Who’s Buying TIPS At These Negative Yields?
Currently, TIPS (Treasury Inflation Protected Securities) investors are paying dearly to protect themselves from inflation. In order to keep up with CPI, an investor in 5 year TIPS chooses to earn a whopping -1.74% annualized real return over the next 5 years.
Yes, investors are literally paying to protect themselves from inflation (as recently as 2019, we could still get paid for owning TIPS). And it’s CPI based inflation, which honestly if you’re living in a coastal city is not the inflation rate you actually experience. For example, I live in the Bay Area — I guarantee you that true cost of living (housing, education, etc.) is increasing at a much higher rate than the 1.4% year over year rate that CPI clocked in at.
So why would anyone buy a TIPS bond? Well as always in markets, it’s important to think about alternatives. Instead of buying a 5 year TIPS bond, an investor could instead buy a series of 1 year TIPS bonds over the next five years (buying a newly issued 1 year TIPS bond as the previous one matures).
You would do better by buying the series of 1 year bonds if you believe that real yields are going to rise more than discounted. That is, if rates rise enough, then it becomes more attractive to roll short term bonds and keep reinvesting your money at higher and higher yields. If rates fall enough, then it becomes more attractive to to invest in longer duration bonds that lock in today’s higher yields (versus the lower ones you expect in the future).
This also means that there is some future path for 1 year real yields that would make an investor indifferent between investing in a series of 1 year TIPS bonds and investing in a 5 year TIPS bond. This is the future path of real yields that is being currently discounted by the market. When the future unfolds differently than what’s discounted, profits can be earned.
If you’ve been following along carefully, you will notice that even if buying a 5 year TIPS bond is better than rolling a series of 1 year TIPS, doing so still locks us into an annualized -1.74% real return — not attractive at all.
The key is to go long what you think is attractively priced and short what you think is not. So if we think real yields will fall more than discounted, we should go long 5 year TIPS and short 1 year TIPS.
This amounts to paying a floating interest rate (since you are short a series of 1 year TIPS bonds, you must pay an interest rate that floats along with the market rate) and receiving a fixed one (from the 5 year TIPS).
Thus, longer duration TIPS bonds are still being bought at negative real yields because many investors believe that real yields will continue to decline. Some are buying TIPS now and hoping to be able to sell at a higher price (when real yields decline) well in advance of the bond’s maturity date (holding to maturity locks in a negative return).
Others are entering relative value (long and short) trades like we described above betting that the fixed rate they receive over the next few years will outweigh the floating rates they must pay.
Finally, there are some that are either betting on or desperate to hedge excessive inflation. These investors are either buying TIPS outright or buying TIPS and shorting Treasury bonds. The rationale being that if inflation comes in higher than expected, there will be a significant rise in the demand for TIPS, pushing up their prices even more (and their yields even lower). The relative value trade here would be to buy TIPS which benefit from high inflation and short Treasuries which are hurt by inflation due to their fixed coupon payments.
So buyers of TIPS are not as hateful of money as they might first appear. Rather, many of them are making a bet that real yields will fall or inflation rates will rise even more than what’s currently being discounted by market prices. In a world of economic recovery and seemingly infinite QE, that actually seems pretty rational.