Beginning in late 2010, Treasury Inflation-Protected Securities (TIPS) began trading with a negative yield. Investors were paying the government twice per year for the privilege of holding its debt rather than receiving their biannual interest payments.
Here's why that happened. On July 17, 2012, the 5-year TIPS had a yield of -1.21%, the 10-year stood at -0.64%, and the 20-year at -0.01%. Only the 30-year had a positive yield of 0.37%.
Learn how TIPS can have negative yields and real returns and why investors still flock to these securities.
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 expected inflation rate. This is an essential characteristic of TIPS—they are designed that way. As a result, when standard Treasury bonds are trading at yields below the expected inflation rate—as has been the case since late 2010—TIPS yields 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 1.53%. However, based on TIPS' comparative yields versus plain-vanilla Treasuries, investors were expecting inflation of about 2.13% in the next decade.
As long as Treasuries continue to offer yields below the expected inflation rate, TIPS will remain in negative territory.
If you subtract the expected inflation rate of 2.13% from the 10-year yield of 1.53%, the result for the 10-year TIPS is -0.59%. Investors still purchased Treasuries at this yield, but why would investors accept an investment that charges them money instead of giving it to them?
Negative Real Returns in Treasuries
There seems to be no rational explanation for an investor putting money into an investment that doesn't pay interest but charges them for holding their money. In reality, this can happen with ordinary "plain vanilla" treasuries as well.
To demonstrate, if you purchased 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 -0.5%. The difference in the negative yields in ordinary treasuries and TIPS is that the negative yield is different because of the way TIPS are tied to the Consumer Price Index.
Negative Yields and the "Flight to Safety"
A phenomenon known as the "flight to safety" or the "flight to quality" explains why investors sometimes accept negative TIPS or any other treasury yields. In times of pronounced economic uncertainty, investors' fear of losing their investments often overcomes their desire for acceptable returns.
Investors accept negative yields to protect their investments. While they might lose some money in the process, the amount of loss is far less than if they left their investments in stocks during a recession.
For example, in troubled low-interest-rate environments, 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.
This explains why junk bonds tend to offer comparatively higher yields over other bonds in troubled times—investors need a powerful inducement to risk their money when other 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 down-swinging economies, the offerors can reduce their interest rate incentives even further than usual.
This is because they know 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 inflation rate.
Financial safety becomes such a high priority that investors are willing to accept a negative real (after inflation) return on all Treasuries, not just TIPS, in exchange for the guaranteed return of principal that Treasuries have.
Why Investors Accept TIPS With Negative Yields
Investors continue to purchase TIPS with negative yields because they are concerned about losing the principal on their investments. Bad economic times are hard on stocks, so paying interest is less costly than losing everything.
Additionally, many investors assume that the Federal Reserve's monetary policies in 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.
Ultimately, this upward adjustment to counter inflation will provide the strong price performance that has characterized TIPS in the past.
Frequently Asked Questions (FAQs)
What happens to TIPS when interest rates rise?
When interest rates rise, the value of TIPS declines. The best way to deal with this risk, though, is to hold TIPS until maturity.
Can you lose money on TIPS?
Because the value of TIPS can decline when interest rates rise rapidly or when inflation turns downward, it is possible to lose money on them. That does not happen very often, though, and TIPS generally help investors stay somewhat on pace with inflation in the long term.
Are TIPS a good inflation hedge?
TIPS are generally a good tool for hedging against inflation, but they do come with some risks and may serve older investors better. For younger investors, the long-term potential of stocks and mutual funds will usually outperform inflation much better than TIPS.