Bond Market Review: TIPs Market Priced for Deflation

Panic in financial markets and the prospect of the Fed buying longer-dated Treasuries drove T-bond prices to extremes in the fourth quarter. The plunge in the 10-year Treasury yield – from 4% at the start of November to 2.1% by the end of December, is unprecedented in the past half-century. The benchmark T-note yield has had a notable upward reversal in the past week, jumping from 2.1% to 2.5%, which is encouraging for those of us not in the deflationary depression camp. T-note rates near 2% are actually viewed as negative for stocks because they are reflecting the very poor economic and financial crisis the U.S. has encountered.

Trends in corporate, mortgage-backed, and municipal bonds have been very constructive in recent weeks; we have seen a notable narrowing of spreads to Treasuries. Fears of default and lack of market liquidity had pushed spreads on municipal and corporate bonds to levels not seen since the Great Depression. The collapse of the Wall Street broker dealer community created pricing anomalies in many corners of the bond market.

Astute investors were able to pick up bargains such as tax-free municipals yielding 200% of comparable maturity Treasuries and investment grade intermediate term corporate bonds with yields in excess of 10%. Despite the recent rally in corporate and municipal bonds, solid value remains in these asset classes.

The only area of the Treasury market that looks interesting is inflation-protected bonds. The TIPs market is priced for deflation out to five years. Five-year TIPs bonds currently yield 1.88% versus a 1.77% yield on nominal five-year Treasuries, suggesting that Treasury investors expect negative CPI inflation over the next five years. There is little question we will see negative CPI inflation in 2009, but with the government printing and spending money like there is no tomorrow, an expectation of CPI deflation for the next five years seems absurd. An investor in five year TIPs gets a 1.88% real return per annum plus whatever increase in CPI occurs over the next five years.

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