TIPS investors: Why the inflation breakeven rate is your friend

As the stock market tumbles a bit from all-time highs, the Treasury market is soaring, with yields dropping to 1.96% yesterday on the 10-year nominal Treasury. It is hard to believe that the US is seeing: 1) better-than-average economic growth, 2) the stock market near all-time highs, 3) ultra-low inflation, and 4) Treasury yields on the decline.

And the market is pricing in very low inflation well into the future. You can see that by calculating the ‘inflation breakeven rate’ – a measure of future inflation expectations –  using this simple formula:

10-year Treasury yield – 10-year TIPS yield = 10-year breakeven rate

Here is where inflation breakevens stand today:

  • 5 year. 1.47% – 0.31% = 1.16%
  • 10 year. 1.96% – 0.39% = 1.57%
  • 30 year. 2.52% – 0.68% = 1.84%

While writing about Treasury Inflation-Protected Securities over the last three years, I have devised a simple formula: When the 10-year breakeven rate falls below 2%, TIPS are cheap, when it rises above 2.5%, TIPS are expensive. Here is the breakeven trend for each of the maturities for the last five years:

5 year inflation breakeven10 year breakeven30 year breakevenIt’s rare to see inflation breakeven rates this low, and so either the world has permanently changed and inflation will permanently be extremely low, or … TIPS are a bargain right now when compared to nominal Treasurys.

I’d argue that inflation expectations are way too low, especially for the longer maturities. Take a look at this chart of the history of inflation from 1961 to today. Over five-year periods, inflation has never averaged lower than 1.3%; for 10 years, 2.3%, and for 30 years, 2.8%. The chart also shows the US has been in a multi-decade trend of declining inflation. At some point – possibly in the next 10 years and definitely in the next 30 – that trend could change toward gradually rising inflation. Or possibly, sharply rising inflation.

A margin of safety. TIPS investors can take comfort in these extremely low inflation breakeven rates. Why? They provide a margin of safety against rising interest rates. Let’s say the 10-year Treasury rises over the next year to 2.75%, an increase of 79 basis points. At the same time, the inflation breakeven rate rises to 2.2%, a fairly routine number. The 10-year TIPS would then be yielding 0.55%, a rise of only 16 basis points.

When the inflation breakeven trend reverses to ‘more normal’ levels, TIPS are going to outperform traditional Treasurys and probably the overall bond market.

That hasn’t been the case over the last 6 months, as shown in this chart, which is a perfect depiction of the effect of a declining inflation breakeven rate on TIPS:

6 month

The TIP ETF has underperformed the Treasury market (shown by IEI, intermediate Treasurys) and AGG (total bond market) over the last six months. SOURCE: Yahoo Finance.

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8 Responses to TIPS investors: Why the inflation breakeven rate is your friend

  1. Pingback: TIPS buyers: Beware of the ‘breakeven rate’ | Treasury Inflation-Protected Securities

  2. maynardGkeynes says:

    I agree that the market is underestimating inflation, which makes TIPS the better deal on a relative basis. But relative to what? The kicker there is “…a bargain ..compared to nominal Treasurys.” That’s not saying much. Arguably, they are both seriously overpriced now, nominals because. Inflation expectations are too low now, and TIPS because real rates are being artificially suppressed by QE. Both are more likely to rise than to fall — the questions is by how much. I still prefer TIPs, because a sharp rise in inflation seems much more likely than a sharp rise in real rates, but it’s hard to feel good about a 30 year TIP at .8 real, when a historical rate is closer to 2%.

  3. tipswatch says:

    MGK, I agree than 10- and 30-year TIPS are pretty unattractive right now, but the 5-year TIPS with a yield of 0.25% above inflation has some appeal. The I Bond is paying 0.0% above inflation. A typical bank CD is paying around 1.52% (on average) and the 5-year Treasury is paying 1.45%. Not many good options out there for money you want to be safe.

    • yellenzmellenz says:

      So tips are a good.deal…but not good.enough to buy. Which means they are not a good enough deal. Maybe the market knows something.

      • maynardGkeynes says:

        Quite true — the market view is where you start. OTOH, the best time to buy insurance protection is when you don’t need it, which seems like the best argument for getting TIPS right now. I also do agree that the recent 5 year (actually 4 and 4 month) auction was almost a no-brainer if you had some safe money you wanted to protect.

  4. Pingback: Here we go again: TIPS yields diving toward negative real returns | Treasury Inflation-Protected Securities

  5. Patty says:

    I find it unwieldy to try to compare traditional fixed income (bank cds and treasury bonds) securities with i-bonds and tips. Where does one even find return information for i-bonds and tips at a point in time to make a decision? Could you provide me with formulas for comparing tax adjusted yields?

  6. tipswatch says:

    Patty, the traditional way to make the comparison is the inflation breakeven rate. If an I Bond has a fixed rate of 0.1%, it will outperform inflation by 0.1%. If a 5-year TIPS has a real yield of 0.34%, it will outperform inflation by 0.34%. Those returns are known. But with a bank CD, you need to turn the equation around. If a 5-year CD is yielding 2.25%, you know you will get a return of 2.25%. But you don’t know what inflation will be, and you have no guarantee to beating inflation. You might, you might now. In that case, inflation would need to average 2.15% over five years for the I Bond to be a winner. It would need to average 1.91% over five years for the TIPS to be a winner. Below those numbers, the bank CD is the winner.

    So it comes down to: Would you like the guaranteed return of a bank CD, or the inflation protection of I Bonds and TIPS?

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