This week, the U.S. government issued federal debt at a negative yield to maturity.
According to Reuters:
The U.S. Treasury Department on Monday sold securities that fetched a negative yield for the first time, implying investors are willing to pay the government to own its debt.
A historic and interesting event. One worth briefly discussing.
This issue required initial investors to pay a premium of USD 105.50. In exchange, they receive a semi-annual interest payment at an annual coupon rate of 0.50%. At the end of 5 years the investors receive the $100.00 principal.
If you want a quick refresher on bond terminology, please review this post.
Crunching the numbers, the yield to maturity is -0.55%.
Not a prudent investment, getting a negative return on your capital over 5 years.
But is it?
Would investors really “pay the government to own its debt”?
The keys lie in the type of debt issue and investor expectations.
Inflation Protected Bonds
This debt issue consists of Treasury Inflation Protected Securities (TIPS).
As the name states, TIPS are inflation protected. The face value of the bond is adjusted each period for any inflation. That gives investors protection against general price increases.
Consider if these bonds were not inflation protected and 0.50% is considered a market interest rate. That would mean that the bonds could be issued at their USD 100.00 face value, with no premium or discount needed. Every 6 months you would receive an interest receipt of USD 25.00 and at the end of the 5 year term you would receive your original USD 100.00.
Now imagine that inflation rises at 3% per annum during the 5 years that you own the bonds. That means that each year the price of a basket of typical goods rises by 3%. Products you could have bought for USD 100.00 had you not invested instead in the bonds will cost USD 115.93 in 5 years time.
Had you invested in the non-inflation protected bonds, you would receive USD 100.00 at maturity. Unfortunately, at a rate of 3% inflation, your purchasing power has diminished significantly over the 5 years.
To protect against the ravages of inflation, inflation protected debt may be issued.
TIPS are one such inflation protected bond.
The face value of the bond is adjusted for any inflation each time an interest payment is made to bondholders. The interest rate itself stays fixed, 0.50% in the above TIPS issue, but the principal changes to account for inflation.
If there is no inflation, the face value of the bond remains at USD 100.00 and the interest payment would be USD 25.00 (semi-annual payment at the annual rate of 0.50%). However, if the inflation rate in year one is 3%, the face value would adjust to USD 103.00 and the payment would be USD 25.75. The extra USD 0.75 reflects the inflationary impact.
If inflation grows at 3% over the term of the bond, at maturity it would pay back principal of USD 115.93. As you can see above, this is the same amount as the general inflation growth. So the inflation protection component serves to keep the investor whole in purchasing power.
Investor Expectations
Okay, TIPS provide investors with inflation insurance. But why would investors take negative returns on the initial issue?
Because of their inflation expectations.
In this case, investors expect inflation to increase over the next 5 years.
If this comes to pass, then these investors will protect their purchasing power. The initial negative yield can be considered an insurance premium paid to the government for protection against future inflation.
Over the 5 years, as inflation adjusts the bonds’ face value upwards, the yield on the debt will become positive. In fact, on a real return basis, the return on the TIPS will likely exceed the real return on similar bonds that are not inflation protected. Whether the TIPS exceed or not will depend on the initial interest rate spreads and the inflation growth over the term.
The fact that the yield is negative also reflects generally low level of interest rates in the U.S. With current rates being low, the premium paid for inflation insurance has tipped the initial yield into negative territory.
Utilizing TIPS
The combination of investor expectations concerning future inflation and the low interest rates in the market has served to create this historic negative yield issue.
Unless the market is incorrect, this foreshadows coming inflation. It will be interesting to see yields on future TIPS offerings as to whether this belief is reinforced.
TIPS can be a useful investment in anyone’s portfolio. They serve as an excellent hedge against inflation and will preserve one’s purchasing power.
TIPS are especially important to retirees and others relying on fixed income. People who need to ensure their income will be able to pay for ever increasing costs of their goods and services. That said, they should not be ignored by younger investors, especially if inflation is a concern.
Because of the premium paid (in the form of lower coupon rates) for inflation insurance, TIPS are better in inflationary times. In stable or deflationary economies, the premium paid usually makes non-real return bonds a better option.
It is never easy to time market shifts, so all investors may want some real return investments in their portfolio at all times. That said, it is easier to assess inflationary trends to a better degree than predicting whether a stock market will rise or fall. So you may be able to shift in and out of real return bonds using market timing.
As with any bond investments, I would generally recommend that one ladder bond purchases over multiple years. While not protecting against inflation specifically, laddering will serve to protect against interest rate fluctuations.
