TIPS sell at negative yield

[Htown Harry]

I saw several news items today regarding the latest Treasury auction of TIPS. This one is typical.

Treasury Draws Negative Yield for First Time During TIPS Sale - Bloomberg

I found this chart on the Treasury web page, which indicates the 5-year market yield for TIPS actually went negative about a month ago.

U.S. Treasury - Daily Treasury Yield Curve

Looking at the chart and using my very basic understanding of bond's price yield relationship, I do understand this is just a milestone on a price path, not an event with independent significance. Still, the concept of a negative yield doesn't fully compute for me.

Could some of the more astute bond investors on the board comment and explain the basic math of a negative yield TIPS bond?

 

[haha]

I saw several news items today regarding the latest Treasury auction of TIPS. This one is typical.

Treasury Draws Negative Yield for First Time During TIPS Sale - Bloomberg

I found this chart on the Treasury web page, which indicates the 5-year market yield for TIPS actually went negative about a month ago.

U.S. Treasury - Daily Treasury Yield Curve

Looking at the chart and using my very basic understanding of bond's price yield relationship, I do understand this is just a milestone on a price path, not an event with independent significance. Still, the concept of a negative yield doesn't fully compute for me.

Could some of the more astute bond investors on the board comment and explain the basic math of a negative yield TIPS bond?

It all depends on inflation between now and maturity. It certainly seems to be an anomaly
.
Ha

 

[NW-Bound]

I found the explanation in the quoted paragraphs below.

Holders of TIPS receive an adjustment to the principal value of their securities equal to the change in the consumer price index, in addition to a fixed rate of interest that’s smaller than the interest paid to a holder of conventional debt. The difference between is known as the breakeven rate.

The fixed payment on five-year TIPS, known as the real yield, has been pushed below zero because the rise in the CPI is greater than the yield on regular five-year U.S. notes, which has fallen with other Treasury yields as investors sought the safety of U.S. government debt. A negative yield suggests investors are betting Fed Chairman Ben S. Bernanke will be successful in preventing deflation and the risk of the economy slipping back into recession.​

It makes me appreciate the money I still have in my I-bond account, which pays a positive rate above the CPI. But I am kicking myself for selling my measly 100 shares of GLD 6 months ago for a mere 32% gain after 2 years.

 

[Bikerdude]

I guess it means some people are willing to buy bonds that will equal inflation minus 0.55%. I assume those same people are expecting a surge in inflation within the next 5 years.

 

[dex]

The fixed payment on five-year TIPS, known as the real yield, has been pushed below zero because the rise in the CPI is greater than the yield on regular five-year U.S. notes, which has fallen with other Treasury yields as investors sought the safety of U.S. government debt. A negative yield suggests investors are betting Fed Chairman Ben S. Bernanke will be successful in preventing deflation and the risk of the economy slipping back into recession.​

I still don't get it. What does the negative rate imply?


People want any US Gov't security so they will pay a premium for it?
Interest rates remain at the current level?
Interest rates will decline?
Interest rates will increase?

I used to think I understood basic finance. This one confounds me.
​

 

[Htown Harry]

Thanks NW-Bound, but I'm still not getting the math 100%.

The overall concept of TIPS I follow, but I feel like there is a key word missing from those paragraphs in the article.

The results summary from Treasury Direct:

Security Term 4-YEAR6-MONTH
Type TIPS
Issue Date 10-29-2010
MaturityDate 04-15-2015
Interest Rate % 0.500
Yield % -0.550
Price Per $100 $105.508607

So:

A month ago the market yield was 0%. Thus the then-current market price per $100 was somewhat lower than today's price of 105.51. Let's say it was $105 to make the math simple.

At a 0% yield the math works out such that the 1/2% 5-year compounded interest on the principal value of $100 might be $2 (again a number I picked to keep the math simple.)

Purchasers of the bond, however, are willing to pay an extra $3 (for a total $105 per $100 of principal) because the 5-year CPI change is 3% plus whatever today's yield is on a 5-year Treasury bond?

If I have that correct, then the missing words from the article are:

"The fixed payment on five-year TIPS, known as the real yield, has been pushed below zero because the rise in the CPI anticipated by bond buyers is greater than the yield on regular five-year U.S. notes, which has fallen with other Treasury yields as investors sought the safety of U.S. government debt"

As written, I was confused about whether the CPI was the value reported recently with the SS COLA news or some future CPI value established by Treasury. Neither of those make sense in this context.

