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Yesterday was an historic day in the bond market. While European government bond yields continue to dominate headlines, a more esoteric market closer to home had a notable day. The United States government sold a record amount of five-year Treasury Inflation Protected Securities (OTC:TIPS) at a record yield of negative 1.08%. The auction marked the fifth consecutive sale of inflation-linked debt that carried a negative yield.

Treasury Inflation-Protected Securities are government bonds whose principal is adjusted by changes in the Consumer Price Index. When inflation is present and the price index is rising, the principal increases at the same rate as the prince index, providing an inflation hedge. When the principal grows, interest payments also grow because they are set at a fixed percentage of the principal. Yesterday's notable issuance was a five-year inflation-protected security paying a 0.125% coupon that priced at $106.39. Novice fixed income investors occasionally get understandably confused by the meaning behind a negative yield. Investors bought a bond for $106.39 that will pay them 0.125% per year for the next five years. If inflation is zero over the next five years, the sum of principal at maturity and the coupon payments will be less than the initial premium outlay, which is why the yield is negative.

The implications of the size of the auction and the amazingly low rate have tremendous repercussions for fixed income investors. The U.S. government was able to raise proceeds more than the notional it currently owes investors while paying a miniscule running financing cost. Investors demanded these securities because of their fear of rising inflation. Since TIPS and traditional U.S. government bonds are both backed by the full faith and credit of the U.S. government, we can glean inflation expectations of TIPS holders by examining the relative yields of matched maturity TIPS and Treasury notes. This differential is commonly referred to as breakeven rates.

With five-year TIPS yielding -1.08% and five-year Treasury notes yielding 0.84%, the breakeven rate is 1.92% as holders of TIPS expect this inflation rate on average over the next five years. The inflation breakeven rate for ten years is 2.22%, which is roughly 26 basis points higher than the current ten-year Treasury yield. TIPS investors believe that inflation will be greater than the nominal return on Treasury securities through the ten year part of the curve, which means that if the inflation forecast embedded in 10-yr Treasury securities proves correct, then holders of Treasury notes will earn negative real returns adjusting for this level of inflation.

As you can see from the chart below, the 5-yr Treasury yield remains near its all-time low, but inflation expectations implied by the breakeven rate are steadily rising. The difference between the two is now more negative than at any point since TIPS were first auctioned in mid-1997. The U.S. government is enjoying the benefit of being able to inflate away a portion of its mounting debts as it pays back its borrowings with dollars whose purchasing power will decline at a rate greater than the nominal interest the government pays.

(click to enlarge)

This of course has implications for other high quality fixed income asset classes where credit spreads do not offer enough incremental yield to provide a sufficient real return. Within fixed income, I remain a proponent of BB corporate credit, which I view as appropriate compensation for the incremental credit risk and the eventuality of rising rates (as compensation for inflation). Near-term volatility notwithstanding, I also still favor domestic equities over credit and rates markets outright. Given that low government borrowing rates in the U.S. have resultantly lowered the borrowing rates of domestic corporations, I would rather own the earnings stream than be the lender that provides historically cheap leverage. Individual investors who seek inflation protection should look beyond TIPS to a basket of commodities, or the equity of companies who are able to adequately pass through rising costs to their end consumers.

Fixed income investors in Treasury notes and high quality bonds should understand that there are investors in an abstruse corner of the fixed income universe who are pricing inflation-protected securities at high levels because they expect zero or negative returns on your holdings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Tips From TIPS: Implications For Bond Investors