March 4, 2008 / 8:42 PM / 9 years ago

U.S. real yields turn negative on inflation risks

NEW YORK, March 4 (Reuters) - Returns on some U.S. Treasury bonds have slipped into negative territory for the first time ever this week as investors anticipate record commodity prices will boost the rate of inflation even as the economy slows.

Investors have been scooping up Treasury Inflation Protected Securities, or TIPS, which peg the principal payout at maturity on the rate of inflation. Investors are betting that inflation rate will rise, fattening the return on the securities and making up for the negative yield.

"TIPS are performing well on an outright basis due to credit concerns. They are outperforming on a relatively basis versus nominal Treasuries due to growing inflation concerns," said Michael Pond, Treasury and TIPS strategist at Barclays Capital in New York.

On Tuesday, eight TIPS issues with maturities of five years and less had negative yields -- an unprecedented event -- according to analysts.

For example, the five-year TIPS issue due April 2011 last traded a yield-to-maturity of minus 0.32 percentage point. This meant that traders see inflation as measured by the government's Consumer Price Index running at about 2.30 percent between now and when this TIPS issue matures.

That level is also well above the top end of the Fed's perceived comfort zone for core inflation of around 2 percent.

Meanwhile, longer TIPS yields have remained positive with the 10-year issue due January 2018 last traded at 1.08 percent.

For now, the negative impact on bonds from a spike in inflation risks has been overshadowed by the broad decline in yields as a result of the Federal Reserve's rate-cutting campaign and safe-haven demand for Treasuries stemming from the credit crunch.

So far this year, regular Treasury securities have generated positive albeit modest returns for investors, compared with the whopping losses in the stock market. The Standard & Poor's 500 index .SPX is down 9 percent and the Nasdaq .IXIC is off nearly 16 percent.

TIPS, given their inflation protection feature, have fared even better.

Through Monday, the year-to-date total return on TIPS was 5.43 percent and on Treasuries 3.75 percent, according to Lehman Brothers.

While government bonds have done well, sustained negative yields will erode the gains fueled by Fed's rate cuts and safe-haven demand, analysts said.

"A negative consequence of negative real interest rates is inflation, a consequence seen in earnest recently," Tony Crescenzi, chief bond market strategist with Miller Tabak & Co., wrote in a research note. (Reporting by Richard Leong; editing by Gary Crosse)

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