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Mark Hulbert
Oct. 26, 2010, 12:07 a.m. EDT
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By Mark Hulbert, MarketWatch
CHAPEL HILL, NC (MarketWatch) "” How much should you have to pay for an insurance policy that protects you against both severe deflation and hyperinflation?
We found out the answer earlier this week: 55 basis points per year.
Though you might not have recognized it as such, this answer was imbedded in the results of the government's latest auction for five-year TIPS "” Treasury Inflation-Protected Securities. For the first time ever, the yield at which the TIPS were sold was negative: minus 0.55%. (Read report on five-year TIPS' negative yield.)
This means that the interest rate that these TIPS are going to pay will be 0.55% less than the Consumer Price Index's rate of increase between now and 2015.
Why would anyone want to buy a bond on these terms that seemingly guarantee that investors will lose ground to inflation? Commentators in the wake of the auction have been struggling to come up with a rational explanation.
It turns out, however, that those who bought the TIPS at this week's auction might not have been all that irrational. That's because, according to Luis Viceira, a professor at Harvard Business School, TIPS don't just provide protection against unexpectedly high inflation; they also protect the investor from deflation as well.
In an interview, Prof. Viceira referred to this deflation protection as a "deflation put." It traces to an under-appreciated feature of TIPS: Regardless of how much deflation occurs during the term of the bond, which otherwise would translate into a negative interest rate, you still will get all your original principal back at maturity.
In other words, TIPS' payoff is asymmetrical: Its yield grows in the event of higher inflation, but does not decline to the same extent in the event of deflation.
TIPS therefore should appeal to investors who are uncertain about whether much higher inflation is in store or, instead, an extended Japanese-style deflation.
Investors like almost all of us, in other words.
Let's say that inflation over the next five years is a lot worse than the market anticipates, say 5% a year. In that event, the TIPS sold on Monday will have an average yield of 4.45% "” a whole lot better than the 1.17% current yield of normal Treasurys that do not provide inflation protection.
What if we get severe deflation, and over the next five years the CPI declines by, say, 2% per year on average? In that event, the investor who bought TIPS on Monday will make a real return over the next five years of 1.45% annually.
Sounds like "heads I win, tails I win too."
Little wonder so many investors were willing to accept a negative yield of 0.55% per year.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.
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