Investors have seen some weird happenings in financial markets this year. None is more bizarre or informative than the recent trend in inflation-protected Treasury securities, known as TIPS.
For the first time since the government began issuing TIPS in 1997, buyers of 5-year TIPS are getting a negative yield to maturity. That means they are paying more for the pleasure of owning a 5-year TIPS than they would get back in return from the 2 percent coupon interest rate plus the downward adjustment of current price to par value when the security matures in April 2012.
As of Monday, the yield to maturity on 5-year TIPS was minus 0.21 percent. The price was just over $109 per $100 of par value. By comparison, regular, or nominal, 5-year Treasury notes, as of Monday, carried a yield to maturity of 2.38 percent.
The 5-year TIPS yield has been in the red since the end of February. It sounds like going to the bank and agreeing to pay the bank interest to own a 5-year certificate of deposit.
Fortunately for TIPS investors, that’s not how it works. The principal value of TIPS is adjusted twice a year to reflect changes in the consumer price index.
A buyer of TIPS with a negative yield “would expect that the realized inflation of the next five years is going to be greater than what’s priced in the market,” said David Hershey, head of fixed-income investing at Lotsoff Capital Management.
One way to visualize negative yields is to look at the current 2.38 percent yield on nominal 5-year Treasury notes, said Ken Volpert, head of fixed-income index investing at Vanguard Group.
The latest CPI inflation, as of January, was 2.5 percent, he noted. Most investors believe the price index is headed higher, but even at 2.5 percent, “you should expect a negative real yield” on your 5-year Treasury note, after adjusting for inflation, Volpert said. That’s what negative yields on 5-year TIPS are indicating.
The inflation outlook explains just half the story of the extraordinary TIPS yields. The other half concerns the weak economy, which has driven Treasury yields lower across the board. Even yields on 30-year Treasury bonds, which tend to jump at the first hint of an inflation surge, have been fairly stable this year.
Normally, inflation fears subside when economic growth slows. This year, investors have convinced themselves that higher inflation and slower economic growth will persist. “High oil prices have something to do with it,” said Hershey. “People think higher oil prices are going to flow into the CPI over the next five years.”
But it’s hard to find anyone who hasn’t bought into the weak economy/strong inflation theme.
“It seems like making money today is a big momentum play that everything will continue in the same direction it’s in,” said Jack Tilton, market analyst at Channel Trend. “Everybody is chasing the prevailing performance. It’s been very hard to fight momentum in anything. These TIPS are about as extreme a thing around to make that point.”
The inflation-protection feature plus the general decline in nominal Treasury yields since last June have made TIPS one of the best bets for investors. The return on the iShares Lehman Brothers TIPS exchange-traded fund has been 19 percent since last June, compared to a 13 percent decline for the benchmark Standard & Poor’s 500 index.
TIPS yields reflect the essence of so-called stagflation worries, said Tilton. “The ‘stag’ part is reflected in low yields; the ‘flation’ part is the expectation of higher future inflation.”
“Unless things are turning around in the economy, I think TIPS are going to continue to perform pretty well,” said Volpert. The Vanguard TIPS index fund recently surpassed the $15 billion mark.
Indeed, the current weakness in the economy, not inflation fears, has been the biggest driver of lower yields for TIPS and regular Treasury securities. Economic weakness has taken hold more firmly than inflation fears.
Therein lies the risk in TIPS, said Volpert.
“The inflation story may still be there, but once the economy turns [up], watch out,” he said. “TIPS are going to be pretty bad.”
On the other hand, he said, if 10-year TIPS, currently yielding about 0.9 percent, turn negative, it would be a sign that the economy has turned “really ugly.”
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bbarnhart@tribune.com
