Treasury Inflation-Protected Securities

Over the last couple of years, Treasury Inflation-Protected Securities were the toughest prizefighter in the investment world: You could knock them around a little, but they always came roaring back.

Then … Ben Bernanke spoke.

It was May 22, and the Federal Reserve chairman was speaking to the Congress’ Joint Economic Committee. Although the Fed chairman said a lot of middle-of-the-road mumblings about economic stimulus, jobs and interest rates, the markets seized on this comment about the Fed’s monthly purchases of $45 billion of Treasuries and $40 billion of mortgage bonds:

“At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.”

Later, in response to a question, Bernanke suggested – but only suggested – that the bond buying could be trimmed back in the next few months, if the economy continues improving.

Even before May 22, yields on TIPS had been rising, because of recent reports showing very weak inflation – running just 1.1% over the last 12 months. Now, with the suggestion that Federal bond-buying might slow down or even halt, the trend was locked. Here’s what has happened in those 23 days:

What’s interesting here?  Yields on TIPS are rising much faster than the overall bond market, hitting 2-year highs. Yields on nominal Treasuries, however, are increasing at a slower pace and really haven’t hit unusual levels. For example, on March 19, 2012, the 10-year Treasury hit 2.39%, 20 basis points higher than the current level. On that same day, a 10-year TIPS was yielding -0.03%, 18 basis points lower than today’s level. That’s a 38 basis-point swing.

And so … the ugly truth. TIPS are being battered because investors have lost their lust for this one particular product. That’s a hard trend to reverse. And when overall interest rates do begin climbing, TIPS will be battered even more. When you see a 10-year Treasury at 2.75%, you can expect to see a 10-year TIPS yielding around 0.6%.

For TIPS traders and mutual fund holders, if overall rates really do rise, that’s going to mean more bad news, possibly a decline of another 5%, especially if inflation remains muted.

The bright spot. This trend also means that TIPS are getting cheaper against nominal Treasurys, and more attractive to the buy-and-hold investor. If you are a buying small amounts with each auction, the outlook is good. Higher yields are a good thing.

The Treasury will announce tomorrow that it will reopen CUSIP 912810RA8, creating a 29-year, 8-month Treasury Inflation-Protected Security that will auction Thursday, June 20. Update: Here is the announcement.

This TIPS will have something going for it that’s been extremely rare: a discount. It originally auctioned Feb. 21 with a coupon rate of 0.625%, and a yield to maturity of 0.639%. It is currently selling on the secondary market for about $87 for $100 of value and a yield of 1.132%.

Yields on TIPS have been rising sharply since May 1. According to the Treasury Resource Center, the yield on a 30-year TIPS rose from 0.44% on May 1 to 1.14% on June 11. That’s an increase of 70 basis points, and it makes this 30-year offering a lot more interesting.

Buyers will get around 1.14%, plus inflation, over 30 years. Sound appealing?

The negatives. There are a couple of caveats, though.

Number 1 is: Will you be holding this issue to maturity? If so, you need to be ready to ride out — and ignore — some wild price swings. This TIPS originally auctioned for $99.61 and has fallen to $87. That’s a drop of 12.7% in four months.

If you are holding to maturity, no problem. You’ll get your 1.14%, plus inflation, and you can ignore the market noise. But this brings up negative Number 2: Will you be alive in 30 years? This is especially important if you are buying this TIPS in a taxable account. Here’s why:

Let’s say you put $10,000 into this TIPS, which will pay that coupon rate of 0.625% on a principal balance that will rise with inflation. And let’s say inflation averages 2.5% over the next 30 years. You will owe current-year taxes on $313 a year, and that number will rise. If you are in a high tax bracket your bill will be maybe $140 a year. But the coupon on this TIPS will provide you with only $62.50 a year, not enough to pay the taxes owed.

So this TIPS will be cash-flow negative until maturity. If inflation escalates, it will be even more negative.

