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Old 10-26-2010, 11:25 AM   #21
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The way I look at it is that the put is only on the CPI-adjusted face, which on this note is currently about 100.70 so the put is really only 0.70 out of the money. The 104+ price is the premium the market is willing to pay for the 0.5% coupon and the embedded put, and amortizes back to 100 over the life of the note, just as would be the case with any bond selling at a premium to par.
I see your reasoning. But if you own a security at 104, and wish to fully protect that with a put, a put at 100 won't do it. It is 4 points out of the money. This ignores the relaatively small cpi adjustment already present. To me, it makes no difference how you allocate the premium, that seems more accounting than economic reality.

But everyone's mind works best with slightly or very different models.

Ha
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Old 10-26-2010, 11:27 AM   #22
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One part of your excellent explanation is not clear to me. The "real rate " is not known except after the fact, only inferred from things like nominal yields and guesses at inflation expectations, I suppose based on trailing inflation, or inferred from reasury/TIP spreads. So it seems that in Part2, above, the real rate assumed by TIPS buyers at this auction is not the .50% coupon, it is in fact negative. If the last 5yr TIPS auction 6 months ago did sell at par, then we can infer that the real rate as estimated in May 2010 was the coupon, 0.5%. But that is no longer the "real rate", as shown by this auction. TYesterday's buyers hope to get all their return out of CPI expansion, because as I see it anyway there is nowhere else for it to come from. So essentially, return over the 4.5 years will equal CPI inflation, plus the sum of coupon payments, minus the amortization of the premium.

Could someone comment?
Very good question. And things are further complicated by the embedded put. It seems to me that the only way to get a handle on what the bond market thinks the real rate is is to look at TIPS with a very large CPI-accrued principal, so the put is way out of the money, and presumably much less valuable, since the buyer will participate in any deflation as well.
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Old 10-26-2010, 11:37 AM   #23
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I see your reasoning. But if you own a security at 104, and wish to fully protect that with a put, a put at 100 won't do it. It is 4 points out of the money. This ignores the relaatively small cpi adjustment already present. To me, it makes no difference how you allocate the premium, that seems more accounting than economic reality.
Imagine a world where real rates were constant but there was lots of inflation. The quoted TIPS price would remain constant at 100, but the CPI-adjusted principal would increase. The embedded put would now be out of the money, not at the money.
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Old 10-26-2010, 01:34 PM   #24
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Imagine a world where real rates were constant but there was lots of inflation. The quoted TIPS price would remain constant at 100, but the CPI-adjusted principal would increase. The embedded put would now be out of the money, not at the money.
I can see tha we have the same understanding; we have just described it slightly differently. My goal in this thread was to check my understanding with others who had given the issue thought. As far as I am concerned, mission accomplished.

These things are tricky!

Ha
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Old 10-26-2010, 07:12 PM   #25
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At first, I thought I understood how buyers bid down the TIPS yield to negative: the fear of inflation makes the 5-yr note look risky. But why did they have to buy anything now? Why not sit in cash and wait? Usually, people clamor to buy something if they think the deal offered tomorrow would not be as good, or in this case, even worse.

So, I searched the Web, and found some talk about how people are "front-running" the Fed, who is going to do another round of QE as discussed in a concurrent thread. Is it really that scary, that people are in the mode where they try to minimize the certain loss, rather than try to maximize the potential risk-adjusted gain as usual?

About Mark Hulbert's explanation that "Heads I win, tails I win too", shouldn't that be "Heads I win, tails I lose just a little"? Anyway, what he says is that deflation is not out of the mind of the TIPS bidders.

And here is another explanation for the negative yield: Deflation and Negative TIPS Yields -- Seeking Alpha. An excerpt follows:

If we do have a brief bout of deflation, then TIPS coupons will be zero — which is actually positive in real terms. TIPS investors never need to give money back to Treasury. So it’s not necessarily true that you’re getting a negative real coupon: if there’s negative consumer price inflation for any length of time over the next five years, the zero bound on coupon payments might even things out. There’s also a lower bound of 100 on principal repayments, which may or may not come into play depending on the price/yield at which you buy your bonds.

So really, negative TIPS yields can be taken as a sign that the markets are beginning to price in some brief dip into negative-inflation territory. They’re not a sign that the markets are expecting no deflation.


Anyway, the above writer is also of the opinion that the market does not believe inflation is a sure thing yet. We are living in a really interesting time.
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