TIPS' Yields Show Fed Has Lost Control of Inflation
By Sandra Hernandez and Deborah Finestone
Bond investors have never been so sure that the Federal Reserve will lose control of inflation. They're so convinced that they're giving up yields just to buy debt securities that protect against rising consumer prices.
The yield on the five-year Treasury Inflation-Protected Security due in 2012 has been negative since Feb. 29, and traded today at minus 0.17 percent. The notes, which were first sold in 1997, have never before traded below zero. Even so, firms from Deutsche Asset Management to Vanguard Group Inc., the second- biggest U.S. mutual fund company, say TIPS are a bargain.
For the first time in a generation, money managers must come to grips with a central bank that's more intent on spurring the economy than restraining price increases. With oil above $100 a barrel, gold approaching $1,000 an ounce and the dollar at a record low against the euro, TIPS show investors aren't convinced Fed Chairman Ben S. Bernanke will be able to tame inflation once policy makers stop cutting interest rates.
``The way TIPS are trading now, investors believe headline inflation will stay lofty and are willing to give up the real yield for that,'' said Brian Brennan, a money manager who helps oversee $11 billion in fixed-income assets at T. Rowe Price Group Inc. based in Baltimore. Prices for the securities indicate ``a real concern of a recession and high headline inflation,'' he said.
Because TIPS pay a principal amount that rises in tandem with the consumer price index, buyers accept lower yields in a bet the inflation adjustment will make up the difference.
Investors typically determine what they are willing to receive in interest by deducting the rate of inflation expected over the life of the securities from the rate on a comparable Treasury. Investors can still earn money from TIPS with sub-zero rates because the principal rises with the CPI.
Five-year TIPS yielded 2.36 percentage points less than similar-maturity Treasuries as of 9:14 a.m. in New York. The so- called breakeven rate has risen from a four-and-a-half-month low of 1.89 percent on Jan. 23, the day after policy makers cut their target lending rate by three-quarters of a point to 3.50 percent in an emergency move.
The last time investors were so worried about faster inflation amid slowing growth, Paul A. Volcker presided over a Fed that would raise rates as high as 20 percent to end the stagflation crisis of the 1970s, according to Seth Plunkett, a bond fund manager at American Century Investment Management in Mountain View, California. The firm manages $20 billion.
Inflation ``is going to be higher than the Fed's targeted area,'' said Plunkett, whose fund owns a greater percentage of TIPS than contained in the index he uses to measure performance.
In forecasts released last month, the Fed said it expects inflation to accelerate 2.1 percent to 2.4 percent this year, and 1.7 percent to 2 percent in 2009.
TIPS have returned 6.2 percent this year, compared with 3.7 percent from regular Treasuries, according to indexes compiled by Merrill Lynch & Co. Mutual funds that specialize in inflation-linked debt attracted a net $2.87 billion in January, boosting their assets to $47.6 billion, according the latest data available from Financial Research Corp. in Boston. In all of 2007, the funds added a net $3.54 billion.
``TIPS are a really good buy,'' said Bill Chepolis, a money manager who helps oversee $9 billion at Deutsche Asset Management in New York. He bought five-year TIPS in the last six months. ``They're cheap with the Fed continuing to emphasize growth over inflation and inflation continuing to come in higher.''
Investors seeking a haven from credit-market losses have pushed yields on all Treasuries lower, including TIPS. Five-year nominal note yields have dropped 1.03 percentage points this year to 2.41 percent.
``It's crazy,'' said Richard Schlanger, a portfolio manager at Boston-based Pioneer Asset Management, which oversees $44 billion in fixed income. ``You're paying the government to buy five-year TIPS. People are hiding in Treasuries for liquidity's sake because of a lack of liquidity in other markets. Eventually this will pass.''
Record-low TIPS yields also reflect bets on surging commodities. Crude oil futures rose to $106.54 last week and are up 70 percent in the past year.
Growth in countries such as China and India mean that rising prices for goods including wheat, gold, and oil ``may be a permanent thing,'' said Paul Samuelson, the second recipient of the Nobel Prize in economics who helped popularize the term ``stagflation.'' ``This time it's primarily not made-in-America inflation.''
The Treasury stopped selling five-year TIPS between 1998 and 2003, and resumed auctions in October 2004. In addition to the current five-year security, seven other inflation-indexed notes with up to four years to maturity currently yield less than zero.
Should five-year TIPS continue to have negative yields when the Treasury holds its next sale April 22, federal rules state investors would receive a coupon of zero percent, said Stephen Meyerhardt, a Bureau of Public Debt spokesman in Washington.
``TIPS have performed really well for the right reasons and they will continue to perform well for the right reason,'' said Kenneth Volpert, a fund manager overseeing $14.7 billion in inflation-linked debt at Vanguard in Valley Forge, Pennsylvania.