Asset Allocation with Conventional and Indexed Bonds

A series of hypothetical indexed bond returns is created using historical yields on conventional Treasury bonds and an inflation-forecasting model. We find that the real (inflationadjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation between stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio. These conclusions are supported by analysis of the short history of actual returns on TIPS (Treasury inflation-protected securities).