Or, if I still have this wrong, somebody will be along shortly to whack some sense into me.

 

[GusLevy]

TIPS are a wacky security that confounds traders, portfolio mgrs and finance professors alike. Having said that, imo, TIPS are the best investment for early retirees who wish to minimize market risk as much as possible. They have relatively low volatility, no credit risk and offer inflation protection. I traded Corp bonds but will try to explain today's TIPS auction from a hack's perspective.

Basic #1: The YTM of a conventional fixed trsy is comprised of 1) the real yield plus 2) the expected inflation rate plus 3) the inflation risk premium.

Basic #2: The YTM of a TIPS is comprised of 1) the real yield plus 2) CPI index from previous period.

Roughly Speaking, the "break-even rate" is the expected inflation rate plus the inflation risk premium. This rate means that if future inflation equals this rate then the returns on both the TIPS and the comparable Nominal bond will be equal.

Since the 5yr Trsy yield is approx 1.20% and the real rate is .50%, the break-even would be .70% on future inflation. Today's TIPS auction went at -.55% as shown by the premium price which tells you that the Market believes that we will have higher inflation than the break-even (.70 - (-.55))=1.25%. The Market is signaling that they have confidence that Helicopter Ben will be able to stem the dangerous threat of deflation.

Finally, the "negative yield" from today's auction does not mean that the buyer today is settling for a negative return...Finance professors may write papers how this may be theoretically possible but traders and investors with actual $ don't act that stupid. Recall that TIPS accrue inflation gains on top of the principal price so today's buyer fully expects to easily make up the "negative yield" through positive CPI numbers from hereon.

 

[BTravlin]

TIPS are a wacky security that confounds traders, portfolio mgrs and finance professors alike. Having said that, imo, TIPS are the best investment for early retirees who wish to minimize market risk as much as possible. They have relatively low volatility, no credit risk and offer inflation protection. I traded Corp bonds but will try to explain today's TIPS auction from a hack's perspective.

Basic #1: The YTM of a conventional fixed trsy is comprised of 1) the real yield plus 2) the expected inflation rate plus 3) the inflation risk premium.

Basic #2: The YTM of a TIPS is comprised of 1) the real yield plus 2) CPI index from previous period.

Roughly Speaking, the "break-even rate" is the expected inflation rate plus the inflation risk premium. This rate means that if future inflation equals this rate then the returns on both the TIPS and the comparable Nominal bond will be equal.

Since the 5yr Trsy yield is approx 1.20% and the real rate is .50%, the break-even would be .70% on future inflation. Today's TIPS auction went at -.55% as shown by the premium price which tells you that the Market believes that we will have higher inflation than the break-even (.70 - (-.55))=1.25%. The Market is signaling that they have confidence that Helicopter Ben will be able to stem the dangerous threat of deflation.

Finally, the "negative yield" from today's auction does not mean that the buyer today is settling for a negative return...Finance professors may write papers how this may be theoretically possible but traders and investors with actual $ don't act that stupid. Recall that TIPS accrue inflation gains on top of the principal price so today's buyer fully expects to easily make up the "negative yield" through positive CPI numbers from hereon.

I somewhat knew this intuitively but I'll be damned if I could have come close to explaining it in an intelligent fashion. Just goes to show I still have a lot to learn.

 

[FIRE'd@51]

Finally, the "negative yield" from today's auction does not mean that the buyer today is settling for a negative return...Finance professors may write papers how this may be theoretically possible but traders and investors with actual $ don't act that stupid. Recall that TIPS accrue inflation gains on top of the principal price so today's buyer fully expects to easily make up the "negative yield" through positive CPI numbers from hereon.

Even though the buyer may not be expecting a negative return, as I understand it, he will still lag the future CPI change by 0.5% per year.

 

[brewer12345]

Let's make it even simpler: a bell has just been rung signalling the imminent top of the bond market.

 

[youbet]

Even though the buyer may not be expecting a negative return, as I understand it, he will still lag the future CPI change by 0.5% per year.

Yes, but the implied expectation on the part of the buyer is that this 0.5% lag will be less than the amount current 5 yr treasuries will lag inflation. That is, they'll be closer to "keeping up with inflation" by buying TIPS with a negative 0.5% real yield than if they bought a traditional 5 yr treasury at today's yield.

 

[ziggy29]

Let's make it even simpler: a bell has just been rung signalling the imminent top of the bond market.

