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Betting on inflation

By Sheyna Steiner · Bankrate.com
Friday, March 23, 2012
Posted: 2 pm ET

Yesterday, the Financial Times website, FT.com, reported that $13 billion of 10-year Treasury inflation-protected securities were sold at a negative yield of -0.089 percent at this week's Treasury auction.

The interest rate on these particular TIPS was 0.125 percent; investors paid a premium of $102.23 for every $100 worth of bonds. Paying the extra $2.23 pushed the yield down to -0.089 percent.

Why would otherwise rational people pay for bonds that are, on the surface, guaranteed to lose money? In a word: inflation. TIPS pay more as inflation rises, thanks to the Consumer Price Index-linked component that adjusts the principal twice per year.

Interest is also paid twice per year and is based on the coupon or the stated interest rate of the bond.

Before interest is paid, the face value of the bond is adjusted for inflation. Upward movements of inflation will result in higher values and vice versa.

Let's say in January, an investor bought a TIPS for $1,000 with a coupon of 0.125 percent.

The interest paid will be based on the stated interest rate of 0.125 percent and the face value of the bond, $1,000. The fact that they paid a premium of $22.30 over par, or face value, is irrelevant to inflation adjustments and interest payments.

If the annual inflation rate remains 2.2 percent for the first half of the year, the inflation adjustment to principal will be $11, changing the par value of the bond to $1,011 to which an interest payment of 63 cents will be added.

If the rate of inflation jumps to 3 percent by the end of the year, the new par value will be adjusted to reflect that, $1026.17, and it will earn an interest payment of 64 cents.

"What people are doing is anticipating that CPI is going to go up, and when they start getting the CPI component added in, it is going to more than make up for the slight premium paid on the bond," says Don Cummings, founder and portfolio manager at Blue Haven Capital in Geneva, Ill.

"They're ignoring the coupon and saying CPI is going to come in at 3 or 4 or 5 percent pretty consistently, and now I will have a very competitive, interest-bearing instrument backed by the U.S. government that I can hold for 9 years," he says.

Inflation is a concern due to the quantitative easing measures enacted by the Federal Reserve. Inflation hawks have cautioned that loose monetary policy will lead to more inflation than would be desirable in coming years.

For instance, on Friday, Bloomberg Businessweek reported that James Bullard, president of the Federal Reserve Bank of St. Louis, warned of the danger of "elevated inflation that persists for years should developed nations mistime their exits from easy monetary policies," according to the story, "Fed's Bullard sees global inflation threat."

Rampant global inflation: not a happy prospect but one that perspicacious TIPS-buyers would surely profit from.

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1 Comment
haha
March 25, 2012 at 4:11 am

For anyone looking more into SAVING than investing and has a 5 year time frame for this cash should look into storing it in a I series Bond. It's been in the 3-4% range for the last year. Not to mention tax deferred until redeemed and state tax free. Blows a 5 year CD out of the water right now.