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Are TIPS Buyers Crazy?

Like a fox, perhaps.

The very idea sounds nutty. Why on earth would anyone buy a bond with a negative yield?

That's the question many people--even some with years in other parts of the investment industry--found themselves whispering tentatively after last week's news that the Treasury sold $10 billion worth of five-year Treasury Inflation-Protected Securities with negative yields of 0.55%.

The answer isn't as esoteric as you might imagine, but it does explain something about investor expectations at this juncture of the economic and political cycles. The central issue is that day-to-day volatility aside, TIPS produce returns from two sources: semiannual income payments (or coupons) and periodic adjustments to principal. (For more detail on how TIPS work, look at this piece or this page from the TreasuryDirect website.) When the press reported that TIPS were selling with negative yields, however, it was another way of saying that the bonds' prices were so high that investors were effectively paying more than the bonds' future income payouts were actually worth.

The context some press reports didn't provide enough of, though, was that those yield numbers don't fully explain investors' expectations for inflation or how much TIPS inflation adjustments will drive up their principal values by maturity. In fact, a comparison between the yield of a plain-vanilla (conventional) Treasury bond and a TIPS counterpart with a very close maturity helps paint a clearer picture.

As of Monday, for example, the yield for a conventional five-year Treasury was 1.16%. The difference between that figure and the (in this case negative) yield of a comparably dated TIPS issue can be viewed as a rough approximation of the market's expectation for inflation over the next five years. At 1.52%, that number isn't very exciting; but if it turns out to be accurate, it will be close to the annualized return enjoyed by today's TIPS investor. If inflation turns out to be lower than that, those buying TIPS at today's negative yields will have overpaid; but if it comes out higher, their purchases will be proved prescient.

What does all of this say about the current state of the economy and markets? For one, it says that investors do think the Federal Reserve is going to have success in maintaining some inflation with its ongoing near-zero short-term rate policy and impending quantitative easing program. Those eagerly snapping up TIPS likely believe the Fed will be more than just a little successful and expect that whether 1.52% or higher, the future level of inflation is going to justify holding securities designed to keep up with it, even if they aren't offering any additional compensation.

Putting things another way, buying TIPS at negative yields is an implicit agreement to purchase something with no promise of additional ''real'' yield above and beyond inflation in exchange for the certainty that one's purchasing power will at least keep up with whatever that price level proves to be.

Et Cetera �
One very common question, negative yields or otherwise, is whether it's a good idea for investors to buy TIPS individually rather than through a mutual fund. But while buying individual TIPS carries many fewer complications than those inherent with the purchase of other market sectors, there are important caveats.

One is simply to remember that you won't earn the same total return as that of a similarly invested fund unless you reinvest your income payments. On the other hand, if you hold individual TIPS in a taxable account, you'll need to pay taxes on each year's inflation adjustments, even though you won't actually receive those dollars unless you sell the bond or it matures. (Funds ''distribute'' amounts equivalent to their inflation adjustments.)

If you're at all concerned that we might slip into a deflationary environment, however, it's important to understand the implication of buying an older TIPS bond with a large, embedded inflation accrual versus a relatively new bond whose price is naturally much closer to $1,000.

If the Fed is successful and we dodge deflation entirely, the issue will be moot. If we do experience deflation, however, bonds with large embedded accruals will behave very differently than those without. That's because TIPS come with a backstop protection against deflation, but one that simply promises to pay investors back at least $1,000 per bond.

Take the TIPS issues maturing in January and April 2028. On Monday, the former had accrued principal of $1,042, while the latter came in at $1,349. If the U.S. economy were to slide into a truly nasty period of deflation, the first bond's inflation accrual would disappear first, and its price would stop falling at $1,000. With that same floor in effect, but much further away for the second bond, however, its potential price loss is much greater. That issue currently offers a slight yield premium over the first, but there's a risk it may not be enough.

Luckily, that's an extreme example, given that most TIPS aren't trading so richly today. And even if the Fed does have trouble boosting the economy, a sustained period of spiraling deflation is a pretty unlikely scenario. For those who don't find those various issues worrisome, TIPS can be easily purchased through, and most brokerage firms sell them with very nominal transaction fees. Investors who would rather sidestep worrying about such considerations, however, have several good TIPS fund options to choose from.