By David Enna, Tipswatch.com
Can anyone make the case that a 5-year Treasury Inflation-Protected Security with a yield lagging inflation by 1.73% and an upfront premium cost of nearly 10% makes sense as an investment?
Hey, I can.
But that doesn’t mean I will be investing in Thursday’s $16 billion reopening auction of CUSIP 91282CCA7, creating a 4-year, 10-month TIPS. I probably won’t. Nevertheless, in today’s low-interest-rate environment — accompanied simultaneously by surging inflation — this TIPS reopening remains an intriguing investment, “relatively speaking.”
A TIPS is an investment that pays a coupon rate well below that of other Treasury investments of the same term. But with a TIPS, the principal balance adjusts each month (usually up, but sometimes down) to match the current U.S. inflation rate. So the “real yield to maturity” of a TIPS indicates how much an investor will earn above inflation.
CUSIP 91282CCA7 was created in an originating auction on April 22, 2021, when it generated a real yield to maturity of -1.631%, the lowest in history for any TIPS auction of any term. The Treasury set its coupon rate at 0.125%, the lowest it will go for a TIPS. Investors had to pay a sizable premium, about about $109.41 for about $100.32 of value, after accrued inflation and interest were added in.
It now trades on the secondary market, and you can follow its current real yield and price in real time on Bloomberg’s Current Yields page. As of Friday’s market close, it was trading with a real yield of -1.73% and a price of $110.30.
If that yield holds through Thursday’s auction, it would set a new auction low for any TIPS of any term. Investors at this week’s auction will actually pay a higher price than Bloomberg indicates, while getting additional principal. Accrued inflation and interest will put the price at about $111.45 for $102 of adjusted value. This TIPS will have an inflation index of 1.01804 as of the June 30 settlement date.
(Just for nerds: As an aside, it’s remarkable that this TIPS was originated on April 15 and non-seasonally adjusted inflation has increased 1.8% since then. The inflation accrual on a TIPS is applied two months after each monthly inflation report. So the calculation for this TIPS is half of February’s rate of 0.547, which is 0.274%, plus 0.71% in March and 0.82% in April. It adds up to 1.804%, and that’s how you get an inflation index of 1.01804).
Here is the trend in the 5-year TIPS real yield over the last five years, showing the remarkable move lower after the market mania of February 2020, which triggered aggressive moves by the Federal Reserve to suppress interest rates and by Congress to stimulate the U.S. economy:
So, how could this TIPS look attractive?
Thursday’s auction could result in a record low real yield for any TIPS in history, of any term. And investors will have to pay a large premium, just to under-perform inflation by about 1.73% over the next 4 years, 10 months. How could that look appealing? It can, because this TIPS might be the prettiest ugly duckling in a pond of extremely ugly ducks.
There is only one U.S. dollar investment that is both very safe and guaranteed to match official U.S. inflation over the next five years. That is the U.S. Series I Savings Bond, which carries a real yield of 0.0%, a whopping 173 basis points better than CUSIP 91282CCA7’s current return. But I Bonds come with a purchase cap of $10,000 per person per calendar year. Once you’ve made that purchase, where do you look for a very safe 5-year investment? Five-year Treasury notes? A 5-year bank CD? Both of those options are safe, but look very likely to severely lag inflation over the next five years.
If you think we are likely to have a run of higher-than-typical inflation over the next five years, this TIPS becomes a logical investment amid a bunch of disastrous choices. Here are the numbers under varying inflation scenarios:
Once inflation averages more than 2.53% a year, this TIPS will out-perform a 5-year Treasury note at 0.76% or a 5-year bank CD at 0.80%, currently among the best in the nation. But the Treasury note and bank CD have no upside potential; they are both going to return well below 1% for five years. The TIPS has unlimited upside potential once inflation averages higher than 2.53% a year.
For that reason, I think this 5-year TIPS is an attractive alternative to other safe 5-year investments.
Inflation breakeven rate
With a 5-year Treasury note currently yielding 0.76%, this TIPS would get an inflation breakeven rate of 2.49% if it auctions with a real yield of -1.73%. That means it will out-perform a U.S. Treasury note if inflation averages more than 2.49% over the next 4 years, 10 months. That’s high, but this breakeven rate has actually dipped a bit in the last two weeks.
Here is the trend in the 5-year inflation breakeven rate over the last five years, showing the remarkable surge in inflation expectations after Federal Reserve and congressional stimulus kicked in in March 2020:
A year ago, I would have said 2.49% is a ridiculously high breakeven rate for a 5 year TIPS. A year ago, in May 2020, inflation had averaged only 1.5% in the previous 5 years. This year, after an impressive surge in inflation, that average has risen to 2.3%. I have no idea what the “new normal” is going to look like, but an inflation rate of 2.5% (or higher) in coming years looks like a reasonable bet.
The key question for investors is: When do you think nominal and real yields will begin rising? If you think higher rates are coming soon, waiting to invest makes sense. If you think rates will remain stable or decline further, and you want to lock in inflation protection, an investment in this TIPS is reasonable. I expect demand to be pretty strong under these market conditions.
If you are planning to invest, keep an eye on that Bloomberg Current Yields page until the morning of the auction. Real yields have been volatile in the last week. This auction closes at noon EDT Thursday for non-competitive bids and finalizes at 1 p.m. I will post the auction results soon after the auction closes.
Here’s a chart of recent auction results for 4- to 5-year TIPS:
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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 discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.