At these prices, should we be unloading TIPS?

Great question from reader Drew:

Tipswatch — I hear you on “buy and forget it”. I’ve been doing that for years to build out a 30-year ladder which anchors the ‘safe’ allocation within my portfolio.

But I have a bit of a wrinkle I’d like to ask you about —

I recently noticed that the longer-duration 30yr notes that I bought at auction just over the last two years have appreciated considerably. For example, a 30-year TIPS note with a 2.13% coupon maturing in 2/14/2040 is currently trading at almost 30% above what I paid for it. In other words, if I sold, I’d achieve 12+ years of coupon payments in one fell swoop.

Even the recent 10-yr that clocked in at 0.639%. I bought, spending $10,008 on a note that is now trading at 10,436. If I were to sell it, just a month latter, I’d net $429, or almost 7 years of coupon payments at once. I figure I could just double up the next time 10-years go to auction.

I’m tempted to do this. . . am I missing something? Obviously if I sell I’m left with some gaps in my ladder.

Drew, I am not a financial adviser – I don’t even play one on TV – but my initial reaction is this:

I can see the quandary. I also have some older Treasury Inflation-Protected Securities that pay a real yield of more than 2% and even 3%. I consider those prized assets, but they are aging. I have one issue that pays a coupon of 3.875% and matures in April 2029. No way would I sell that one. I need those higher-yielding issues to balance off some of these more recent lower yields.

But there is logic to what you are saying, since you can sell and reap a large amount of future interest payments in the form of instant capital gains (and a lower tax rate, too). My cautions would be: 1) make sure you get the price you want since TIPS in the open market are thinly traded, and 2) understand that you may never – at least for several years – be able to replace those higher-yielding issues. The real yield on TIPS has been declining for years and that decline has even escalated recently. Eventually, we will hit bottom and start back up.

But you are right that this is a great selling opportunity.

On the 10-year paying 0.639%, that is a yield you could easily see again in a few months. So selling it, if you can get a good price, is a non-issue.

(But then this sort of reminds me of the time when I bought Apple at $80, and then sold it a couple of months later at $11o. Hmm … that worked.)

As of today, I wouldn’t be a buyer of new TIPS issues, or TIPS mutual funds. The rates are ridiculously low for all Treasuries. Treasuries are priced for a deep recession. The Fed’s announcement today of continued near-zero interest rates for two years is a slap at savers. We have few places to turn, and this could last for many more months. The lousy TIPS yields of a few months ago – like your 0.639% on a 10-year – now look very attractive.

Could the entire TIPS yield curve eventually go negative? Whoa, I don’t want to even think about that.

One of my favorite bloggers, Michael Ashton (The Inflation Trader) posted this chart today on the trend in the 10-year Treasury yield:

10-year Treasury yields

If this really is a bubble, selling and getting your profit now does make sense, especially for a 10-year yielding 0.639%!

One nagging question: Where will you put that money that was earning the rate of inflation plus 0.639%, until you can reinvest it in a super-safe asset?

I won’t waver from my buy and hold strategy, though. But sometimes, I say: Don’t buy. This is one of those times.

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4 Responses to At these prices, should we be unloading TIPS?

  1. Drew says:

    Thanks for the response. And as for where I’d put the money, no ideas yet — I think I’d just pocked the cap gains and rebuy TIPS at the next auction. But I hear you: that auction may leave me with a much lower yield on the bills.

    I’ve been happy with TIPS thus far, and I’ve been investing in them for about five years. It’s been a good five years to be holding them.

    In the back of my mind I am concerned that the US Govt doesn’t accurately report true inflation in the CPI. Some economists — Peter Schiff for example — note that the underreportage is approaches 1% . . .that’s 1% we’d be losing over time, putting most TIPS at a negative real return to *true* inflation. That said, I’m not sure if there’s anything better out there that can guarantee being in the ballpark.

    Have you thought about this disadvantage?

    • tipswatch says:

      Drew, I have written before that I think that the U.S. government under-reports inflation, from my real world experience. My power company is about to get a 5% rate increase. My property tax bill is about to go up 10%. The cost of gas is going down, but I live a mile from work and use a tank a month in a 25 mgp car. The price of computers is going down, but I am not buying a computer. My wages are going down because of multiple furloughs and meager 1.5% pay raises.

      Many others who are more expert than I say that the CPI-U is a fair number, and I guess I have to accept that. For TIPS buyers, CPI-U is it … the one true inflation.

  2. slizzle says:

    With TIPS yields getting more and more negative, the rates on I-bonds are looking more and more superior every day (since they do not drop below zero). Is anyone else speculating that the government might change their I-bond policy because of this? I could speculate on some possibilities: 1) Paper bonds will not be offered in 2012; perhaps they won’t raise the $5,000 purchase cap on electronic bonds, 2) Perhaps they will allow the fixed rate to go negative like TIPS, 3) perhaps they will change the CPI to make inflation look smaller, and 4) perhaps they will phase out I-bonds altogether. I’m not one for conspiracy theories but it seems I-bonds yields are way above market at this point, and something has to give doesn’t it?

    I have already purchased $10,000 of I-bonds for myself this year but I could still purchase another $10,000 in my spouse’s name. I was going to hold off until next year for the convenience of having them all in one TreasuryDirect account, but the huge drop in TIPS yields makes me wonder if it might be smart to buy these sooner rather than later. Thoughts?

    • tipswatch says:

      Slizzle, the government is way ahead of you, unfortunately. The Treasury announced earlier this year that it won’t issue paper I Bonds after Dec. 31, and there is no indication that it will budge the $5,000 electronic limit up an inch. So our buying power in I Bonds falls by half after Jan. 1. That news was rather nasty for savers, but you can understand why the government found this attractive: TIPS real yields are dropping into negative way up the yield curve.

      So, you get the BEST ADVICE OF THE MONTH: Buy those paper I Bonds right now. You will be guaranteed an interest rate of 4.6% for six months, and you will need to hold them a year. It could well be that the rate for the following six months will be near zero, so you are guaranteed a return of 2.3% over the next year.

      If you sell after a year, you would face a 3 month interest rate penalty, but 3×0 = 0. There would be no penalty or it will likely be minimal.

      I Bonds are an unusually attractive option right now. This is easy advice for the super-safe part of your portfolio: Buy I Bonds to the limit before Oct. 31, when that 4.6% rate is going to drop dramatically, possibly to zero. If you buy before Oct. 31, you will get the full six months of 4.6%.

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