- Jan. 8, 2015, update: TIPS investors: Why the inflation breakeven rate is your friend
A curious thing happened last week. The Treasury market took a hit, with the yield on a traditional 10-year Treasury rising to 2.31%, its highest level since Oct. 28, 2011. With that increase in yield came a decline in the value of all Treasuries, including Treasury Inflation-Protected Securities.
But at the same time, the ‘breakeven rate’ for 10-year TIPS issues went up, meaning that even as TIPS values went down, they were becoming more expensive.
What is the breakeven rate? If you are interested in buying the 10-year TIPS being auctioned this Thursday (March 22), you should be looking at the breakeven rate, which reached a very high level at the end of last week. Here is the formula:
10-year Treasury yield – 10-year TIPS yield = 10-year breakeven rate
As of Friday, this equation was 2.31 – (-0.118) = 2.428.
Is this important? Very. Here’s why: On Friday, you could get a 10-year Treasury with a yield of 2.31% or a 10-year TIPS with a yield of negative 0.118%. If you buy that TIPS, inflation must average 2.428% over the next 10 years for you to ‘breakeven’ over a traditional Treasury.
It is as simple as this: When the breakeven rate rises, TIPS are more expensive, at least compared with traditional Treasuries. Here is a breakeven chart for 10-year TIPS auctions over the last five years, with Friday’s rates at the top for comparison:
|Date||TIPS base rate||Treasury||rate|
As you can see, Friday’s breakeven rate popped well above the rate of recent auction dates. It’s also interesting to see the extraordinarily low breakeven rate of 0.265% in January 2009, when the world feared deflation and economic meltdown. That was the single greatest day to buy TIPS at auction in the last five years.
This chart shows the one-year and one-month trends in the breakeven rate:
What happened last week? I have been speculating that the soaring stock market, relative calm in Europe and waning Federal Reserve stimulation might result in higher interest rates, especially for Treasuries. The market took a step in that direction last week. Will this continue? Who knows.
If you invest in the TIP ETF (or any TIPS mutual fund), you took a hit, as this 5-day chart shows, but the damage was not severe:
I included IEI (red line) in this chart because it is an ETF of traditional Treasuries, with a similar duration to TIP. The damage was worse for IEI, and note that on Friday, the TIP ETF recovered more of its losses than IEI. That is the breakeven rate rising.
This week’s auction. My feeling is that the breakeven rate needs to come down and the TIPS base yield must rise for Thursday’s 10-year TIPS auction to be attractive. If Treasuries continue their decline next week, and Treasury yields rise, how much appetite will there be for TIPS with negative real yields?