Investors get another chance to demonstrate insanity on Thursday, April 18, 2013, when the U.S. Treasury will auction a new 5-year Treasury Inflation-Protected Security.
This thing will be expensive. CUSIP 912828UX6 will have a coupon rate of 0.125% and will probably auction with a yield of about -1.7%. That means buyers will be paying up for a 1.825% boost to yearly income, probably about $109 for every $100 of value. (The last new issue of a 5-year TIPS went off in April 2012 with a yield to maturity of -1.080% and a cost of $106.38 per $100 of value.)
I get a lot of feedback from readers who dismiss buying short-term TIPS because of the negative yield, and I understand that. And paying up for a TIPS is a poor strategy because it undercuts the deflation protection TIPS provide. When you pay $100 for $100 of a TIPS (as in the good old days), at maturity you get back $100 plus inflation. When you pay up, your premium is at risk because at maturity you get back $100 plus inflation. If there was no inflation, you get back $100. Bad deal.
But is buying this 5-year TIPS an act of insanity? No, it is not. Actually, it makes some sense for the big-money folks: Hedge funds, foreign banks, foreign governments. They are looking to stash money in a super-safe, inflation-protected investment and can afford to make little or no income.
And … it matures in five years. That makes it easy to buy and hold-your-nose.
For the small investor, though, this 5-year TIPS looks like a loser. The 5-year time-frame opens up competing investments, such as bank CDs and especially U.S. I Bonds, that aren’t practical for the super-big-money investors. When comparing these investments, you need to look at how they will perform under varying inflation rates.
This chart of actual returns shows that a bank CD paying 1.7% (you might find better) will outperform a 5-year TIPS and I Bonds up to an inflation rate of 1.7%. Once inflation reaches 1.8% – the current rate is 2.0% – or higher, I Bonds outperform. A 5-year TIPS won’t outperform a bank CD until inflation reaches 3.5% or higher.
But what if you look at after-inflation return?
The bank CD outperforms up to an inflation rate of 1.7%. The I Bond outperforms at inflation rates of 1.8% and higher. The TIPS outperforms the bank CD only when inflation reaches 3.5% or higher.
Conclusion: When there’s actual inflation, I Bonds are clearly superior, and you should buy them to the max ($10,000 per person per year at TreasuryDirect). Purchases through April will pay the inflation-adjustment rate of 1.76% for six months. Earnings are tax-free until you sell the bonds.
After the I Bonds, where do you go with money you want in a super-safe investment, a 5-year TIPS or a 5-year bank CD?
- If you think we are heading toward deflation and economic Armageddon, buy insured bank CDs or traditional U.S. Treasurys.
- If you think inflation will remain tame over the next five years, buy bank CDs.
- If you believe inflation will average 3.5% or higher over the next five years, feel free to buy the new 5-year TIPS being auctioned April 18.
It’s not insanity. It’s math.
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Joe, I can’t imagine any ‘normal’ person buying a 5-year Treasury at 0.7% when there are insured bank CDs out there at 1.7%. No sane person would do that. It would take a non-person with mega amounts of cash (say a foreign national bank or a massive hedge fund) to see the need to park money at 0.7% for five years.
The only thing more insane than buying a 5 year TIP is to buy a 5 year nominal US treasury.