(Bloomberg News) Bonds that pay negative yields are turning into the hottest part of the $9.94 trillion market for U.S. Treasuries, a sign of shaken investor confidence in an economy the Federal Reserve says shows only "modest" strength.
A $15 billion auction of Treasury Inflation-Protected Securities this month drew the strongest demand since March even though yields on the notes average less than zero percent for the first time, according to Bank of America Merrill Lynch indexes.
Yields on all types of Treasuries are at or near record lows and, except for the 30-year bond, provide negative real returns after taking into account the consumer price index.
Investors are seeking the safety of U.S. debt as analysts cut their growth forecasts and Europe's fiscal crisis deepens, helping the government borrow record sums to support the economy almost five years after the subprime mortgage meltdown led to worst financial disaster since the Great Depression.
TIPS have returned 111.3 percent the past decade, beating the 73.4 percent for Treasuries not indexed to inflation. The Standard & Poor's 500 Index has gained about 33 percent, including dividends.
"Even with real rates being negative, investors view TIPS as the optimal place to put your money if you do have to buy U.S. bonds because it is still government paper while also protecting you from long-term inflation," said George Goncalves, the head of interest-rate strategy in New York at Nomura Holdings Inc. The firm is one of 21 primary dealers of U.S. government securities that trade with the Fed.
Treasuries of all kinds rallied last week as the Fed said it "expects economic growth over coming quarters to be modest" and that it may need to keep interest rates near zero through 2014, more than a year later than planned. A day later, the Treasury sold $29 billion of seven-year notes at a record low yield of 1.359 percent.
The week ended as figures from the Commerce Department showed that gross domestic product, the value of all goods and services produced, climbed at a 2.8 percent annual pace last quarter, less than the 3 percent median forecast of 79 economists surveyed by Bloomberg News.
Yields on 10-year Treasuries dropped last week by 13 basis points, or 0.13 percentage point, to 1.89 percent, according to Bloomberg Bond Trader. The price of the 2 percent note maturing November 2021 rose 1 6/32, or $11.88 per $1,000 face amount, to 100 30/32. The yield fell four basis points today to 1.86 percent at 6:46 a.m. in New York.
Yields on 10-year TIPS fell to negative 0.2 percent from negative 0.004 a week earlier, as the price of the benchmark 0.125 percent note due January 2022 rose 10/32 to 103 10/32. The yield was negative 0.24 percent today.
The allure of TIPS was never more clear than in the auction of 10-year securities earlier on Jan. 19. Even though the yield was minus 0.045 percent, the first time in history that it was less than zero at an auction of that maturity, investors submitted offers for 2.91 times the amount raised. That was the highest so-called bid-to-cover ratio since the 2.97 at March's auction, when the yield was 0.49 percent.
While buyers of the TIPS sold this month aren't paid interest, the principal on the bonds rises with consumer prices, a feature not found in the rest of the Treasury market, which is already trading at its most expensive levels on record.
TIPS have "yields that are pathetic by normal standards," said Jeffrey Schoenfeld, a partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $45 billion. With rates this low, TIPS "stand out as being a little on the cheap side," he said.
TIPS have returned 4.2 percent since September, compared with 0.9 percent for all Treasuries, Bank of America Merrill Lynch indexes show. Trading has increased to an average $9.51 billion a day since the end of June among the primary dealers of U.S. government securities, according to the Fed. That's up from $6.78 billion in the second half of 2010.
TIPS, which have grown to a $739 billion market since being introduced in 1997, pay interest on a principal amount that rises and falls with the CPI, which increased an average of 3.2 percent in 2011. The securities yield negative 0.535 percent overall, down from last year's high of 0.72 percent in February, Bank of America Merrill Lynch indexes show.
The difference in yields between 10-year TIPS and 10-year Treasury notes of 2.1 percent, known as the break-even rate, represents traders' expectations for inflation over the life of the securities. The CPI is forecast to rise 2.1 percent this year, down from 3.2 percent in 2011, according to the median estimate of 66 economists surveyed by Bloomberg.
After taking inflation into account, 10-year Treasury notes yield negative 1.14 percent, compared with the median positive of 2.58 percent over the past two years, according to data compiled by Bloomberg.
"It's dangerous being very long Treasuries right now," said Christopher Sullivan, who oversees $1.9 billion as chief investment officer at United Nations Federal Credit Union in New York.
Many investors see little choice but to own U.S. government debt of any type. In an update of its World Economic Outlook report on Jan. 24, the International Monetary Fund cut its estimate for global growth this year to 3.3 percent from a September forecast of 4 percent.
A day later, the Fed extended its previous pledge to keep the target rate for overnight loan between banks near zero until the middle of 2013, as more than two years of economic growth have failed to push unemployment below 8.5 percent.
"Economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014," the Federal Open Market Committee said in a statement on Jan. 25.
The decision bolstered speculation that Fed Chairman Ben S. Bernanke will tolerate faster gains in consumer prices, which erode the value of bond interest payments over time. The FOMC last week set a goal of 2 percent inflation, with most policy makers forecasting 1.4 percent to 1.8 percent in 2012.
The gauge of inflation used by the Fed is called the personal consumption expenditures index. The measure, excluding food and fuel prices, rose 1.7 percent in November from a year earlier, below the average increase of 1.9 percent the last decade, according to the latest government data.
"Fed policy is the main reason real rates are in negative territory," said Michael Pond, co-head of interest-rate strategy in New York at Barclays Capital, also a primary dealer.
Yields on benchmark 10-year TIPS may fall to negative 0.4 percent by the end of June, even as the government sells more of the securities to diversify its debt offerings, according to Pond. In its quarterly survey of bond dealers on Jan. 13, the Treasury asked how it could to further develop TIPS.
Donald Ellenberger, the co-head of government and mortgage- backed debt at Federated Investors in Pittsburgh, agreed the securities still have room to gain.
"There are some investors who feel the Fed's action will ultimately be inflationary," said Ellenberger, who oversees about $10 billion. "We are overweight the asset class."