By David Enna, Tipswatch.com
I’ve been a big advocate of purchasing Treasury Inflation-Protected Securities over the last decade, and much of that time … I’ve been wrong.
TIPS are investments that provide a market-based real return above (or below) inflation, and they can be directly compared with nominal Treasurys of the same term. The spread between the after-inflation (real) yield of a TIPS versus the nominal yield of a traditional Treasury is called the inflation breakeven rate.
- A 10-year Treasury note currently has a nominal yield of 1.15%.
- A 10-year TIPS currently has a real yield of -1.06%.
- Today’s 10-year inflation breakeven rate is 2.21%.
An investor looking at a 10-year TIPS as a buy-and-hold-to-maturity investment today needs to ask this question: Do I believe inflation will average more than 2.21% over the next 10 years? If the answer is yes, buy the TIPS. If the answer is no, buy the nominal 10-year.
(Actually, the better solution is to first buy U.S. Series I Bonds, up to the $10,000 per person per year limit. An I Bond purchased today has a real yield of 0.0%, which is a 106-basis-point advantage over a TIPS. And the I Bond’s inflation breakeven rate is only 1.15% versus the nominal U.S. Treasury. I Bonds are the superior investment.)
For much of the time over the last decade, inflation expectations — reflected in the 10-year inflation breakeven rate — have been running above 2.0%, like they are today. However, inflation over the last 10 years has only averaged 1.7%. So TIPS have been highly likely to underperform nominal U.S. Treasurys over the last decade.
This brings us to CUSIP 912828PP9, a 10-year Treasury that matured Jan. 15, 2021. It had an originating auction on Jan. 20, 2011, which generated a real yield to maturity of 1.17% and a coupon rate of 1.125%.
Today, we’d be jumping for joy over a real yield of 1.17% on a 10-year TIPS — and in fact I was a buyer at this auction and just hand this TIPS mature. Sad moment.
But this TIPS wasn’t a relatively great investment. Why? On the date of the auction 10 years ago, a 10-year nominal Treasury note had a nominal yield of 3.34%, creating an inflation breakeven rate of 2.17%, close to where we are today.
Here’s the bad news: U.S. inflation only averaged 1.7% over the last 10 years, meaning this TIPS under-performed a nominal Treasury by about 0.47% a year over 10 years. An investor would have done better by grabbing a 10-year Treasury note yielding 3.34%.
Putting this into perspective
A TIPS investment has the advantage of protecting against unexpectedly high future inflation, but will under-perform in times of unexpectedly low future inflation. We’ve just completed a decade of unexpectedly low inflation, with 10-year average rates running as low as 1.3% for the 10 years ending in January 2017.
In general, when the inflation breakeven rate has dipped well below 2.0%, TIPS have out-performed, because they became “cheap” versus a nominal Treasury.
We don’t know what the future will bring. The market expects higher inflation, and many people foresee inflation climbing into the 3% to 4% range. It could happen. Or, it won’t. We don’t know.
A lower inflation breakeven rate makes TIPS a more attractive investment versus a nominal Treasury. That’s the lesson of the last decade.
Here are the TIPS vs. nominal results for all 5- and 10-year TIPS that have matured over since 2013:
To view this at a glance, the annual variance number in the last column shows how the inflation breakeven rate compared to actual inflation. When the numbers are green, a TIPS was the superior investment. When they are red, the nominal Treasury was the better investment.
Inflation breakeven rates of less than 2.0% are noted in green. In general, TIPS out-perform nominal Treasurys when this happens. The 10-year TIPS that matured in July 2020 had only a rounding error (less than 0.1%) of difference.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
Ben, it’s an interesting issue because interest on a nominal Treasury and the TIPS coupon rate is paid out as current-year income and not reinvested. So we don’t know what the investor could have earned on the reinvestment. But for the nominal, 10 years x 3.34% = 33.4% for the 10-year Treasury. That’s an underestimate because the interest paid could have earned more elsewhere.
On the TIPS, you get 10 years at 1.125%, also not reinvested, so that is 11.25%. That TIPS ended with an inflation index of 1.19, so it did earn an extra 19% (compounded) at maturity, for a total of 30.25%. So the benefit of inflation being compounded reduced the apparent deficit, but the TIPS still under-performed, 30.25% versus 33.4% for the nominal.
The ending inflation index of 1.19 does take into account times of deflation, including the ending month, where the principal balance fell -0.06% to reflect November’s negative inflation number.
This is where I Bonds have a big advantage over TIPS, since their value never declines during a period of deflation, but can bounce higher with the full effect of rising inflation when the deflationary period ends. A TIPS has to make up lost ground.
David, I’m not at all sure about this, but I wonder that because, unlike a nominal bond, the principal value of the TIPS increases (or decreases) over the 10 years, sequence risk of what year the inflation occurred might – might – make a difference in the terminal values. So to make it simple for me, how much was your 10-year TIPS worth when it was matured, and how much would the 10 year nominal be worth at maturity? I’m sure that the nominal still came out ahead, but it might be smaller or larger than the difference you have calculated. I’m curious.