The bond market made history this week: investors paid to lend the government money. The government may want to throw a parade. Investors shouldn’t. On Monday, five-year Treasury inflation-protected securities (TIPS) were auctioned off at a negative yield of -0.55%. Demand was so strong that the Treasury auction was oversubscribed by a 2.84 bid-to-cover ratio—the number of bids received divided by the number of bids accepted. Anything above a ratio of two is considered a successful auction.
TIPS can be an attractive inflation hedge because the principal value increases with inflation. As a result, coupon payments increase with inflation, and principal is returned at maturity just like a Treasury bond. The expected inflation rate for the market, or breakeven inflation rate, can be determined by comparing five-year TIPS with nominal five-year Treasuries. The five-year Treasury nominal yield is 1.18%, resulting in an expected 1.73% inflation. Those who purchased TIPS at auction on Monday fear that inflation will be greater than 1.73% over the next five years. They sniffed trouble around the corner with the Federal Reserve signaling another round of quantitative easing (QE II).
In fact, if you look at the 10-year TIPS breakeven inflation rate as shown in the chart below, you’ll see a dramatic uptick from only 1.5% to 2.1%. Your best protection in this bond market is to stay with short-term bond funds and corporate bonds. It’s certainly possible that the initial reaction to further QE II may be overdone. But don’t expect investors to pay to lend the government money forever. History says they won’t.