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Ever since Ben Bernanke hinted that a second round of quantitative easing was a possibility during a speech at Jackson Hole, speculation has centered on what the program would look like. With the Fed set to meet on November 3rd, it is safe to say that the investment community has been anxiously awaiting the announcement of how a second round of quantitative easing (or QE II for those of you without access to the outside world) will be implemented. But with the question not revolving around if the Fed will act but rather the manner in which they will act; investors have been searching for ways to trade the Fed’s next move.

The traditional thought process among traders focused on the dollar and the section of the yield curve the Fed is expected to target (most anticipate the FOMC will do most of their buying in the 2-10 year range). This meant that traders sold the dollar and as Bill Gross likes to put it, “shook hands with the government,” by buying the type of bonds that the Fed may buy.

The result of this herd mentality trade has been a decline in the dollar and a big drop in treasury bond yields over the past several months. However, just recently some words from Mr. Bernanke caused traders to focus on another type of bond: the TIPS.

TIPS stands for Treasury Inflation-Protected Securities. According to Treasury Direct, Treasury Inflation-Protected Securities provide protection against, yep, you guessed it; inflation. The principal of a TIPS bond increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS bond matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

So, with inflation currently running at very low levels, the question becomes why investors are interested in this type of bond. Well, the minutes from the most recent FOMC meeting showed that Mr. Bernanke and friends have decided that inflation it too low. And since the Fed fears deflation more than the other end of the pricing spectrum at this time (nobody wants to see a replay of the Japan-style deflationary spiral), Bernanke basically told the investment community that the Fed was going to create some inflation if it was the last thing they did.

One of the arguments against the implementation of QE II has been the fear of “unintended consequences” such as runaway inflation or the creation of asset bubbles. And while we’re not sure if a negative yield on the 5-year TIPS necessarily qualifies, it definitely got our attention this week.

On Monday, the Treasury held a 5-year TIPS auction and the results were quite interesting. In short, there was such a demand for these inflation-adjusted bonds that the yield on the 5-year TIPS wound up being -0.55%. Yep, that’s right, if you decided to lend the government money for 5 years via this TIPS bond and things stayed the same in the economy over that period, you would wind up losing money on these government guaranteed bonds. This brings new meaning to the phrase “buying right.”

In fact, Monday’s auction marked the first time TIPS bond resulted in a negative yield. Why would investors pay such a price to create a negative yield, you ask? In short, those participating in the auction are banking on the idea that Helicopter Ben will achieve his goal and create a little inflation over the next 5 years. And since most experienced investors know that the winding up with just “a little inflation” is like trying slow a boulder rolling down a hill once it gets moving.

For the mathematically inclined, it is interesting to note that the 5-year breakeven inflation rate following Monday’s auction is 1.55%. This means that if held to maturity, holders of the auctioned TIPS would expect a return of 1.00%. Should inflation of, say 3.0% per year occur, the return would be 2.45%. But the problem with TIPS yields being negative is that if inflation shifts back towards more normal averages, investors could easily suffer capital losses.

So, anyone buying TIPS these days had best hope that Bernanke and Co. come with “shock and awe” on Wednesday and open up that checkbook in a big way.

Disclosure: No positions

Source: Why Buy Bonds With a Negative Yield?