Markets

Why the Concern over Negative TIPS Yields Is Overblown

By Larry Swedroe

Updated on: November 4, 2010 / 10:03 AM EDT / MoneyWatch

On Monday, the Treasury Department sold $10 billion of five-year Treasury inflation-protected securities (TIPS) at yield of -0.55 percent, marking the first time ever that the government has sold TIPS with a negative yield. This announcement drew quite a stir, despite the fact that the real yield on five-year TIPS had been negative since late September. However, this situation has simply been overblown.

Investors seem to have a problem that I call the money illusion: the inability to clearly understand the difference between real and nominal rates. While they wonder why anyone would buy a bond with a yield of -0.55 percent, they don't realize they're already buying bonds with negative expected returns.

The yield on nominal five-year Treasury bonds has been consistently below 2 percent since late June 2010. At the same time, the Philadelphia Federal Reserve's Survey of Professional Economists projects an inflation rate of 2 percent over the next five years, down from 2.2 percent in the prior quarter. Thus, investors have been buying nominal bonds with negative expected real returns for quite a while. And buyers of nominal bonds are taking risks that investors in TIPS don't -- the risk of unexpected inflation. In other words, the yield of nominal bonds actually has three parts:

A real rate
The expected rate of inflation
A risk premium for unexpected inflation

As I write this, the yield on the five-year Treasury is about 1.3 percent, and the yield on the five-year TIPS is about -0.4 percent, making the break-even inflation rate 1.7 percent. In other words:

If inflation is less than 1.7 percent, the nominal bond will earn a higher return.
If inflation is higher than 1.7 percent, the TIPS will earn the higher return.

It seems to me that relatively speaking, TIPS are the more prudent choice over nominal bonds. In the worst case scenario, if you buy the five-year TIPS today and hold to maturity, you will earn -0.41 percent in real terms. If there's cumulative deflation over the period, the real return will be higher. However, if you buy the nominal bond and inflation rapidly rises, your real return would be dramatically worse. For example, if inflation averages 5 percent, the real return on the five-year Treasury will have been about -3.7 percent -- and it could be worse. Thus, the consequences of being wrong with buying the nominal bond can be much worse than the consequences of being wrong and buying the TIPS (a classic example of a Pascal-type wager.

There's one last important point. Another equally safe option involves -- FDIC-insured CDs. Today, five-year CDs can be bought with yields as high as 2.6 percent (with a three-month early withdrawal penalty). That changes the break-even inflation rate relative to TIPS to 3 percent (less than forecasted inflation). Thus, you might want to consider CDs as alternatives where available. While you would be taking some risk of unexpected inflation, the three-month early withdrawal penalty offers protection at a very low price.