My philosophy for investing in Treasury Inflation-Protected Securities is to buy them at auction when the yield is attractive, and then hold them to maturity. At the very least – in almost every case – you will get the original investment back at maturity, along with the biannual coupon payments.
But there are cases where a TIPS investment can backfire. Although rare, this generally involves buying a TIPS at a reopening auction where the yield is set well below the coupon rate. Or, buying a new TIPS at auction where the yield is strongly negative to inflation. Since TIPS carry a coupon rate of 0.125% at the very least, buying TIPS at a time of negative yields can be expensive, and create added risk.
An example. Take the most recent auction of a new 5-year TIPS on April 23. The yield at auction was -0.335% and the coupon rate was 0.125%, so buyers wanting to invest $10,000 in this TIPS paid about $10,252 for $10,000 of par value and a 0.125% coupon rate, which generates about $12.50 a year in income.
So, roughly, five years of coupon rates are going to pay the investor $62.50 (this will rise slightly with inflation). That leaves a shortfall of about $189.50 that the investor needs to make up in the next five years. In theory, rising inflation will push up the principal balance and will make up the difference. But if it doesn’t, the investor will never make back that original investment. Remember, par is $10,000, and that is all the investor will get back if there is zero inflation or deflation during the five-year term.
An extreme case. While working on an analysis of that April auction, I noticed a particularly ugly example: The 4-year, 4-month reopening of CUSIP 912828SQ4 on Dec. 20, 2012. This TIPS has a coupon rate of 0.125% and auctioned with a yield to maturity of -1.496%. Here’s the fact sheet.
Back on December 20, 2012, I looked at this TIPS and wrote: “I mean, who really cares? Who is actually buying this thing?” On December 10, 2012, I advanced the auction and tried to steer buyers toward I Bonds instead. In other words, I wasn’t a fan. But I had no idea how much of stinker this would become, because it was issued just before a period of deflation in the US economy.
This TIPS matures on April 15, 2017. Let’s see how it has performed so far:
Because of the spread between the coupon rate and the negative yield to maturity, the buyer of this TIPS paid $10,918 for adjusted principal of $10,184 and a par value of $10,000. When this TIPS matures on April 15, 2017, only the par value is guaranteed.
So far, the combination of months of deflation and inflation has caused the inflation index to rise from 1.o1844 in December 2012 to 1.03898 in May 2015, but that isn’t enough to make up for the initial $733.60 extra cost of this TIPS. Adjusted principal has risen from $10,184 to $10,390, still far below the initial cost of $10,918.
This particular TIPS is a ‘horror story’ – it was expensive and purchased just before an extended time of deflation. Even if inflation averages 2% a year for the next two years – best case scenario? – its principal value will rise only to about $10,810, still a bit below the original cost.
The lesson. Be wary of buying TIPS when the yield to maturity is well below the coupon rate. In today’s market, with a 5-year TIPS yielding -0.11%, the risk is minimal and acceptable.