Inflation worries show in negative TIPS yield
History was made in the bond market on October 25 when the government’s auction of TIPS — Treasury Inflation Protected Securities — resulted in a negative interest rate. It marked the first time TIPS were sold at a negative yield.
Why would investors knowingly accept a negative return?
TIPS have a special feature — their value adjusts when the rate of inflation increases. The negative yield on October 25 shows that investors for the first time were willing to pay for protection from future inflation. And investors’ desire for protection has increased since late August, when the Federal Reserve began talking about another round of quantitative easing to stimulate the fragile economy. Depending on its magnitude, quantitative easing could generate a rise in inflation.
What do TIPS offer investors?
As investors, it’s important to keep in mind that TIPS offer long-term inflation protection. The price of TIPS adjusts with a lag. In the short and medium term, these prices can go down if interest rates rise faster than the inflation-adjustment mechanism can keep pace.
Today, with TIPS yields so low — even negative, in some cases — TIPS prices are especially vulnerable. At the end of September 2010, the duration — or sensitivity to interest rates — of the Barclays Capital U.S. Government Inflation-Linked Bond Index was 8.04, almost twice as high as the broad bond market, as measured by the Barclays Capital Aggregate Bond Index, which sported a duration of 4.67.
An alternative to TIPS
Putnam Absolute Return 100 Fund offers a more flexible way for investors to prepare for the possibility of inflation. It has the objective to outperform inflation, as measured by Treasury bills, by 100 basis points over three-year periods.
However, the fund has investment flexibility to choose securities that can perform well in an inflationary environment rather than rely solely on TIPS, and use strategies that minimize the negative impact of rising interest rates. Examples include focusing on shorter-term bonds approaching their maturity date or using interest-rate futures contracts to reduce the fund’s duration as part of a consistent goal to outperform inflation.
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