I try to check, at least occasionally, the TIPS inflation breakeven rate – determined by subtracting the current TIPS yield from the current nominal Treasury rate for the same term. A high 10-year breakeven rate (generally above 2.5%) indicates that inflation fear is running high and TIPS are expensive. A low breakeven rate (generally under 2%) indicates that TIPS are inexpensive, at least relative to nominal Treasuries.
In my opinion, a breakeven rate between 1.5% and 2.0% indicates TIPS are an attractive buy, but also may indicate fear of deflation. For TIPS owners, deflation is not a good thing. TIPS protect against inflation. Traditional Treasuries are better to protect against deflation.
5-year breakeven rate
A TIPS maturing Jan 15 2018 is currently trading on the secondary market at -1.446% and the 5-year nominal Treasury closed Monday at 0.72%. That pegs the 5-year inflation breakeven rate at 2.166% – not excessively high, but higher than the current rate of U.S. inflation of 1.8% over the last 12 months.
10-year breakeven rate
There is no TIPS maturing in January 2023, so I am using the TIPS maturing on July 15 2022, which currently trades at -0.751%. The 10-year nominal Treasury closed Monday at 1.78%, setting the 10-year inflation breakeven rate at 2.531%.
While this is not near an all-time high, it is high and indicates that the 10-year TIPS is expensive relative to a 10-year Treasury. Here is a chart of the historical 10-year breakeven rate:
It’s interesting to note how little time the breakeven rate has spent above 2.5% and below 2.0%. The sharp plunge in the breakeven rate in late 2008 made TIPS a screaming buy, for those willing to gamble that deflation would not be severe over a long period. (Very good gamble, even though today’s inflation remains muted.)
But today’s breakeven rate just above 2.5% indicates that TIPS are historically expensive.
The better alternative. The breakeven rate is the perfect illustration of why US Savings I Bonds are superior to TIPS at almost all maturities. Reader Ed sent along this chart that compares ‘real’ yields of TIPS and I Bonds of various maturities:
Since I Bonds currently pay the inflation rate – not below the inflation rate – the breakeven rate for an I Bond is the same ultra-low rate as a traditional Treasury: 0.72% for 5 years or 1.78% for 10 years. Plus, I Bonds earn tax-deferred interest that compounds over time.
I Bonds are the last great deal in super-safe investing. The new year opens up your chance to buy another $10,000 per person at Treasury Direct. That’s a no-brainer.
For longer term reckoning, I suppose that the protection against unanticipated higher inflation that is provided by TIPS would equate to a sizable yield increment.
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One point of view I came across suggested TIPS as a defensive tool for deflation as TIPS valued and redeemed at par as the money supply contracted helped preserve purchasing power?
Jim, TIPS aren’t bad but aren’t the best investment in times of deflation. In extended deflation, traditional Treasurys paying positive interest would do better, and I Bonds, which can never go down in value, are also better than TIPS. With TIPS, you do get your original par value back at maturity, but you can lose some built-up principal when deflation strikes. This has happened several times in the last decade.. Also, if you ‘pay up’ at auction because of a negative yield, you’d lose that premium at maturity if deflation continued for the entire term (which is is highly unlikely, of course).