Working Paper

The Benefit of Inflation-Indexed Debt: Evidence from an Emerging Bond Market

Abstract: Portfolio diversification is as important to debt management as it is to asset management. In this paper, we focus on diversification of sovereign debt issuance through greater reliance on inflation-indexed bonds for a representative emerging economy, Colombia. Using an arbitrage-free dynamic term structure model of fixed-coupon and inflation-indexed bond prices, we account for inflation and liquidity risk premia and calculate the net benefit of issuing inflation-indexed bonds over nominal bonds. Our results suggest that the Colombian government could lower its funding costs by as much as 0.69 percent by increasing its issuance of inflation-indexed debt, in particular at long maturities.

Keywords: term structures; Modeling; liquidity risk; financial market frictions; central bank credibility; debt management;

JEL Classification: D84; E31; E43; E44; E47; E52; E58; G12;

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Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2023-02-02

Number: 2023-04

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