Why the breakeven rate is important: A TIPS versus Treasury example

I had a 10-year TIPS mature in July and I thought it would be interesting to look at how that Treasury Inflation-Protected Security performed against a traditional 10-year Treasury. Did it outperform? By how much?

So here are the basic details: The TIPS was CUSIP 912828BD1 and it was auctioned on July 9, 2003, with a coupon rate of 1.875% and a yield to maturity of 1.999%. That means this TIPS was sold at a discount to par, $98.881 for each $100 of value.

On the same day – July, 9, 2003 – the 10-year Treasury closed at 3.73%. This established an inflation breakeven rate of 1.731%. (3.73 minus 1.999 = 1.731%). I didn’t know it in 2003, but this was an excellent breakeven rate. It meant that if inflation averaged more than 1.731% over the next 10 years, this TIPS would outperform the nominal Treasury.

So, what happened? It turned out that the next 10 years were a period of extremely low inflation, averaging 2.4%, the lowest of any 10-year period in 50 years. There was a two-year period, from 2009 to 2010, when inflation was actually negative, falling -0.2%. (You can find detailed inflation data on eyebonds.info, a site that is loaded with data about TIPS and I Bonds.)

And yet, despite that weak inflation, this TIPS greatly outperformed the Treasury.

The lesson? The inflation breakeven rate does matter. When it falls below 2%, TIPS are cheap relative to Treasurys. When it rises above 2.5%, TIPS are expensive. (This assumes long-term inflation trends continue, we can never be sure.)

In September 2012, the 10-year breakeven rate rose above 2.6% and earlier this year  above 2.5%, a rate that’s higher than the last 10 years of inflation. After weeks of turmoil in the bond markets, it has settled in about 2.21% after recently dipping below 2%.

Back in 2003, when the economy was still in shock from the Internet crash, investors were pricing in very low inflation (1.731%). That was fortunate for buyers of CUSIP 912828BD1.

And here are the numbers:

$10,000 investment 10-year Treasury 10-year TIPS
15-Jul-13 Matured Security 10,000.00 12,670.80
15-Jul-13 Interest Payment 186.50 118.79
15-Jan-13 Interest Payment 186.50 117.82
16-Jul-12 Interest Payment 186.50 117.38
17-Jan-12 Interest Payment 186.50 115.53
15-Jul-11 Interest Payment 186.50 115.05
18-Jan-11 Interest Payment 186.50 111.66
15-Jul-10 Interest Payment 186.50 111.32
15-Jan-10 Interest Payment 186.50 110.38
15-Jul-09 Interest Payment 186.50 108.99
15-Jan-09 Interest Payment 186.50 109.59
15-Jul-08 Interest Payment 186.50 110.07
15-Jan-08 Interest Payment 186.50 106.94
16-Jul-07 Interest Payment 186.50 105.79
16-Jan-07 Interest Payment 186.50 102.94
17-Jul-06 Interest Payment 186.50 103.08
15-Jan-06 Interest Payment 186.50 101.31
15-Jul-05 Interest Payment 186.50 99.29
15-Jan-05 Interest Payment 186.50 97.46
15-Jul-04 Interest Payment 186.50 96.22
15-Jan-04 Interest Payment 186.50 94.31
15-Jul-03 Purchase discount 0.00 111.90
Total interest paid 3,730.00 4,936.62
Actual yield to maturity 3.73% 4.43%

Note: The 10-year Treasury in this example is theoretical, since there wasn’t a 10-year Treasury auction on July 9, 2003. The TIPS numbers are the actual interest payments from a $10,000 investment in CUSIP 912828BD1, reconstructed with data from eyebonds.info.

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9 Responses to Why the breakeven rate is important: A TIPS versus Treasury example

  1. Ed says:

    Hi David,
    TIPS also provide inflation insurance — the real yield equivalent of this insurance is surely sizable, I bet.

  2. Drew says:

    Tipswatch:

    I have another breakeven rate question for you — the breakeven inflation rate when comparing the current market value of a tips bond/note with the present value if held to maturity.

    I’ll explain . . .

    Now, I am typically a buy-and-hold TIPS investor. Ever since reading Zvi Bodie, I’ve been building my own TIPS ladder through Vanguard (commission-free, so it’s basically the same as buying through Treasury Direct, but they also give you a market price for each TIPS issue).

    I am debating selling off a couple rungs of my TIPS ladder, and I wanted to run the logic by you. Take issue 912828KM1, which has a 1.25% coupon, expiring 4/15/14. It’s a 5-year TIPS, I bought 10 at issue for $10,000. Vanguard is telling me the market price on this is now $11,173! Seems high, no? I mean, there’s only one more coupon payment between now and next April, so shouldn’t this be valued at closer to 10125 ($10K + one coupon payment of $125 + inflation is flat). I did a quick present value calc in Excel, and solved for an inflation rate that would make the market rate justifiable — that turned out to be 9%.

    Seems like a no-brainer to sell it now. What am I missing?

    Thanks for a great blog and helping inform my annual purchases.

  3. tipswatch says:

    Drew, I also own $10,000 of 912828KM1 but since I am strictly a buy-and-holder, I don’t often ponder the pluses and minuses of an early sale. (Sophisticated investors rightly criticize me for that. I am single-minded.) This TIPS, which pays a decent 1.25% above inflation, currently has accrued principal of 1100, so my $10,000 investment is currently worth $11,000 at maturity, and that will grow with inflation until April 2014.

    Here is the fact sheet from eyebonds.info: http://eyebonds.info/tips/hist/tips33hista.html

    If you sold now you would capture all that inflation appreciation, plus the benefit of the higher coupon rate. The current price seems to be 101.19 per 100, so this TIPS has a market value of $11,130.90, pretty close to what Vanguard is telling you. But remember, you will get $11,000 plus additional inflation if you hold to maturity. So if you sell now you are actually netting $130.90 above your current value (approximately).

    However, if you hold instead of sell, you will still get an interest payment in October 2013, then again in April 2014 when this matures. Each of these payments will be around $69 (or slightly more), for about $138 total, slightly better than you would get for selling now.

    • Drew says:

      Ahhhh. Light dawns on marblehead. Thanks TW. So to run these calculations, you have to know the accrued principle for each note. Where are you finding that data? On Eyebonds I’m seeing an accrued interest per $1000 of 52.21130943… what am I missing to get to your $1100 figure?

      • tipswatch says:

        Drew, here is a good site to find your accrued principal:

        http://online.wsj.com/mdc/public/page/2_3020-tips.html?mod=topnav_2_3021
        Right now it shows the April 2014 TIPS having accrued principal of 1100 (1000 is par, so that means you have 10% above par in accrued principal.) So at this point you would get $11,000 at maturity, but you will still get 2 more interest payments and any additional inflation until then.

        Or, you could sell right now at a price of 101.13 and you would get about $11,125.

  4. E Royce says:

    It’s a function of the change in real interest rates and the inflation-adjustment on the principal. See here for more detail:
    http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm

  5. joe says:

    Would be interestingt so see what the stock marekt did in that peroid of time. I’m assuming about 7% but I may be wrong

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