So you will want to live to maturity, to see that money you’ve been paying taxes on for 30 years. If you die, you lose.

This is why I prefer buying 10-year TIPS and having them mature at a set date in the future, when I can decide to spend the money or reinvest.

The appeal. A yield to maturity of 1.14% (or possibly higher) will be the best yield on any TIPS auctioned in more than two years. I can see the appeal of adding that to a TIPS portfolio, just to get a boost in income. It is still below the ‘more normal’ yield of 2% to 2.5% that long-term TIPS buyers expected in the past, as this chart shows:

Another positive is the inflation breakeven rate versus a nominal 30-year Treasury, which closed Wednesday with a yield of 3.33%, up 50 basis points since May 1. That sets the probable breakeven rate for this TIPS at 2.19%, and that number could drop a bit before the auction.

It’s not much of a gamble to expect inflation higher than 2.19% over the next 30 years.

One more thing to consider. If the Treasury follows its usual pattern – and I expect it will – this 30-year TIPS will be reopened one more time in October. So you’ll need to ask yourself: Where are rates headed over the next four months? Buy in June, or wait for October?

Also, a new 10-year TIPS is coming in July.

After a month of very sharp rises in the yield on Treasury Inflation-Protected Securities, the trend continued Monday, with the yield on the benchmark 10-year TIPS rising to 0.11%, plus inflation, marking two trading days in a row the yield has gone positive.

That is an incredible gain of 75 basis points since May 1, when the yield stood at -0.64%. This is the first time the 10-year TIPS yield has gone positive since Dec. 15, 2011. That has been a very long, painful slog for net buyers of TIPS (buying more than mature each year).

The trend has reversed. TIPS are interesting again, for the buy-and-hold investor.

Buy and hold is my TIPS philosophy. That means buying TIPS at TreasuryDirect and holding them to maturity. There is very little risk in this strategy. You aren’t trading, you can ignore the secondary price and never consider ‘duration.’ Along with I Bond purchases, it is a very conservative way to preserve capital, for a portion of your portfolio. (And a poor way to build wealth, I must say.)

However, buyers should be choosy. I stopped buying TIPS in June 2011, a 30-year TIPS with a yield of 1.774%. Nearly two years later, last month, I got back in the game, purchasing the 10-year TIPS reissue with a yield of -0.225%.

Painful day. But for investors in TIPS mutual funds and ETFs, these are painful times. The flagship ETF, with the ticker TIP, declined $0.80 today to close at $114.64, down 0.69% on the day and down 5.9% since May 1.

Obviously, money is pouring out of TIPS funds, just as it poured in during a heady 20-month period from July 1, 2011, to April 30, 2013, when TIP increased from $105.96 to $122.15, or 13.3%.

Unlike a stock mutual fund, there are no ‘fundamentals’ to support the price of the ETF or other TIPS mutual funds. No one looks at 200-day moving averages or strange chart formations. The value of TIPS is determined by the yield to maturity, and the yield is rising. That means the price is falling, and will keep falling as long as the yield increases.

There are several factors at work here:

• Overall interest rates are rising. The nominal 10-year Treasury closed today at 2.22%, up 56 basis points since May 1.
• The yield on TIPS is rising even faster – 77 basis points since May 1. That means TIPS are getting cheaper versus traditional Treasurys. Today’s 10-year inflation breakeven rate stands at 2.11%, getting close to my 2.0% ‘cheap’ marker.
• Inflation is currently muted, running just 1.1% over the last 12 months. Since TIPS offer extremely low yields, low inflation is a double whammy for TIPS holders.
• Despite the pain for traders and mutual fund investors, TIPS are a much better deal for investors today than they were 40 days ago. This chart shows just how rarely the breakeven rate drops below 2.0%:

At some point, I might get interested in TIPS mutual funds. I speculate (not with money, just my mind) that the TIP ETF is heading down to about $110 and the 10-year Treasury will hit 2.75%. At that point, a 10-year TIPS would be yielding maybe 0.55%, maybe higher, but still substantially below the 1% to 2% that TIPS investors saw in the past.

