Here’s why this week’s 5-year TIPS reopening auction makes investment sense

By David Enna, Tipswatch.com

Can anyone make the case that a 5-year Treasury Inflation-Protected Security with a yield lagging inflation by 1.73% and an upfront premium cost of nearly 10% makes sense as an investment?

Hey, I can.

But that doesn’t mean I will be investing in Thursday’s $16 billion reopening auction of CUSIP 91282CCA7, creating a 4-year, 10-month TIPS. I probably won’t. Nevertheless, in today’s low-interest-rate environment — accompanied simultaneously by surging inflation — this TIPS reopening remains an intriguing investment, “relatively speaking.”

A TIPS is an investment that pays a coupon rate well below that of other Treasury investments of the same term. But with a TIPS, the principal balance adjusts each month (usually up, but sometimes down) to match the current U.S. inflation rate. So the “real yield to maturity” of a TIPS indicates how much an investor will earn above inflation.

CUSIP 91282CCA7 was created in an originating auction on April 22, 2021, when it generated a real yield to maturity of -1.631%, the lowest in history for any TIPS auction of any term. The Treasury set its coupon rate at 0.125%, the lowest it will go for a TIPS. Investors had to pay a sizable premium, about about $109.41 for about $100.32 of value, after accrued inflation and interest were added in.

It now trades on the secondary market, and you can follow its current real yield and price in real time on Bloomberg’s Current Yields page. As of Friday’s market close, it was trading with a real yield of -1.73% and a price of $110.30.

If that yield holds through Thursday’s auction, it would set a new auction low for any TIPS of any term. Investors at this week’s auction will actually pay a higher price than Bloomberg indicates, while getting additional principal. Accrued inflation and interest will put the price at about $111.45 for $102 of adjusted value. This TIPS will have an inflation index of 1.01804 as of the June 30 settlement date.

(Just for nerds: As an aside, it’s remarkable that this TIPS was originated on April 15 and non-seasonally adjusted inflation has increased 1.8% since then. The inflation accrual on a TIPS is applied two months after each monthly inflation report. So the calculation for this TIPS is half of February’s rate of 0.547, which is 0.274%, plus 0.71% in March and 0.82% in April. It adds up to 1.804%, and that’s how you get an inflation index of 1.01804).

Here is the trend in the 5-year TIPS real yield over the last five years, showing the remarkable move lower after the market mania of February 2020, which triggered aggressive moves by the Federal Reserve to suppress interest rates and by Congress to stimulate the U.S. economy:

So, how could this TIPS look attractive?

Thursday’s auction could result in a record low real yield for any TIPS in history, of any term. And investors will have to pay a large premium, just to under-perform inflation by about 1.73% over the next 4 years, 10 months. How could that look appealing? It can, because this TIPS might be the prettiest ugly duckling in a pond of extremely ugly ducks.

There is only one U.S. dollar investment that is both very safe and guaranteed to match official U.S. inflation over the next five years. That is the U.S. Series I Savings Bond, which carries a real yield of 0.0%, a whopping 173 basis points better than CUSIP 91282CCA7’s current return. But I Bonds come with a purchase cap of $10,000 per person per calendar year. Once you’ve made that purchase, where do you look for a very safe 5-year investment? Five-year Treasury notes? A 5-year bank CD? Both of those options are safe, but look very likely to severely lag inflation over the next five years.

If you think we are likely to have a run of higher-than-typical inflation over the next five years, this TIPS becomes a logical investment amid a bunch of disastrous choices. Here are the numbers under varying inflation scenarios:

Once inflation averages more than 2.53% a year, this TIPS will out-perform a 5-year Treasury note at 0.76% or a 5-year bank CD at 0.80%, currently among the best in the nation. But the Treasury note and bank CD have no upside potential; they are both going to return well below 1% for five years. The TIPS has unlimited upside potential once inflation averages higher than 2.53% a year.

For that reason, I think this 5-year TIPS is an attractive alternative to other safe 5-year investments.

Inflation breakeven rate

With a 5-year Treasury note currently yielding 0.76%, this TIPS would get an inflation breakeven rate of 2.49% if it auctions with a real yield of -1.73%. That means it will out-perform a U.S. Treasury note if inflation averages more than 2.49% over the next 4 years, 10 months. That’s high, but this breakeven rate has actually dipped a bit in the last two weeks.

Here is the trend in the 5-year inflation breakeven rate over the last five years, showing the remarkable surge in inflation expectations after Federal Reserve and congressional stimulus kicked in in March 2020:

A year ago, I would have said 2.49% is a ridiculously high breakeven rate for a 5 year TIPS. A year ago, in May 2020, inflation had averaged only 1.5% in the previous 5 years. This year, after an impressive surge in inflation, that average has risen to 2.3%. I have no idea what the “new normal” is going to look like, but an inflation rate of 2.5% (or higher) in coming years looks like a reasonable bet.

Conclusion

The key question for investors is: When do you think nominal and real yields will begin rising? If you think higher rates are coming soon, waiting to invest makes sense. If you think rates will remain stable or decline further, and you want to lock in inflation protection, an investment in this TIPS is reasonable. I expect demand to be pretty strong under these market conditions.

If you are planning to invest, keep an eye on that Bloomberg Current Yields page until the morning of the auction. Real yields have been volatile in the last week. This auction closes at noon EDT Thursday for non-competitive bids and finalizes at 1 p.m. I will post the auction results soon after the auction closes.

