3.31.2005

Q: Explain the spread between the yield of a TIP strip...

...and a nominal Treasury strip with the same maturity.

A: Since a nominal strip is more liquid than a TIP strip, it should provide a lower yield. But the nominal strip presents the possibility that it will pay the par amount when the actual inflation risk is a lot higher than what it was expected to be at the time of purchase. This is less of an issue with the TIP security, therefore the TIP strip should provide a lower yield.

Both strips are subject to taxation on accrual. This penalization is more severe for TIP since it is taxed on the inflation accrual as well. The inflation risk premium is also present in TIP due to the lag in the TIP indexing process.

Category: C++ Quant > Debt

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