This TIPS was originally auctioned July 19, 2012, with a coupon rate of 0.125% and a record-low yield to maturity of -0.637%. Because the principal of a TIPS investment also grows at the rate of inflation, TIPS buyers back in July were accepting -0.637% less than the rate of inflation over the next 10 years.
What about it? So now, two months later, what can buyers expect? More of the same. This TIPS trades on the open market, and today it closed with a yield to maturity of -0.730%, meaning next Thursday’s auction could set another record low.
You can check the daily yields here. The line you care about looks like this:
Notice that the accrued principal on this issue stands at 997, when it should be 1000 or more. Why? Because we have seen slight deflation in the last two months, instead of inflation. So July’s buyers got two slaps in the face: 1) negative yield and 2) negative inflation.
But deflation isn’t likely to continue. The August inflation report, due out Friday, could show a monthly rise of as much as 0.6%, which you could speculate indicates an annual rate of 7% or more. Don’t speculate. It won’t be that high. But headline inflation – the number that matters for TIPS buyers – could easily rise back to the 3% to 4% range we saw last year. Reasons? 1) The Fed today again launched a stimulus program with a plan to buy mortgage-backed securities, 2) turmoil in the Mideast threatens a spike in oil prices and 3) drought conditions in much of the country are forcing food prices up.
If … and it is a HUGE if … inflation were to rise quickly in the next year, this TIPS reissue would end up being a very wise investment. If … on the other hand … the economy continues slogging along (and high oil prices could cause that), and inflation remains muted over the long term, this will be a fairly lousy investment.
I contend that TIPS bought and held to maturity will never be a horrible investment. You will get your money back. You may get a miserable return, but you will get your money back.
Look at the breakeven rate. The Wall Street Journal had an article this week titled ‘Uncle Sam Has an Inflation Deal for You‘ with the very odd premise that because the breakeven rate – comparing a TIPS versus a comparable Treasury – has been rising, TIPS are a good buy.
… the amount that investors have been willing to pay has risen noticeably. Ever since talk heated up that the Federal Reserve will engage in a third round of bond buying, implied bets on inflation have, too. The 10-year break-even rate has risen to 2.376% currently from 2% in late July.
But the article continued:
Perhaps the oddest thing about TIPS, though, is that they aren’t even pricier, whatever the Fed’s immediate plans. Today’s 2.39% break-even rate over 30 years not only is well below the actual average inflation rate of 3.8% since 1950.
OK, but I would still contend that TIPS are most attractive (‘cheap’) when the breakeven rate is around 2%. Where are we today? The 10-year Treasury closed today at 1.75%, well above the rate of 1.54% when this TIPS was auctioned on July 19. So the yield to maturity has declined at the same time traditional Treasuries are paying more.
The result: A breakeven rate, today, of 2.48%. Folks, that is a high breakeven rate. (It was 2.17% back in July, just saying …) When the breakeven rate rises, it means inflation fear is rising. And when inflation fear is rising, TIPS are expensive.
Update: On Friday, the breakeven rate rose even higher. The 10-year Treasury closed the day at 1.88%, while the July 15 2022 TIPS closed at -0.811%, pushing the breakeven rate out to 2.69%. If this trend continues a 10-year Treasury may actually look attractive.
I’d say keep an eye on the market yield of CUSIP 912828TE0 over the next week. Perhaps the breakeven rate will slip. If not, this auction is risky.