I am often wrong. Very wrong. Back in May 2011, I wrote a blog explaining why I was exiting Fidelity Inflation Protected Bond (FINPX) in favor of Vanguard Total Bond Fund. I was doing this at EXACTLY the wrong time, and to my embarrassment, this was one of my most popular blog posts of all time. It still gets viewed, every day.

Oh well, here is how that worked out:

I looked wise for about a month, then very stupid as the Federal Reserve launched QE after QE, buying Treasurys and creating money to stimulate the economy.

But my bond portfolio is more about preserving capital, along with a minimal interest-rate return. Vanguard Total Bond Fund is still one of my favorites. And here’s how it has gone since May 1:

I won’t claim to know what the future holds. I have long believed that yields on TIPS were unnaturally low, and that trend had to – and would – reserve. I think that trend has started. Let’s watch to see if I am right.

I was on vacation and away from a computer (an iPad is NOT a computer) the last two weeks, and blog-writing was impossible. Enjoy the glories of Vancouver Island, B.C., or struggle with writing a blog on an iPad? Easy choice.

But it has been an amazing three- to-four weeks for TIPS, with yields rising sharply and the price of the TIP ETF falling sharply, all starting about two weeks before the May 23 reissue auction of a 10-year TIPS.

Recapping how the yields have risen:

The 10-year TIPS yield rose a dramatic (!) 67 basis points in little over a month, while the rate on a nominal 10-year Treasury rose 51 basis points. That means TIPS got cheaper, pushing the 10-year breakeven inflation rate to a decent 2.14%. Remember it was running at 2.53% in January 2013, when TIPS were in much greater demand.

The rise in yields took a toll on the TIP ETF, which fell from $121.81 on May 1, all the way down to $115.44 on June 7. That’s a decline of 5.3% in 38 days — and demonstrates why I have not been a fan of owning TIP ETFs or mutual funds since July 2011. As these funds continued to hit all-time highs, risk was being built into the price.

And the decline may not be over: TIPS are the ugly stepchild of Treasurys right now, because they are being hit by the worst-case ‘perfect storm’: 1) higher interest rates, and 2) lower inflation. With inflation running just 1.1% over the last 12 months, TIPS have little appeal to the average investor, offering a low (or negative) base yield plus a paltry inflation adjustment.

This chart demonstrates what a rising breakeven rate looks like, at a time when Treasury yields are also rising. The TIP ETF has performed much more poorly than the IEI (intermediate-term Treasurys, a fund with a similar duration):

Should buyers avoid TIPS? No way. For the buy-and-hold investor of Treasury Inflation-Protected Securities, the trend means that TIPS are getting interesting again. The yield on a 10-year TIP has inched back into positive, and this month’s 30-year auction should generate a yield well above 1%. Not stellar, but at least interesting.

And inflation? The current very low rate can’t and won’t continue if the economy continues to improve and central banks across the world continue creating money. The inflation  protection that TIPS offer continues to be valuable.

What about the ETF? My theory is that the 10-year Treasury could rise to about 2.75% by the end of the year, and if it does, that would set the 10-year TIPS yield at about 0.5%, about 47 basis points higher than it is today. If that happens, the TIP ETF would fall another 4%, or maybe to the $111 to $110 range. At that point, I might be a buyer.

The Treasury just announced that today’s auction of a 9-year, 8-month Treasury Inflation-Protected Security resulted in a yield of -0.225%, the highest yield on a 10-year TIPS in more than a year. This was a bit better than the -0.244% experts were predicting just before the auction.

Here is the Treasury announcement.

CUSIP 912828UH1, with a coupon yield of 0.125%, was first auctioned in January with a yield to maturity of -0.630% and then reissued in March with a yield of -0.602%.

The rise in yield means that buyers at today’s auction will be paying a much lower price for that 0.125% coupon, about $104.27 per $100 of value. That is down from $107.50 from the January auction.

