By David Enna, Tipswatch.com
The U.S. Treasury’s auction of $19 billion in a new 5-year Treasury Inflation-Protected Security generated a real yield to maturity of -1.685%, the lowest ever recorded for any TIPS auction of any term.
This is CUSIP 91282CDC2. Its coupon rate was set at 0.125%, the lowest the Treasury will go for any TIPS. That means investors had a pay a lofty premium at this auction, paying about $109.51 for about $100.14 of value, after accrued inflation and interest are added in. The settlement date is Oct. 29.
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 (or in this case, below) inflation.
The auction result doesn’t mean that investors were accepting a negative nominal return, but they were willing to pay a 9% premium to par value to collect a 0.125% coupon rate plus five years of inflation accruals. To put this another way, official U.S. inflation will have to increase about 9% before investors reach a breakeven point on this investment.
The previous record low real yield for any TIPS auction was set on April 22, 2021, when a new 5-year TIPS got a real yield of -1.631%. The 5-year term seems especially sensitive to investor fears of near-term inflation, but oddly, this auction’s bid-to-cover ratio was a rather lukewarm 2.45.
Here is the year-to-date trend in 5-year real yields, which are up only about 8 basis points since January but have followed a volatile trend. The market seems to be struggling to adjust to the Federal Reserve’s intention to scale back its monthly purchases of $80 billion in U.S. Treasurys, including TIPS:
Inflation breakeven rate
With a 5-year Treasury note trading at 1.20% at the auction’s close, this TIPS gets a 5-year inflation breakeven rate of 2.89%, by far the highest rate for any 5-year TIPS auction in more than a decade. The 5-year breakeven rate was last at this level in March 2005.
Investors are pricing in higher inflation in the near-term future, which seems logical with U.S. inflation currently running at 5.4% and looking likely to continue at a high rate for many months ahead. A high inflation breakeven rate makes a TIPS a pricey investment versus a nominal Treasury, but it comes with the comforting insurance of protection against runaway inflation.
Here is the year-to-date trend in the 5-year inflation breakeven rate, showing that inflation expectations have been peaking in the last month, up from about 2.4% in mid-September:
Reaction to the auction
The lukewarm bid-to-cover ratio has me stumped, because the real yield to maturity of -1.685% seemed to be a bit lower than market expectations, which indicates decent investor demand. At the market close Wednesday, the U.S. Treasury had estimated the 5-year real yield at -1.61%, about 7 basis points higher.
The TIP ETF, which had been trading slightly higher all morning, took a tiny bounce higher after the auction close, again indicating that auction met expectations.
My conclusion is that demand was good and the auction was a success, at least for the Treasury, which gets to pay back investors 1.685% less than the rate of inflation over the next five years.
This TIPS will get a reopening auction on December 23. Here’s a history of 4- to 5-year TIPS auctions over the last three years:
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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.
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Is there a way to calculate the nominal return?
After the premium price is paid, the nominal return will be the rate of U.S. inflation, plus the 0.125% coupon rate. So it will depend on the rate of inflation over the next five years. Roughly, this works out to inflation rate (plus) coupon rate (minus) 1.685%. So if the inflation rate averages out to be 2.8% it would be 2.8% + 0.125% – 1.685% = 1.24% nominal return.
Thank you that makes good sense. In today’s environment I can see the attractiveness. If we get devastating deflation you could “lose” 8% nominal. But in exchange you get runaway inflation protection less 1.685% real return. Keeping 98.315% of your money during serious inflation doesn’t sound too bad actually. At least compared to the destruction nominal bonds have incurred in historical hyperinflations.