“Asset Allocation with Inflation-Protected Bonds." Kothari & Shanken

Kothari S. P. and J. Shanken, “Asset Allocation with Inflation-Protected Bonds.”,Financial Analyst Journal, Charlottesville, Jan/Feb 2004, Vol.60, Iss.1, p.54

Essentially they show that both indexed and non-indexed stocks and bonds should be kept for portfolio optimization. 

Key Points:

• Returns on indexed bonds are less volatile than non-indexed bonds

• The correlation between the returns on indexed stocks and non indexed stocks, appears to be zero, as opposed to the internal relationship of non-indexed securities to be 0.4. This is important as it provides scope for portfolio diversification.

• Conventional bond yields (non-indexed) contain a positive premium for the inflation risk they carry. Research, however,  says that this yields have not provided the positive premium in recent years.

• Indexed bond market is less liquid and thus is attractive for long-term investors and has potential to increase yields. 

• “...the results suggest that substantial weight should be given to indexed bonds in an efficient portfolio. We do not recommend that an investor’s actual asset allocation be based solely on observations of thus sort, but the results certainly have affected our beliefs about the potential benefits of indexed bonds.” p67 

• Speculation of the future yield spread for the indexed bonds is more difficult, but as suggested above if the inflation risk premium on conventional bonds has been too low then this should increase attraction for indexed bonds and stocks.