Honey, there’s a hole in our TIPS ladder!

Treasury Inflation-Protected Securities are almost entirely risk free when bought and held to maturity. Default risk? As close to zero as you can get. Inflation risk? Covered. Duration risk? Hold to maturity and forget it. Downgrade risk? We’ve been through this and it actually caused TIPS values to rise. Liquidity risk? Hold to maturity and forget it.

But there is this one nagging thing: Reinvestment risk.

The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. – Investorwords.com

One way to minimize reinvestment risk is to build a ladder of bonds with maturities stretching out many years. Each year, as a bond matures, you buy another of a set maturity. My preference is to build the ladder with 10-year TIPS purchased at auction, because the 10-year maturity seems to be the ‘sweet spot’ for yield and term. I worry about the negative cash flow of taxable 30-year TIPS.

Reinvestment risk is something that longtime TIPS holders are facing right now. Each year, we have TIPS maturing with real yields of 1.5% to 2.5%. For most of the last two years, we faced replacing these with TIPS paying yields negative to inflation. That is a 200 to 300 basis point drop in return.

Depressing. My reaction was to stop buying TIPS from July 2011 to May 2013, but I continued buying I Bonds, which have an open-ended maturity date, up to 30 years. So here is what my TIPS ladder looks like right now:

Holdings Maturity Coupon Rate
912828BW9 15-Jan-2014 2.000
912828KM1 15-Apr-2014 1.250
912828ET3 15-Jan-2016 2.000
912828QD5 15-Apr-2016 0.125
912828FL9 15-Jul-2016 2.500
912828GX2 15-Jul-2017 2.625
912828JX9 15-Jan-2019 2.125
912828MF4 15-Jan-2020 1.709
912828PP9 15-Jan-2021 1.125
912828UH1 15-Jan-2023 0.125
912828VM9 15-Jul-2023 0.375
912810FH6 15-Apr-2029 3.875
912810QP6 15-Feb-2041 2.125

My ladder actually remains pretty intact, with TIPS maturing in 2014, 2016, 2017, 2019, 2020, 2021, 2023, and then jumping out to 2029 and 2041.

But notice that I have ladder rungs missing in 2015 and 2018. I can’t do anything about 2015, but I can fill the 2018 spot with August’s reissue of a 5-year TIPS. Normally, I wouldn’t get too excited about a 5-year TIPS with a yield of about -0.47%, but I think this would a good investment to fill the gap.

It won’t return much, but it will set aside money for me to reinvest in 2018, probably into a TIPS maturing in 2028. When that matures, I will be 75 years old. I will have punted money forward to my 75-year-old self.

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11 Responses to Honey, there’s a hole in our TIPS ladder!

  1. Bill says:

    What were you referring to when you said: “I worry about the negative cash flow of 30-year TIPS.”? And thanks for the previous article comparing TIPS vs nominal.

  2. tipswatch says:

    Bill, a 30-year TIPS has currently has a yield of 1.39%, or let’s say a coupon rate of 1.375%. Let’s say you put $10,000 into this TIPS, which will pay that coupon rate of 1.375% on a principal balance that will rise with inflation. And let’s say inflation averages 2.5% over the next 30 years. You will owe current-year taxes on $387 a year, and that number will rise. If you are in a high tax bracket your bill will be maybe $155 a year. But the coupon on this TIPS will provide you with current income of only $137.50 a year, not enough to pay the taxes owed. You recoup all that at maturity, but 30 years is a long time to wait.

  3. Bill says:

    TIPS still have a reinvestment risk, but it is different than normal bonds.

    You can certainly build a ladder of 10-yr TIPS (mine will soon consist of 20 distinct issues), all purchased at auction, and use it to move assets forward in time. At each maturity, the inflation-adjusted principle amount is rolled over into the new issue about to be auctioned; the USTreasury’s timing of the TIPS auctions makes this relatively easy, since the payment from the matured TIPS is credited to your bank account before the auction of the replacement. Since the auction purchases can only be in multiples of $100, there is some small amount of slippage. But generally, the par amount of the newly purchased bonds will match the adjusted par amount of the matured bonds.

