Why Are Treasury Inflation-Protected Securities Yields Negative?

Treasury Inflation-Protected Securities (TIPS) are a type of U.S. government bond designed to protect against inflation. Issued by the U.S. Department of the Treasury, these securities are considered among the safest investments available, backed by the full faith and credit of the U.S. government. They represent a unique class of fixed-income assets that behave differently from traditional Treasury bonds.

A bond’s yield represents the total return an investor expects to receive from holding the bond, expressed as an annualized percentage. This return considers the bond’s interest payments, its current market price, and the price paid for it. While typically yields are positive, TIPS can sometimes exhibit negative yields, a concept that warrants closer examination.

Understanding Treasury Inflation-Protected Securities and Yields

Unlike conventional Treasury bonds that pay a fixed interest rate on a fixed principal, the principal value of a TIPS is adjusted periodically based on changes in the Consumer Price Index for All Urban Consumers (CPI-U), a widely recognized measure of inflation. This adjustment means that as inflation rises, the principal value of the TIPS increases, and conversely, it decreases with deflation.

The interest rate, also known as the coupon rate, for a TIPS is fixed at the time of auction. However, the actual interest payments received by the investor fluctuate because this fixed rate is applied to the inflation-adjusted principal value. For example, if a TIPS has a 1% coupon rate and its principal increases by 2% due to inflation, the interest payment will be calculated on the new, higher principal amount, resulting in a larger dollar payment.

At maturity, investors are guaranteed to receive no less than their original principal amount, even if deflation has occurred, or the inflation-adjusted principal, whichever is greater.

For TIPS, the yield typically refers to the “real yield,” which is the return an investor receives after accounting for inflation. A “negative yield” for TIPS specifically indicates a negative real yield, meaning that the return on investment, after factoring in inflation, is less than zero.

This implies that while the principal’s purchasing power is protected, the investor is effectively paying a small amount for that protection over time. Despite a negative real yield, the core benefit of TIPS—preserving the purchasing power of the principal—remains intact, distinguishing them from traditional bonds during inflationary periods.

Causes of Negative TIPS Yields

Negative yields on Treasury Inflation-Protected Securities (TIPS) primarily reflect strong market demand for inflation protection. High inflation expectations among investors are a significant driver; when market participants anticipate substantial future inflation, they accept a lower, or even negative, real return for the guaranteed protection TIPS offer. This heightened demand pushes up TIPS prices, driving down their yield into negative territory.

Increased demand for inflation protection contributes to negative TIPS yields. During economic uncertainty, investors seek assets that preserve capital in real terms. TIPS become highly attractive, leading to competitive bidding that depresses yields. This demand stems from various investors, including large institutional funds and individual savers, all seeking to mitigate inflation risk.

A “flight to safety” dynamic also plays a role during heightened economic volatility. Investors move capital into secure assets like U.S. Treasuries, which are considered safe due to government backing. TIPS offer the dual benefit of government backing and inflation protection, making them appealing during risk-off periods, increasing demand and pushing yields lower. This underscores a preference for capital preservation over maximizing returns when uncertainty looms.

Central bank monetary policy, particularly Federal Reserve actions, profoundly influence TIPS yields. Large-scale asset purchases (quantitative easing or QE) involve the central bank buying government bonds, including TIPS. This increases demand, driving up prices and lowering yields. If the Federal Reserve maintains very low nominal interest rates, it can suppress real yields across the bond market, as investors seek any available positive real return.

The basic economic principles of supply and demand also directly impact TIPS yields. If the demand for TIPS significantly outpaces the supply of newly issued TIPS by the U.S. Treasury, their market prices increase. This increase in price leads to a corresponding decrease in their yields, pushing them into negative real territory. The U.S. Treasury issues TIPS with maturities of 5, 10, and 30 years, and the supply at each auction can vary, interacting with market demand to determine the prevailing yields.

Effects of Negative Yields for Holders

For investors holding Treasury Inflation-Protected Securities (TIPS) with a negative real yield, their overall real return on investment will be below zero. Despite receiving semi-annual interest payments and principal adjustments for inflation, the actual purchasing power generated by their investment will slightly diminish over time. This means that while the dollar amount of their principal may increase with inflation, the return earned on that adjusted principal does not keep pace with, or even falls short of, the rate of inflation itself.

A primary benefit of holding TIPS, even with a negative real yield, is the preservation of the principal’s purchasing power. Unlike traditional bonds, where inflation erodes the value of future fixed payments, TIPS actively adjust their principal value upward with inflation as measured by the Consumer Price Index. This ensures that the original investment amount maintains its real value, providing a safeguard against the corrosive effects of rising prices. The negative yield applies to the return on that protected principal, not to the principal’s ability to retain its real value.

In certain economic environments, holding TIPS with a small negative real yield might still be considered a more favorable option compared to other alternatives. Simply holding cash during inflationary periods guarantees a loss of purchasing power, as inflation directly reduces the value of static funds. TIPS, by contrast, protect the principal’s real value, offering a form of insurance against inflation that cash does not. In times of market uncertainty, the safety and inflation protection of TIPS can make them preferable to riskier assets that may experience significant capital depreciation.

Investors should also be aware of the tax implications associated with TIPS, even when yields are negative. The inflation adjustment to the principal value is considered taxable income in the year it occurs, even though the investor does not receive this adjusted principal until the bond matures or is sold. This “phantom income” can result in a tax liability on income not yet received in cash. Interest payments from TIPS are also subject to federal income tax, though they are exempt from state and local income taxes.