Executive Summary
The news this week has been abuzz with Monday's Federal government auction of Treasury Inflation-protected Securities (TIPS) that resulted in a yield of -0.55%. Surely, an investor willingness to accept a negative return in exchange for inflation-protection means investors are panicked about an impending surge of inflation, right? Actually, no, in this case, it doesn't.
First of all, it may be helpful to clarify exactly what actually happened. The Federal government took some 5-year TIPS which it had partially auctioned back in April, and completed the issuance of the remaining bonds (now with a 4-year-and-6-month maturity) on Monday. The bonds will pay a stated interest rate of 0.5%, and will return a par value of $100 per bond at maturity in 4.5 years - plus, of course, any inflation adjustments to the principal value, which generates the secondary component of return for TIPS. So what actually happened at the TIPS auction? As revealed in the Treasury Department's announcement of the auction results, some investors ultimately paid a price as high as $105.51 to receive a bond that will only pay 0.5% per year for 4.5 years and return $100 at the end. When you do the math, you find that (before any inflation adjustments) this is equivalent to a yield of -0.55%.
So literally speaking, yes it actually is true that investors were so eager to buy inflation protection, that they were willing to pay a markup on the bond (as much as $105.51 for a bond that matures at $100) that exceeds what they will receive in the form of bond interest payments alone (i.e., getting 0.5% per year for 4.5 years doesn't make up the extra $5.51 you just paid for the bond). And consequently, they are counting on inflation adjustments to increase the par value of the bond by enough to ultimately provide a reasonable total return.
In turn, this begs the question - how much inflation do you actually need to get a reasonable return on the bond, such as a return comparable to what you could earn by just buying a nominal 5-year Treasury Bond? As a Wall Street Journal Online article pointed out later that day, not much... it only takes an inflation rate of 1.59% to break even between the TIPS investment and a standard non-inflation-adjusting 5-year Treasury Bond.
So all of the hubbub about "investors are betting on inflation" with a negative TIPS yield really needs to be viewed in this context. Investors are betting that the actions of monetary and fiscal policy will produce a whopping 1.59% inflation over the next 5 years. In point of fact, our latest data on inflation (as measured by CPI-U) for the 12 months ending in September 2010 (the last data point available) was 1.1%. In fact, using the same data chart, the average annual growth rate of inflation compounded out over the past 5 years leading up to this month was only about 1.9%. So what is the TIPS auction really telling us? That investors think inflation is going to stay pretty darn low, right around where it is now.
Certainly, from the perspective of many who fear that the US could be slipping into a deflationary spiral, the fact that investors are apparently not betting on deflation is good news. There is some expectation of inflation, and the "good" news is that a 1.59% inflation expectation is definitely not a deflation expectation.
But on the other hand, with a breakeven rate of only 1.59%, the recent TIPS auction is hardly a harbinger of inflationary doom. It's just a numerical reality that will occur any time general interest rates (including both the 5-year Treasury Bond and the nominal interest rate paid on TIPS before inflation adjustments) get so low. When a 5-year Treasury Bond barely pays more than 1% interest in the first place, it just doesn't take much of an inflation rate at all to create a negative TIPS yield.
If you're really concerned about inflation and inflation expectations, the real number to watch is the inflation breakeven rate (in essence, the difference between TIPS yields and a non-inflation-adjusting government bond of the same maturity). This time around, it was only 1.59% with a -0.55% TIPS yield, because regular Treasury Bonds already have an incredibly low yield. But when investors are still accepting negative TIPS yields while non-inflation-adjusting Treasury Bonds have a higher yield - or if TIPS yields get really negative - then you've got a real warning for more serious inflation coming down the road.
But as far as Monday's negative TIPS yield results are concerned, the only "news" is that when government bond yields are so low, it doesn't take much inflation to break even.
So what do you think? Is there any buzz from your clients about the news of negative TIPS yields?
I happened upon this article from Mark Hulbert at Market Watch:
CHAPEL HILL, NC (MarketWatch) — How much should you have to pay for an insurance policy that protects you against both severe deflation and hyperinflation?
We found out the answer earlier this week: 55 basis points per year.
Though you might not have recognized it as such, this answer was imbedded in the results of the government’s latest auction for five-year TIPS — Treasury Inflation-Protected Securities. For the first time ever, the yield at which the TIPS were sold was negative: minus 0.55%. (Read report on five-year TIPS’ negative yield.)
This means that the interest rate that these TIPS are going to pay will be 0.55% less than the Consumer Price Index’s rate of increase between now and 2015.
Why would anyone want to buy a bond on these terms that seemingly guarantee that investors will lose ground to inflation? Commentators in the wake of the auction have been struggling to come up with a rational explanation.
It turns out, however, that those who bought the TIPS at this week’s auction might not have been all that irrational. That’s because, according to Luis Viceira, a professor at Harvard Business School, TIPS don’t just provide protection against unexpectedly high inflation; they also protect the investor from deflation as well.
In an interview, Prof. Viceira referred to this deflation protection as a “deflation put.” It traces to an under-appreciated feature of TIPS: Regardless of how much deflation occurs during the term of the bond, which otherwise would translate into a negative interest rate, you still will get all your original principal back at maturity.
In other words, TIPS’ payoff is asymmetrical: Its yield grows in the event of higher inflation, but does not decline to the same extent in the event of deflation.
TIPS therefore should appeal to investors who are uncertain about whether much higher inflation is in store or, instead, an extended Japanese-style deflation.
Investors like almost all of us, in other words.
Let’s say that inflation over the next five years is a lot worse than the market anticipates, say 5% a year. In that event, the TIPS sold on Monday will have an average yield of 4.45% — a whole lot better than the 1.17% current yield of normal Treasurys that do not provide inflation protection.
What if we get severe deflation, and over the next five years the CPI declines by, say, 2% per year on average? In that event, the investor who bought TIPS on Monday will make a real return over the next five years of 1.45% annually.
Sounds like “heads I win, tails I win too.”
Little wonder so many investors were willing to accept a negative yield of 0.55% per year.