    But negative yields at recent auctions somewhat interfere with that simple strategy. If the auction yield is negative, the cost of the replacement bonds will exceed the adjusted par amount of the matured bonds. You don’t want to reduce the par amount of the purchase, as that will destroy the balance of the ladder. You need to come up with the extra cash to cover the higher purchase price. That is the reinvestment risk with TIPS.

    But the situation isn’t really that bad. All 20 of the TIPS in the ladder are generating an income payment, payable on the same day as the matured issue. The amount of these payment can be used to cover the purchase price of a negative yield auction. But might it not be enough?

    What is the worst case situation? When there is a long series of low or negative yield auctions, so each issue has a coupon rate of 0.125%. With 20 of these in a row, the interest payment would be only P*0.0125, which would cover an auction price 101.25, or not much of another negative yield. But how likely is this in reality? To evaluate this risk, I did a Monte-Carlo simulation with the parameters set from all previous TIPS auctions. With 28 issues of 10-yr TIPS auctioned, the average yield is 1.9965% and the standard deviation is 1.2982. Out of 60000 sequences of auction returns, 99.85% of the cases had income sufficient to cover the additional cost of the new issue.

    So a ladder of TIPS does have reinvestment risk, but I’d consider it negligible.

    (p.s. different “Bill” than previous comment)

  4. tipswatch says:

    Bill #2, that is a fantastic analysis, and you explained it beautifully. My view of the reinvest risk of TIPS is slipping into a return that isn’t adequate to achieve the purpose for which you bought the TIPS in the first place. In 1999 would I have bought TIPS with a negative real return instead of 3.75%? Probably not. We’ve had to reexamine the role TIPS play in our portfolio with each decline in yield. Is it better to leave a gap in the ladder to capture a better yield later? Or is that too risky, because rates can continue to decline, as they did until spring of this year?

  5. E Royce says:

    Ditto on the great analysis. Separately, in the same vein that Gross often raises, with a 30 year TIP, you’re going to have a 10 year TIP in 20 years, so you’ll be rolling down the curve. Given how steep the real yield curve was recently, it would have been a good play to get some duration.

    Re having the cash to pay, I find that a false constraint. Yes, you have to come up with the cash but it’s fungible. If you invest in a 20 year nominal t bond, you need to come up with the cash to buy a matching duration bond(let) to restore the inflation loss. Otherwise, you’re just slipping behind

  6. Godfrey Oakley says:

    I had to smile about punting until your 70s given I am there. Nice to see someone of your age writing such an interesting and important column.

  7. Jeff says:

    Hi guys, sorry for the naive question, but which inflation rate are TIPs referencing? I’m guessing that as long as health care and tuition are not a concern (makes sense for the boomers) and food/energy consumption are modest (less control over that for anyone, especially for the long term) – then CPI referencing would not “matter” that much. Just trying to wrap my head around this…thanks!

    • Ed Hamilton says:

      Jeff, CPI-U is used.
      From BLS site.
      Note: CPI-U is the broadest, most comprehensive consumer price index published by the U.S. government. (“The CPI is generally the best measure for adjusting payments to consumers when the intent is to allow consumers to purchase at today’s prices, a market basket of goods and services equivalent to one that they could purchase in an earlier period.”)

  8. tipswatch says:

    Jeff, TIPS are tied to the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U). This is what is often called ‘headline’ inflation, as opposed to ‘core’ inflation which strips out food and energy. But … when you hear an inflation news report, that is generally giving the seasonally-adjusted CPI-U, and so it isn’t the number that adjusts TIPS for that month. But the annual rate is accurate, because the seasonal adjustments balance out over 12 months.

  9. Pingback: Up next: 5-year TIPS reissue will auction Thursday, Aug. 22, 2013 | Treasury Inflation-Protected Securities

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