Negative TIPS Yield Shows Market Expects Increase in Inflation

Treasury Inflation Protected Securities (TIPS) auctioned on April 21, 2010 at a negative 0.18%. Why would an investor by a bond at a negative yield and what does it mean?

TIPS are a Treasury security but unlike regular Treasury bonds, bills, or notes, the interest paid on a TIPS adjusts based on inflation. Read a detailed description of how TIPS work. Every six months, the principal of a TIPS is adjusted based on the CPI-U. In general, the spread between a TIPS and a regular Treasury of the same maturity tells you what investors expect inflation to be over the timeperiod of the bond. That's because if TIPS are inflation protected, regular Treasuries are not, and to make up for inflation expecations, regular Treasuries have to pay more. Read more for a description of how the TIPS/Treasury spread works. Investor look at this spread and if the spread is greater than the expected rate of inflation than investors will be better off buying Treasuries. If the spread is less than the expected rate of inflation, then it makes sense to buy the TIPS, even if the yield is negative. Let's take a look at an example.

So, even though TIPS start with a -.18% yield, it will adjust every six months based on inflation. The market is pricing in the expectation of 2.29% inflation. If you expect inflation to be higher than that, then it makes sense to purchase the TIPS, even if the initial yield is negative, because it will adjust to a higher rate based on the inflation numbers.

By gobbling up 5-year TIPS at -.18%, the market is saying right now it is expecting inflation higher than 2.29%. That doesn't mean the market will be right, or that it won't change in the future. But right now, that's where inflation expectations lie.

The reality though, is that inflation above 2.29% is not saying very much. The TIPS yield went negative more because the regular 5-year Treasury yield is so low, not because investors see hyper-inflation on the horizon. When regular yields rise significantly and the TIPS yield is still low will be the time to say inflation expecations have truly arrived.