Negative TIPS Yields

Frowning George on a weak dollar
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Beginning in late 2010, Treasury Inflation Protected Securities (TIPS) began trading with a negative yield – meaning that investors were paying the government for the privilege of holding its debt, rather than the other way around. For example, on July 17, 2012, the 5-year TIPS had a yield of -1.21% while the 10-year stood at -0.64%; the 20-year was at -0.01% and only the 30-year had a positive yield of just 0.37%.

How can this be?

How TIPS Can Have Negative Yields

The answer is that the yield on a TIPS bond is equal to the Treasury bond yield minus the rate of expected inflation.This is an essential characteristic of TIPS -- they are designed that way. As a result, when standard Treasury bonds are trading at yields that are below the expected inflation rate – as has been the case since late 2010 – TIPS yields will fall into negative territory.

Let’s look at July 17, 2012, again as an example. On that day, the 10-year Treasury note was yielding 1.49%. However, based on the comparative yields of TIPS versus plain-vanilla Treasuries, investors were expecting inflation of about 2.13% in the next ten years. If you subtract this 2.13% from the 10-year yield of 1.49%, the result is a negative number for the 10-year TIPS: -0.64%. As long as Treasuries continue to offer yields below the rate of expected inflation, TIPS will remain in negative territory.

But why would investors accept a negative yield?

Negative Real Returns in Treasuries

On the face of it, there seems to be no rational explanation for an investor putting money into an investment that not only doesn't pay interest, however slight, but actually charges the investor for holding their money.

In reality, this can be the case with ordinary "plain vanilla" treasuries as well. If, for example, you buy a Treasury note that pays 2% interest to maturity and the average inflation rate over the period is 2.5%, your real return is a negative 0.5%. The difference in the negative yields in ordinary treasuries and in TIPS is that because of the way tips are structured, the negative yield becomes more apparent.

Negative Yields and "the Flight to Safety"

A phenomenon known as "the flight to safety," or, alternatively, "the flight to quality," explains why investors sometimes accept negative yields on TIPS or any other treasury. In times of pronounced economic uncertainty, investors' fear of losing their investments often overcomes their desire for acceptable returns. In troubled low-interest rate environments, for example, although high-yield bonds may be the only bond products offering positive yields, investors generally shy away from them because of the (accurately) perceived greater risk. In fact, this explains why junk bonds tend to offer comparatively higher yields over other bonds in troubled times: investors need a particularly strong inducement to risk their money when investments generally seem riskier than usual.

For a similar reason, investment grade bonds, and Treasuries, in particular, tend to offer particularly low-interest rates in troubled times. Because the demand for the safest possible products increases in troubled economies, the offerers can reduce their interest rate incentives even further than usual, knowing that plenty of investors will take them anyway -- the flight to safety phenomenon. Another valid way of looking at this is that it's the result of the supply vs. demand phenomenon. 

For example, investors’ quest for safe investments amid concerns about the debt crisis in Europe that accelerated in 2009 drove the yield on plain-vanilla Treasuries below the rate of inflation. In other words, safety became such a high priority that investors were willing to accept a negative real (after inflation) return on all Treasuries, not just TIPS, in exchange for a guaranteed return of principal.

Why Investors Accept TIPS With Negative Yields 

Investors continue to purchase TIPS with negative yields for these reasons: 

  • Safety of Principal: Always a concern for investors in securities, but, as noted, a particularly strong incentive in bad economic times;
  • The risk of Inflation: Many investors act on their expectations that the Federal Reserve’s stimulative monetary policies in these same troubled economic times will eventually cause inflation to accelerate. If inflation accelerates investors will once again earn a positive return on TIPS because TIPS’ principal adjusts upwards with inflation. Eventually, this upward adjustment to counter inflation will provide the strong price performance that has characterized TIPS in the past.

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