Here’s a chart of recent auction results for 4- to 5-year TIPS:

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Bank CDs, I Bond, Inflation, Investing in TIPS | 6 Comments

U.S. inflation surges 0.6% in May, again higher than expected

By David Enna, Tipswatch.com

For the third month in a row, U.S. inflation surged to higher-than-expected levels in May, reaching the highest annual level in nearly 13 years, the Bureau of Labor Statistics reported today.

The Consumer Price Index for All Urban Consumers increased 0.6% in May on a seasonally adjusted basis, the BLS said. Over the last 12 months, the all-items index increased 5.0%; this was the largest 12-month increase since a 5.4% increase for the period ending in August 2008. The May numbers were well above the consensus forecasts of 0.4% for the month and 4.6% for the year.

Core inflation, which removes food and energy, rose 0.7% in May and 3.8% over the last 12 months, also racing well ahead of the consensus forecasts of 0.4% and 3.4%. That was the highest increase in core inflation since June 1992.

One amazing aspect of this report was that seasonally-adjusted gasoline prices actually fell in May, down 0.7% for the month but still up 56.2% over the last 12 months. I expected to see higher gas prices, caused by shortages throughout the Southeast thanks to the Colonial Pipeline shutdown. (Gasoline prices in the Southeast have definitely not fallen. Before seasonal adjustment, gasoline prices rose 4.2% in May, the BLS said.)

The index for used cars and trucks continued to rise sharply, the BLS said, increasing 7.3% in May. This increase accounted for about one-third of the all-items increase. Here are other highlights from the report:

  • Food prices increased 0.4% in May, the same increase as in April, but are up only 2.2% over the last year.
  • The May increase for food was mostly due to the index for meats, poultry, fish, and eggs, which increased 1.3% over the month. The beef index rose 2.3 percent in May.
  • The energy index was unchanged in May after declining slightly in April, but is up 28.5% over the last year.
  • Apparel prices rose 1.2% in May and are up 5.6% over the last 12 months.
  • The household furnishings and operations index increased 1.3% in May, its largest monthly increase since January 1976. Widespread shortages are being reported in furnishings.
  • The index for car and truck rentals continued to rise, increasing 12.1% after rising 16.2% the prior month.
  • The medical care index declined 0.1% in May after rising in each of the four previous months.
  • The costs of shelter rose 0.3% in May, and are up 2.2% over the last 12 months.

The May report again shows a widespread pattern of unexpectedly high inflation across the U.S. economy, with almost every category except energy showing strong price gains in the month. Here is the 12-month trend for all-items and core inflation, showing the impressive surge higher after the Federal Reserve and congressional stimulus programs stepped up in March 2020:

What this means for TIPS and I Bonds

Investors in Treasury Inflation-Protected Securities and U.S. Series I Savings Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust principal balances on TIPS and set future interest rates for I Bonds. For May, the BLS set the inflation index at 269.195, an increase of 0.80% over the April number. This follows increases of 0.82% in April, 0.71% in March and 0.55% in February.

For TIPS. The new inflation index means that principal balances for all TIPS will rise 0.80% in July, following the 0.82% increase in June. Because non-seasonally adjusted inflation rose a bit faster than the seasonally adjusted number, you can expect a reversal of that trend in coming months. (Seasonal and non-seasonal numbers balance out over 12 months.) Here are the new July inflation indexes for all TIPS.

For I Bonds. The May inflation report is the second in a string of six months that will determine the I Bond’s new inflation-adjusted variable rate, which will be reset on November 1. After two months, inflation is up 1.63%, which translates to a variable rate of 3.26%, already getting close to the current rate of 3.54%. Four months remain, and a lot can happen in four months (especially summer months, when inflation is notoriously volatile.)

Here are the numbers so far:

What this means for future interest rates

The Federal Reserve continues to predict this surge in inflation will be “transitory,” but it’s disturbing that inflation has been running much higher than expectations for three months in a row, even while gas prices were stable. The Fed is hoping to discourage an “inflation psychology” seeping into our consciousness, because it could set off a snowball effect of higher wages and higher raw material costs.

From today’s Wall Street Journal report:

Food makers said their costs are climbing at an alarming rate, prompting them to raise some prices. “The inflation pressure we’re seeing is significant,” General Mills Inc. Chief Executive Jeff Harmening said at a recent investor conference. “It’s probably higher than we’ve seen in the last decade.”

He and his peers point to transportation, commodity and labor costs all increasing at the same time. They expect the trend to continue for at least the rest of this year.

The Federal Reserve tracks a different inflation index — Personal Consumption Expenditures — which was up 3.6% through April and looks likely to top 4.0% for May when that number is released later this month. The Fed wants inflation to “average” above 2.0% for a sustained time. It seems well on its way to reaching that goal.

At some point, probably soon, the Fed will need to begin “talking up” potential plans to taper its bond-buying stimulus programs, which would allow longer-term U.S. rates to begin rising. As of this morning, the stock market is rising nicely despite today’s inflation report. That indicates the financial markets don’t see Fed tapering beginning anytime soon.

But the Fed faces serious challenges if U.S. inflation continues to rise much higher than expectations.

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in I Bond, Inflation, Investing in TIPS | 25 Comments