There’s been lots of pondering about the negative five-year Treasury inflation-protected (Tips) rate, but here’s one explanation that strikes us as extremely sensible.
Tips are the best.
In the event of deflation, they perform just as well as conventional bonds because it’s not their coupons that are adjusted for inflation but their principals.
Coupons are fixed, but obviously yield greater nominal sums as the principal increases.
But since the principals have an inbuilt floor — i.e. the value cannot fall below the issuance sum — investors continue to be protected from potential wealth erosion in a deflationary environment.
In the event of inflation, meanwhile, Tips benefit immediately from principal appreciation.
So, as Nemo at the Self Evident blog points out — they become the perfect investment for anyone simultaneously worried about deflation and sizeable inflation in the long term.
More importantly, as Nemo also points out, they protect against volatility too:
If you are unable to identify an asset which you are confident will appreciate as least as quickly as the CPI, then again you could rationally purchase TIPS at a negative yield. (Can you name such an asset? Go ahead; I dare you.)
In my view, the negative TIPS yield is saying something about the perceived levels and volatility of traditional inflation hedges such as stocks, real estate, and gold.
If these valuations and/or volatilities are high enough, rational people might well be willing to sacrifice some slight amount of real wealth for the relative certainty of preserving most of their purchasing power.
In short, the negative TIPS yield is a rational reaction to the lunatic casino that has infested essentially every market in the world.
And in a lunatic casino, an investor might very well be prepared to put in more than he currently expects to receive, if there’s a flexibility put like there is in Tips.
As Nemo sums up:
My point is that the certainty of TIPS returns, relative to the uncertainty of everything else, can make them attractive even if they are guaranteed to lose value in real terms. It is the valuation and volatility of the alternatives that makes this possible.
Quite.
Related links
Tipsy in the TIPS market - FT Alphaville
The perils of releasing the repo rate - FT Alphaville