Thursday, October 28, 2010

A Comment on the Recent TIPS Auction

There has been some comment about the negative yield realized on the October 25 auction of 41/2 year Treasury Inflation Protected Securities (a reopening of a security originally issued with a maturity of 5 years.)  Excluding accrued interest, winning bidders paid $105.508607 for an original par value of $100 of the security.

Most commentary said that, based on the spread between the negative yield on this security with conventional Treasury securities in the five-year maturity area, this implied that market participants believe that inflation will be increasing.

I did not see any commentary that mentioned that TIPS also provide more real yield under certain circumstances when there is deflation. I discussed this in a previous post. In short, purchasers of TIPS are assured of getting $100 back at maturity for an original par value of  $100 in the event of deflation over the life of the security.

Given the index ratio of 1.00725 for the issue date of the reopened securities, deflation would have to run at an average annual rate of more than approximately -0.16% for the next 4 1/2 years for Treasury to be required to pay a supplement to the adjusted value of the principal at maturity. Any supplement payment would mean that the negative real yield of the TIPS would be reduced, and, if deflation were severe enough, the realized real yield could become positive.

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