The principal balance of TIPS is adjusted to reflect inflation, so a buyer at today’s auction is accepting a return of 0.225% less than inflation each year over 10 years.

TIPS yields, which have been as low as -0.750% for a 10-year issue, have been rising in the last month because of a trend of weakening inflation, plus a fear among investors that the Federal Reserve soon could halt or slow its bond-buying stimulus.

10-year breakeven rate

At midday today the 10-year Treasury was trading with a yield of 2.03%, making the 10-year inflation breakeven rate 2.255%. This is substantially lower than the lofty 2.54% resulting from the March reissue of this same TIPS. That means TIPS have become cheaper relative to traditional Treasuries.

Analysis of the auction

Carolyn Cui of the Wall Street Journal writes:

With real yield rising to the highest in more than a year, the inflation-adjusted Treasurys attracted decent demand from investment funds and foreign investors. …

One negative reflection of the auction, however, was that it had a light ratio of bidders to the amount of debt sold, at 2.52 times compared with the average of 2.66 times for 10-year TIPS during the past six auctions. As a result, the auction stopped at -0.225%, higher than the -0.246% for similar notes already in circulation before the auction.

Daniel Kruger of Bloomberg writes:

“Investors felt like this was meeting their support levels where they felt it was time to jump back in,” said Michael Lorizio, senior trader at Manulife Asset Management in Boston. “Digging deeper into the data really does spell this as a really solid auction.”

I am going to say yes on this auction, and that is significant: It will be the first TIPS I will have bought at auction since June 2011, a 30-year TIPS with a yield of 1.774%. I won’t be going ‘all in’ but I will be reinvesting money from a TIPS that matured earlier this year.

I am pretty thankful that a series of economic events have driven the likely yield on this TIPS up to somewhere around -0.28%. That is 35 basis points higher than the yield of this TIPS, CUSIP 912828UH1, when it was first auctioned on Jan. 24, just four months ago.

Yes, I know that -0.28%, plus inflation, is not an attractive yield. But look at the history of recent 9- to 10-year TIPS auctions, and you can see that Thursday’s reissue will be the most attractive since March 2012:

Back in March 2012, by the way, the auction set an all-time low for a 9- to 10-year TIPS. But things were about to get a whole lot worse, as the Federal Reserve ramped up its bond buying and stoked fears of inflation.

Jump forward to May 2013, and inflation is running an extremely mild 1.1% over the last 12 months. Inflation is currently out of the picture as a major concern. Just look at what Fed Chairman Ben Bernanke said today:

“I would point out that even though we have a dual mandate, that inflation if anything is a little bit too low. Inflation has been very low; the dollar has been strong. We have not in any way failed on that responsibility.”

So inflation fears are dwindling, but at the same time interest rates are rising. Here are numbers for yields on the 10-year nominal Treasury:

• May 1, 2013 = 1.66%
• May 10, 2013 = 1.90%
• May 20, 2013 = 1.97%
• May 22, 2013 = 2.03%

And then, this is the important point: TIPS are getting cheaper. We have seen a very gradual decline in the 10-year TIPS breakeven rate (nominal Treasury yield minus TIPS yield = breakeven rate). Here is the trend in breakeven rates, drawn from Treasury data:

• March 16, 2012 = 2.43%
• Jan. 2, 2013 = 2.53%
• March 21, 2013 = 2.54%
• May 1, 2013 = 2.30%
• May 10, 2013 = 2.35%
• May 20, 2013 = 2.28%
• May 22, 2013 = 2.27%

It’s not a dramatic change, but TIPS have been getting steadily cheaper versus nominal U.S. Treasurys.

Thursday’s auction offers a chance to reload with a buy-and-hold 9-year, 8-month TIPS at a yield that is a definite improvement over more than a year of auctions.

The future (for TIPS buyers) may be even brighter. Who knows?

I think it’s time to jump cautiously back into the pool.