TIPS selling for negative yield first time ever

First things first, TIPS are Treasury Inflation Protected Securities.  The purpose for the creation of TIPS is to protect investors from the negative effects of inflation.  TIPS are able to achieve this by having a fixed interest rate, usually very low (in the case of the most recent auction, just .5%), and adding an indexing factor based on the CPI (Consumer Price Index).  The indexing is accomplished through an adjustment to the principal value based on the CPI.  So, while the interest rate remains fixed, the semiannual coupon payment is adjusting for the effects of inflation by an increase in the principal amount.  For example, if a TIPS bond is issued at par for $1,000 at a 2% annual rate, and inflation is 1% over the first 6 months, the inflation-adjusted principal would be ($1,000 * 1.01) $1,010.  The investor would receive a coupon payment of ($1,010 * (2% / 2 payments per year)) $10.10.  This differs from the $10 the investor would have received without the inflation adjustment to the principal.  Inflation is constantly adding to the principal and that final amount is repaid at maturity along with the last coupon payment.

In the case of the most recent TIPS auction, investors purchased the TIPS with a rate of .5% at a premium, $105.50 for a $100 face value bond.  Over the life of these bonds, the .5% rate alone, without the inflation adjustment to the principal would result in the -.55% yield due of the premium over face value.  With very moderate inflation around 1.5% every year for the life of the bond, investors who purchased these TIPS would break even.  Inflation has historically averaged 3% since 1926 and 1.1% the last 12 months.  So, if inflation heads towards the 3% historical rate, past the 1.5% break even, these investors will be returning money on their investment, most likely at a better rate than the near zero money market rates.

After an extended period of the Fed keeping short-term interest rates bordering zero to spur the economy and wage war on deflation, it seems as though inflation is starting to be priced into the market.  This is with anticipation of more quantitative easing measures by the Fed to purchase securities in the open market with newly printed money.  If the old truth holds that bond investors are a step ahead of equity investors, prepare for inflation and quit worrying about deflation.

I hope that settles some requests about the understanding of this negative yield TIPS auction.  Please continue providing feedback and requests and always *preserve your capital*!