Montreal, Canada

Who’s buying Treasury Inflation-Protected Securities or TIPS? Rates are at rock bottom and inflation is falling, not rising.

For the first time since their introduction in 1997, TIPS now harbor the lowest yields.

Yesterday, the five-year TIPS closed the session yielding nothing – that’s right, absolutely zero. At this morning’s opening, the note has dropped a bit to yield a mind-blowing 0.06% or six basis points! That’s not exactly the Field of Dreams when it comes to yield.

The break-even rate, calculated by subtracting the nominal Treasury bond rate less TIPS’ yield, is just 1.36%. Nominal five-year Treasury bonds yield 1.42%.

In 2010, the total return of the Vanguard Inflation-Protected Fund is 5.6%; that’s an enigma because inflation expectations have literally crashed since May when benchmark ten-year Treasury bonds yielded about 4%. Investors buy TIPS because they seek inflation protection – not a deflation hedge. Or perhaps this is not the case…

Benchmark ten-year TIPS yield 0.94% and, adjusted for the break-even compared to nominal Treasury bonds, which yield 2.61%, pay just 1.67%. That means the market expects an average ten-year inflation rate of just 1.67% from now until 2020.

Who is buying TIPS in this accelerated environment of disinflation?

TIPS provide an absolute floor even amid deflation. TIPS can’t yield less than zero whereas nominal bonds can — if demand is strong enough to drive rates into negative territory. This occurred in the 1930s. But TIPS are attractive for this reason: Yields can’t go into minus territory. That would explain why investors continue to bid TIPS prices higher even though deflation fears have mounted since May.

From my end, I would not buy TIPS now. I wouldn’t lunge after non-TIPS fixed-income securities, either.

We’ve had an explosive rally in bonds since May and prices right across the curve are really expensive. TIPS aren’t cheap and offer a raw deal. Ultimately, higher inflation down the road might draw interest from bond investors into these securities; but what’s the point if interest rates are rapidly rising? Who’ll want to buy TIPS? If anything, Treasury bills will draw the bulk of fund-flows, not bonds or TIPS as rates eventually rise.

TIPS are not forecasting an inflation problem any time soon. Recent price action, however, might be a deflationary strategy now in-play among bond investors as they seek to hedge not against inflation, but deflation.