An Empirical Analysis of the Liquidity and Tax Disadvantage of TIPS and Their Effect on Treasury Borrowing Costs

Treasury Inflation Protected Securities (TIPS) are unique in that they are inflation-indexed, default risk-free bonds. However, TIPS are not free from all risk— they are still subject to liquidity risk (due to a thin secondary market) and tax disadvantage risk (due a specific tax liability in their cash flows).In this thesis, I demonstrate through various empirical models that liquidity and tax disadvantage premia are priced into TIPS yields in order to compensate for these risks. I determine that since mid-2004 the TIPS liquidity premium is relatively stable and averages 27 bp. My results also weakly support a time-variant TIPS tax disadvantage premium that averages 56 bp over the same time period. Furthermore, I find that these two premia are principally driven by the uncertain volatility of expected future inflation. Consequently, as a result of these premia, it is on average 3 bp more expensive for the Treasury to issue a TIPS rather than a conventional nominal bond, which has cost the Treasury over $221 million. So why does the Treasury continue to issue TIPS if they do not in fact lower borrowing costs, as was the intention of the program? It is possible that TIPS offer several nonmarketable public benefits that offset their additional cost, thus making the program worthwhile for the Treasury and market participants alike.