This paper takes a new look at the market for Index-Linked Debt in the U.K.. I begin by clarifying the theoretical links between the observed prices of nominal and index-linked debt, and the term structure of real interest rates. On basis of this analysis, I then advocate a new methodology for studying the data. This involves first estimating the "index-linked term structure" which summarizes the information in index-linked bonds. The term structure of real interest rates can then be derived from an asset pricing model estimated from the index-linked and nominal yield curves.
Several important findings emerge from my analysis of the U.K. data. First, there is strong evidence to reject the joint hypothesis of no (or constant) inflation risk premia and rationally anticipated inflation. Second, my estimates of the real term structure differ significantly from those derived in earlier studies that assumed a constant or zero risk premium. Together these findings imply that is difficult to accurately track movements in expected inflation from the behaviour of conventional and index-linked bond prices. Third, there is evidence that market participants have been willing to pay a significant premium for index-linked bonds in return for the inflation insurance they provide. This raises the possibility that a change in policy towards the issuance of index-linked debt could have substantial fiscal benefits to the U.K. Government.
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