The problem is, that bell has been ringing for quite some time.

 

[brewer12345]

The problem is, that bell has been ringing for quite some time.

Doesn't mean we should not pay attention to it.

 

[FIRE'd@51]

Yes, but the implied expectation on the part of the buyer is that this 0.5% lag will be less than the amount current 5 yr treasuries will lag inflation. That is, they'll be closer to "keeping up with inflation" by buying TIPS with a negative 0.5% real yield than if they bought a traditional 5 yr treasury at today's yield.

I agree, but the hold-to-maturity buyer is still guaranteeing himself a negative real return over the next 5 years.

 

[CCdaCE]

Mark Hulbert has an explanation:

Heads I win, tails I win too.

TIPS don’t just provide protection against unexpectedly high inflation; they also protect the investor from deflation as well.
<snip>
In other words, TIPS’ payoff is asymmetrical: Its yield grows in the event of higher inflation, but does not decline to the same extent in the event of deflation.
TIPS therefore should appeal to investors who are uncertain about whether much higher inflation is in store or, instead, an extended Japanese-style deflation.

-CC

 

[FIRE'd@51]

Mark Hulbert has an explanation:

Heads I win, tails I win too.

-CC

This makes sense - essentially Hulbert is saying that the 0.5% per year is the cost of the embedded put that guarantees the buyer the right to "put" the TIPS at 100 back to the government at maturity. So one should view the TIPS as a symmetric CPI-indexed note (up and down) plus a 5-year European put, and the cost of that put is approximately 2.5%.

 

[haha]

TIPS are a wacky security that confounds traders, portfolio mgrs and finance professors alike. Having said that, imo, TIPS are the best investment for early retirees who wish to minimize market risk as much as possible. They have relatively low volatility, no credit risk and offer inflation protection. I traded Corp bonds but will try to explain today's TIPS auction from a hack's perspective.

Basic #1: The YTM of a conventional fixed trsy is comprised of 1) the real yield plus 2) the expected inflation rate plus 3) the inflation risk premium.

Basic #2: The YTM of a TIPS is comprised of 1) the real yield plus 2) CPI index from previous period.

Roughly Speaking, the "break-even rate" is the expected inflation rate plus the inflation risk premium. This rate means that if future inflation equals this rate then the returns on both the TIPS and the comparable Nominal bond will be equal.

Since the 5yr Trsy yield is approx 1.20% and the real rate is .50%, the break-even would be .70% on future inflation. Today's TIPS auction went at -.55% as shown by the premium price which tells you that the Market believes that we will have higher inflation than the break-even (.70 - (-.55))=1.25%. The Market is signaling that they have confidence that Helicopter Ben will be able to stem the dangerous threat of deflation.

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?

Ha

 

[haha]

I believe Hulbert is wrong or sloppy on this quote

"In an interview, Prof. Viceira referred to this deflation protection as a “deflation put.” It traces to an under-appreciated feature of TIPS: Regardless of how much deflation occurs during the term of the bond, which otherwise would translate into a negative interest rate, you still will get all your original principal back at maturity. "

As I understand it, you get back the original face at maturity, if that is greater than the CPI adjusted face. So yesterdays buyers at worst will get back 100- but they paid 104+, plus a small imbedded cpi adjustment. So if they are getting a put, and in a sense they are, it is way out of the money.

Ha

 

[FIRE'd@51]

As I understand it, you get back the original face at maturity, if that is greater than the CPI adjusted face. So yesterdays buyers at worst will get back 100- but they paid 104+, plus a small imbedded cpi adjustment. So if they are getting a put, and in a sense they are, it is way out of the money.

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.

 

[GusLevy]

I believe Hulbert is wrong or sloppy on this quote

I originally quoted the incorrect message...the following is a response to #17 by haha:


The way to think about yesterday's events is to remember that it was an auction. The Treasury offered the Market the real yield at .50% but the Market climbed over one another to bid the .50% coupon down to -.55% yield. In effect, the real yield had a -.55% bid-side and a .50% offered-side so the Market real yield is effectively negative these days.

The break-even rate is therefore wider than it was before the auction as well. The Market is expecting higher inflation which means that they will expect to receive higher Nominal yields from hereon, ceteris paribus.

 

[haha]

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

 

[FIRE'd@51]

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.

 

[FIRE'd@51]

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.

 

[haha]

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

 

[NW-Bound]

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.