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This week investors bought $10 billion in Treasury inflation-protected securities -- and paid for the privilege of lending the federal government money.
Investors paid $105 for each $100 in face value. That reduced the yield on these bonds to a negative 0.55%.
These investors weren't insane. Just very, very afraid of inflation.
That fear doesn't tell you much about when inflation will pick up or how high the inflation rate will go.
But that fear -- and investors' willingness to accept a negative yield to make things a little less scary -- does tell you that despite the big increase in the prices of hedges against inflation, tangible things like oil, copper, tin and fertilizer are going to get pricier.
How TIPS work
Treasury inflation-protected securities, or TIPS, don't pay interest like regular Treasury bills, notes and bonds, and they don't return principal at maturity the way that regular Treasury bonds do.
Jim Jubak
TIPS do come with a coupon yield, just like any other bond. The coupon on the TIPS sold this week was for interest of 0.5%. Positive interest, if only a very little of it. It was the bidding of investors at the Treasury auction that pushed the price of a $100 bond to $105. And that took the interest rate into negative territory.
The yield on a regular five-year Treasury note is 1.31%. So why was there so much demand that this $10 billion in TIPS paying only a coupon of 0.5% wound up selling for $1.05 on the dollar?
Because, unlike regular Treasury issues, where rising prices can destroy the value of interest payments and principal, TIPS offer a promise of protection against inflation.
At the end of five years, owners of regular five-year Treasurys get their principal back. But how much is that principal worth in real buying power if the prices of everything you want to buy have been rising every year because of inflation?
The inflation calculation
Let's say inflation runs at a 3% rate during the five-year life of a regular Treasury note. At the end of one year, $100 in principal has the buying power of just $97 because the prices of those things you want to purchase have climbed 3%. The next year, your principal is worth just $94.09. The year after that $91.27. Then $88.53 and $85.87.
You may get $100 in cash back when that Treasury matures, but in buying power you've taken a 14.13% loss on your principal.
Yes, you get paid interest while you wait. But at the current interest rate of 1.31% on five-year Treasurys, you can't hope to make back that 14.13% loss on the real value of your principal from interest payments -- especially because the real value of those interest payments is also declining because of inflation. At 1.31%, your five-year Treasury isn't generating much income, but with 3% inflation, the $1.31 that each $100 of Treasury generates is worth 4 cents less after one year. And so on.
The principal of a TIPS bond and its interest payments, on the other hand, are protected from inflation. (Well, inflation at the official rate, anyway.)
At the end of five years, when the shortest-duration TIPS mature, the value of the principal is increased to reflect the rate of inflation. (The inflation benchmark is the rate of increase in the Consumer Price Index over the previous six years.) Interest payments, too, are indexed to the inflation rate.
To give you an example from the Treasury's website of how this works: At maturity in January 2009, $1,000 in a 10-year TIPS bond with a coupon of 3.875% would generate $50.84 in interest -- considerably more than the $38.75 coupon yield, thanks to the TIPS inflation adjustment -- and a $309.14 gain to principal from the inflation adjustment.
