Monday, October 25, 2010

Money Losing Government Bonds?

The New York Times reported today that investors are willing to accept a negative interest rate for the privilege of investing in a particular type of bond.  The bonds in question are known as Treasury Inflation-Protected Securities, or TIPS.  You can learn more about them here, but basically they are a type of loan to the U.S. Government.  What makes them unique is that your interest rate is tied to the inflation rate.  The more inflation rises, the more interest you earn.  Of course, if inflation rises, the cost of goods increases, so you are just breaking even.  However, it does provide an investor with a way to protect his or her money if inflation spikes.

The unique thing about the more recent sale of these bonds is that investors were willing to accept a negative interest rate in return for this inflation protection.  The article says that investors are willing to pay the government 0.55% in interest for this protection.  In other words, if inflation stays constant, then investors actually have to pay a little over half a cent for every dollar invested.   If inflation rises, then investors will get an interest rate equal to inflation, minus the 0.55%.  On the surface this seems like a bad deal.  After all, you can put your money into any savings account and not lose money (unless you trigger fees and penalties, but that is another story).

So why would an intelligent investor engage in such an investment?  One quirk of TIPS is that if there is deflation (i.e. where prices are falling), the U.S. Government doesn't lower the interest rate below -0.55%.  That is the worst that you can do.  However, if inflation goes up, then you end up making money.  Investors who feel like inflation is going to rise sharply will do what it takes to protect themselves, and TIPS are one way to insure oneself against rising prices.  If you put $100 into TIPS and inflation rises 10%, you get back $109.45 which will just about make up for the fact that $100 of products will now cost you $110.  Yes, there are other investments which will rise with inflation, but with TIPS the connection is built into how the investment is designed.

Who knows?  Maybe these crazy investors aren't so crazy after all!

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