(Extract from pages 6 to 7 of BIS Quarterly Review, December 2010)
On 25 October 2010, the US Treasury for the first time ever issued TIPS1 at a negative real yield. TIPS are bonds that pay coupons on a principal that is indexed to the US CPI, and that pay a principal at maturity that compensates for increases in the CPI since the bond was issued. At the auction, investors bought $10 billion of 4½ year TIPS bonds, for which they paid $105.51 for $100.00 principal and a 0.50% coupon. The pricing of the bonds implied that the real yield to maturity was -0.55% annually, meaning that investors who bought this issue were expecting to lose over ½% annually on their investment in real terms., Why did investors accept this deal?
The high prices paid at the auction were in line with the prevailing pricing in the TIPS market, where real yields had already fallen well below zero, in particular for short- to medium-term bonds (Graph A, left-hand panel). While real yields, together with nominal yields, had been falling throughout much of 2010, the slide accelerated following Federal Reserve Chairman Bernanke's Jackson Hole speech on 27 August, which investors saw as signalling additional Fed Treasury purchases (Large-Scale Asset Purchases (LSAPs)). In the two months after this event, the fall in real yields outpaced the decline in the nominal yields, eventually pushing real five-year yields below zero.
The drop in real yields mainly reflected increasing inflation compensation (expected inflation and inflation risk premium) among investors in September-October (Graph A, centre panel), in line with growing expectations of easier US monetary policy. In an environment where LSAP expectations were placing particular downward pressure on nominal yields, higher inflation expectations or inflation risk premia had to be accommodated by real yields dropping even more.3
There was little evidence to suggest that bond market-specific factors (such as bond liquidity considerations) were behind the rise in bond break-even rates. Inflation swap rates rose broadly in parallel with the bond break-evens in September-October.4 If, instead, changing investor perceptions about the relative liquidity of the nominal and the index-linked bond market segments had been driving developments, the two break-even measures would probably have moved less in sync. The same argument would apply to the possibility that the bond break-even rate could have been "distorted" by expectations of Fed interventions in bond markets.
The negative real yields were also in line with the pricing of nominal bonds. For example, a rough measure of the expected real yield on five-year nominal Treasuries, obtained by subtracting the five-year inflation swap rate from the nominal yield, moved essentially in parallel with the real TIPS yield, and was also deeply negative on the day when the aforementioned TIPS auction took place (Graph A, right-hand panel).5 This too suggests that there was nothing "odd" about the pricing of TIPS bonds around that time.
The negative real yields also reflected market expectations that future short-term real yields would be negative for some time. According to the standard expectations hypothesis, the yield on a Treasury bond reflects the average future short-term interest rate during the life of the bond plus a term premium component. This applies to nominal as well as real bond yields. With the Fed continuing to signal that it is committed to keeping the nominal fed funds rate close to zero for a prolonged period, short-term real interest rates will be negative for as long as inflation is positive. Hence, abstracting from term premia, TIPS yields should turn negative over maturities where average short-term real rates are expected to remain negative.
An additional factor contributing to higher TIPS prices, and hence lower real yields, is that these bonds incorporate an option-like feature that is valuable in times of high uncertainty about the future path of inflation. First of all, TIPS - in contrast to nominal bonds - offer investors insurance against inflation surprises. In addition, this inflation insurance is asymmetric. While investors are compensated for higher inflation by having the principal indexed to the CPI, the principal is not reduced in case of deflation.6 Hence, TIPS investors benefit from deflation in the same way as nominal bond investors, but they receive the extra benefit of protection from rising inflation.7 Put differently, TIPS have a built-in inflation option with a strike price of 0% inflation. This option, as any option, is particularly valuable when it is at the money (close to the strike price) and when uncertainty (volatility) is high. This essentially characterises the current US situation. It therefore adds further value to TIPS bonds, thereby depressing their yields more.8 Thus, investors accepted a negative real yield in order to protect the principal from inflation while maintaining the option to benefit from possible deflation.
1 These instruments are sometimes also referred to as Treasury Inflation-Indexed Securities (TIIS).
2 This is unless the US CPI were to fall over the period until the maturity of the bond; see below.
3 Investors widely anticipated that the Fed would concentrate almost all of its purchases in the nominal Treasury market.
4 An inflation swap (zero coupon) pays the CPI inflation accrued on a notional value over the relevant maturity of the swap against a fixed payment, which reflects the inflation swap price.
5 On 25 October, the date of the TIPS issue, the five-year nominal yield stood at 1.18% while the five-year inflation swap rate (which is a rough measure of expected inflation over the next five years) was 1.91%, implying an expected real yield on the nominal bond of around -0.73%.
6 This is by construction. The US Treasury will repay the higher of par and the inflation-adjusted principal at maturity.
7 There is still a small disadvantage for TIPS holders in case of deflation over the life of the bond, compared with holders of nominal bonds, in that the deflation floor applies only to the principal, not to the coupons. TIPS coupons are based on the inflation-adjusted principal, even if inflation turns out to be negative.
8 This option is especially valuable for newly issued TIPS, which have not accrued much inflation and for which the principal therefore is close to par. As a result, yields on such bonds tend to be lower than for more seasoned bonds with similar outstanding time to maturity.