The impact of liquidity on inflation-linked bonds: A hypothetical indexed bonds approach

• We calculate hypothetical ILB yields in the vein of Campbell and Shiller (1996).
• We present a new strategy for estimating the liquidity premium in ILB yields.
• We find significant effects of liquidity measures for the US, the UK and Canada.
• We derive liquidity-adjusted break-even inflation rates.
• For the US, we estimate the inflation risk premium.

Sovereigns mainly issue inflation-linked bonds (ILB) in order to save money. More than 15 years’ experience with this financial instrument in the United States has led to the conclusion that these bonds are characterized by low liquidity issues. Recently, various papers have started to analyze the impact of liquidity on ILB yields. This paper develops a new strategy for estimating the liquidity premium based on Campbell and Shiller's (1996) hypothetical ILB yields. We find significant effects of ILB-specific liquidity measures for the United States, the United Kingdom and Canada. Based on these findings, we derive the liquidity premium in ILB yields, liquidity-adjusted estimates for the break-even inflation rate and the inflation risk premium. In the United States, for instance, the average of the liquidity premium is 0.56%-points, and the average liquidity-adjusted break-even inflation rate and inflation risk premium amount to 2.67%-points and 0.22%-points, respectively.