• / Free eNewsletters & Magazine
  • / My Account

Related Content

  1. Videos
  2. Articles

Are TIPS Buyers Crazy?

Like a fox, perhaps.

Eric Jacobson, 11/04/2010

Get mutual fund and stock information from our analyst team delivered to your e-mail inbox every Tuesday. Sign up for our free Investment Insights e-newsletter.

The very idea sounds nutty. Why on earth would anyone buy a bond with a negative yield?

That's the question many people--even some with years in other parts of the investment industry--found themselves whispering tentatively after last week's news that the Treasury sold $10 billion worth of five-year Treasury Inflation-Protected Securities with negative yields of 0.55%.

The answer isn't as esoteric as you might imagine, but it does explain something about investor expectations at this juncture of the economic and political cycles. The central issue is that day-to-day volatility aside, TIPS produce returns from two sources: semiannual income payments (or coupons) and periodic adjustments to principal. (For more detail on how TIPS work, look at this piece or this page from the TreasuryDirect website.) When the press reported that TIPS were selling with negative yields, however, it was another way of saying that the bonds' prices were so high that investors were effectively paying more than the bonds' future income payouts were actually worth.

The context some press reports didn't provide enough of, though, was that those yield numbers don't fully explain investors' expectations for inflation or how much TIPS inflation adjustments will drive up their principal values by maturity. In fact, a comparison between the yield of a plain-vanilla (conventional) Treasury bond and a TIPS counterpart with a very close maturity helps paint a clearer picture.

As of Monday, for example, the yield for a conventional five-year Treasury was 1.16%. The difference between that figure and the (in this case negative) yield of a comparably dated TIPS issue can be viewed as a rough approximation of the market's expectation for inflation over the next five years. At 1.52%, that number isn't very exciting; but if it turns out to be accurate, it will be close to the annualized return enjoyed by today's TIPS investor. If inflation turns out to be lower than that, those buying TIPS at today's negative yields will have overpaid; but if it comes out higher, their purchases will be proved prescient.

What does all of this say about the current state of the economy and markets? For one, it says that investors do think the Federal Reserve is going to have success in maintaining some inflation with its ongoing near-zero short-term rate policy and impending quantitative easing program. Those eagerly snapping up TIPS likely believe the Fed will be more than just a little successful and expect that whether 1.52% or higher, the future level of inflation is going to justify holding securities designed to keep up with it, even if they aren't offering any additional compensation.

Putting things another way, buying TIPS at negative yields is an implicit agreement to purchase something with no promise of additional ''real'' yield above and beyond inflation in exchange for the certainty that one's purchasing power will at least keep up with whatever that price level proves to be.

blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.