Investors betting on inflation are doing strange things to the bond market.

Commentary about business and finance.
Oct. 26 2010 6:08 PM

Don't Be So Negative

Investors betting on inflation are doing strange things to the bond market.

Bonds. Click image to expand.
Bonds

On Monday, the U.S. Treasury sold $10 billion in government bonds to investors who, if current conditions prevail, have agreed to lose money. For the first time ever, the Treasury sold debt with a negative yield. Does that mean that the investors are paying the Treasury to hold their money? And if so, why would they do that?

The answer to the first question is no—they aren't paying Treasury for anything but the bonds, though they could lose money on the deal. And the answer to the second is that they're betting that inflation will rise.

To explain, let's run through some bond basics. The negative yield resulted from the bond's specific cocktail of interest payments (its coupon), price (what investors paid for it at auction), and its expected return on investment (its yield, a function of the coupon and price, and inversely related to the price). In a bond auction, the Treasury takes investors' cash, borrowing dollars from them in exchange for the bond, a kind of IOU. Each bond comes with a redemption date: anywhere from a few months to 30 years, at which point the Treasury gives investors their money back.

There are two main types of bonds: short-term and long-term. When investors buy short-term bonds from the Treasury, they get them at an auction, usually for just below face value. (People bid differently, but everyone pays the same amount.) When the bond's time is up—when it "matures"—Treasury gives the investor the face value of the bond back in cash.

Longer-term bonds work in much the same way, except they also come with interest payments, called the bond's "coupon." Every year, for example, Treasury might pay the investor 1 percent of the bond's face value. Then, when the bond matures, the investor can cash it in at full face value—just like a short-term bond.

For short-term bonds, the yield is a function of the difference between what the investor pays for the bond and its face value. Say you bought a $100 short-term Treasury bond, a T-Bill, for $98. You would make $2, for a yield of about 2 percent. For long-term bonds, the yield is a function of the difference between the price of the bond and its value over its lifetime. Say you bought a $100 10-year Treasury bond with a 1 percent coupon for $109. By the time the bond matured, you would have gotten 10 $1 payments—and then you would have gotten the face value of the bond ($100) back, for a total of $110. You would have made $1, for a yield of a bit less than 1 percent.

So how can bond yields—depending on the difference between what the investor invests and what the Treasury gives back—be negative? Why would any investor overpay, so obviously?

For short-term bonds, there are a few rare circumstances in which investors might pay more for a bond than its face value—making the yield negative. They might prefer to lose a small but defined amount of money by lending cash to the government, rather than losing everything in, say, a financial market collapse.

But that's not what happened Monday. There was another variable in play: The Treasury sold a type of bond called Treasury Inflation-Protected Securities, or TIPS.

Bond investors tend to be allergic to inflation, because longer-term bonds provide a set interest payment. If a 30-year bond grants an investor $10 a year, every year, then the lower the rate of inflation, the more that money is worth. For most of the bonds it sells—actually, 93 percent of them—Treasury lets investors worry about how to cope with inflation. But for that other 7 percent—TIPS bonds—Treasury takes inflation into account by adjusting the value of the bond according to the Consumer Price Index.

If the country experiences inflation, the Treasury marks up the value of the bond. If the country experiences deflation, it marks it down. Treasury pays interest on the adjusted value of the bond, not its face value. And it pays back the adjusted value of the bond, rather than its original face value, when it matures.

So, let's say that you bought a $100 five-year bond with a 0.5 percent coupon at its face value. For a normal bond, Treasury would give you $2.50 in interest payments, plus your $100 back. But let's say that inflation increased 1 percent per year over the life of your bond. With a TIPS bond, Treasury would compensate you for that change. It would mark up the bond from $100, to $101, to $102.01, to $103.03, to $104.06. Your interest payments would total about $2.56 over five years. And you would get $104.06 back when you cashed in. With a normal bond, you would have lost money in real terms. With a TIPS bond, you would have come out a bit ahead.

Investors at Monday's auction paid $105.50 for a $100 five-year bond with a 0.5 percent coupon. All things being equal, the investors overpaid—hence the negative yield. But that just means that they expect inflation to be positive for the next five years. Crunching the numbers, annual inflation for the next five years needs to be somewhere north of about 1.55 percent for the investors to break even. Any more inflation than that, and they make money.

So why do so many investors think that inflation might head upward? Because next week, the Federal Reserve is expected to announce a new round of quantitative easing—printing money, and possibly stoking inflation. Of course, not everyone believes the Fed's policy will have that effect. In that case, these negative-yield bonds will be true to their name.

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