also fluctuate with inflation.

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In general, TIPS have a low correlation with other asset classes and a very low default risk. In times of high inflation, they protect investors from loss on their real returns, whereas in the US the final payment of their principal is protected against deflation. However, their coupons are not, and therefore, the inflation-adjusted value of the principal for coupon computation purposes can fall below the initial value at issuance1. It is clear that in periods of substantial inflation uncertainty, TIPS are an attractive bet. In Exhibit 3 we can observe the values of inflation from 1914 until 2011.

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