TIPS: Negative Yield vs. Inflation Hedge

TIPS bond incomeYields on 10–year Treasury Inflation-Protected Securities (TIPS) are at record lows. As of this writing (July 2012), the 10-year TIPS have a negative yield of -0.637%. This indicates that investors believe so strongly in future inflation that they are willing to bid up prices of the security to the point of negative returns. It’s important to understand that in practice, when you purchase a TIPS with a negative yield, you don’t have to actually make interest payments back to the Treasury. The Treasury will payout interest to you at 0.125%, but an appropriate premium is added to the price you pay for the security so that the stream of interest payments minus the premium is equivalent to the negative yield. Some analysts believe it makes no sense at all to buy securities with negative yields. Others, however, say that you should consider current economic conditions and prospects to determine if buying negative-yield TIPS might make sense.

The Math

Let’s look at the arithmetic. The current 10-yr Treasury yield is 1.43%. Buyers of the 10-yr TIPS are therefore betting that inflation over the next ten years will average at least 2.067% (Treasury yield minus TIPS yield). That seems like a very reasonable assumption to me. Under this scenario, the TIPS investors believe that the TIPS inflation adjustments will increase the principal of their holdings at a rate that will more than make up for the initial price premium they paid for the security. The greater the inflation rate is over the period, the greater their return. Theoretically, this all sounds okay to me. In practice, I do have a couple of concerns.

Concerns

One of my concerns is the inflation scenario. Let’s say I buy a 10-year TIPS today (holding it in a tax-favored account of course). Suppose due to political and other factors, the Fed undertakes no further quantitative easing, and the economy stagnates. Over the next 5 years the inflation rate is -1.0% (deflation). Then a new political order takes power, circumstances change, and the Fed goes forth with quantitative easing resulting in inflation of greater than 4% annually over the final 3 years prior to my TIPS maturing. If, averaged over the 10-year period, the annual inflation rate turns out to be 2.2%, would that mean I made money on this investment? Not necessarily. I haven’t run the numbers, but I don’t think it would be too hard to come up with a scenario where an initial deflationary period reduces the adjusted principal (and, thus, the associated interest payments) to the point where later inflation adjustments on the smaller adjusted principal balance don’t make up for the earlier losses. I would get my principal back at maturity, but the total interest payments that I received might not be enough to offset the initial price premium I paid when I purchased the security.

A more fundamental concern I have is with the basis of the inflation adjustment. TIPS adjustments are based on CPI-U. Because of the way that statistic is calculated, there is a 2-month lag in the adjustment. Again, if significant inflation occurs during the final months prior to maturity, the lag in adjustments means there may be a couple months of inflation that are unaccounted for at maturity. Also, as a government statistic, CPI-U can always be manipulated and redefined for political reasons.

Bottom Line

So do I invest in TIPS now? For me personally, the answer is no. I will wait until the yield on 10-year TIPS turns positive, i.e. at least 1.5%. After all, I am primarily interested in investments for income, not just capital
preservation. If I can get at least 1.5% yield, and the 10-year Treasury yield remains below 4.0%, I’m in.

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