Buying a 5-year TIPS? The trend is working against you

The U.S. Treasury on Thursday issued its formal announcement for the April 18, 2013, auction of a new 5-year Treasury Inflation-Protected Security.

This will be CUSIP 912828UX6, and although the coupon rate will be set at auction, we can say with 100% certainty that it will be 0.125%, the lowest rate the Treasury allows on TIPS. The yield to maturity is likely to be somewhere near -1.69%, maybe a bit higher.

Although several consecutive 10-year TIPS auctions have failed to set record low yields, this 5-year TIPS will probably blow out the record low for any 4- to 5-year TIPS, -1.496% for an auction last December. Here is a history of 5-year TIPS auctions running back to 2005:

5 -year TIPS auctionsI’ve highlighted the last three auctions to show the trend of a sharply declining yield, and that trend appears likely to continue in Thursday’s auction. Compare that with the reverse trend in 10-year TIPS:

10-year TIPSSo 5-year TIPS must have some sort of magical appeal? Why are they so desirable? I can think of only one reason: There has been a surge of money pouring into shorter-term TIPS funds and this has expanded demand for TIPS of 5-year maturities or less.

For the small investor, maybe those short-term TIPS funds make sense, although they offer very little, if any, return. But buying this new 5-year TIPS will have you fighting a trend – one that’s working against you. To demonstrate this, I will compare this year’s TIPS auction versus last year’s (April 2012) and other similar investments:

5-year TIPS, 2013 vs. 2012The key here is that the yield to maturity on a 5-year TIPS has dropped 61 basis points, double, triple or quadruple the decline for nominal Treasuries. An insured 5-year bank CD has barely budged. I Bonds, of course, still pay inflation minus nothing. And this has happened at a time of declining inflation, creating a double whammy for TIPS buyers.

But what about the ‘real’ return, after inflation? Isn’t that where a TIPS should shine? This chart shows the real return buyers could expect at the time of purchase, 2012 vs. 2013:

Real returnBecause inflation has declined and the TIPS yield has also dropped, the current TIPS yield of -1.69% is dramatically more expensive than similar investments, all of which are yielding a better return against current inflation, compared with last year. Except for I Bonds, of course, which pay inflation no matter what.

OK, let’s say you believe the current rate of inflation can’t continue, and you believe it is going much higher. (The current trend in housing prices supports that theory, but the weak job market counters it.) Let’s say inflation doubles, to 4%. How would this 5-year TIPS perform, versus 2012 and similar investments?

4 percent inflationHere’s a manta for TIPS buyers: The yield to maturity is the real return. When you buy a TIPS with a yield of -1.69%, you are getting an after-inflation return of -1.69%, no matter how high inflation goes. However, this chart shows that in 2013, a 5-year TIPS provides a better real return at 4% inflation than similar investments, except the stalwart I Bond, which is clearly superior.

It also shows that a 5-year TIPS has gotten much more costly than similar investments in the last year.

That is the trend buyers at next week’s auction are fighting.

Advertisements
This entry was posted in Investing in TIPS. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s