Treasury will reopen a 5-year TIPS at auction Wednesday, as real yields are creeping higher.
By David Enna, Tipswatch.com
The last TIPS auction of the year is coming Wednesday, a day early because of the holiday season, when the U.S. Treasury will offer $17 billion in a reopening of CUSIP 91282CDC2, creating a 4-year, 10-month Treasury Inflation-Protected Security.
This auction follows just a week after the Federal Reserve announced it will accelerate tapering of its bond-buying program, cutting its January purchases by $20 billion for Treasury securities and $10 billion for mortgage-backed securities. Federal Reserve Chairman Jerome Powell said Wednesday the bond-buying should end by March 2022:
“If the economy evolves broadly, as expected, similar reductions in the pace of net-asset purchases will likely be appropriate each month, implying that increases in our securities holdings would cease by mid-March, a few months sooner than we anticipated in early November. “
You’d think the end to Treasury purchases by the Fed would lead — at least — to a tick higher in real yields (meaning the yield TIPS provide above or below inflation) but this isn’t a sure thing. The Fed is likely to continue rolling over its past purchases, keeping its balance sheet stable. The Fed now owns well over 20% of the entire Treasury market, so its influence over future yields will continue, even without a bond-buying program. This Bloomberg chart shows the massive escalation of the Fed’s Treasury ownership over the last two years:
The point is: An end to the Fed’s bond-buying program will not end its dominance of the Treasury market. That will continue until the Fed begins shrinking its balance sheet, an event that could cause panic in the stock and bond markets. If you examine that chart, you can see that despite the tapering event of 2014, the Fed’s balance sheet remained stable until well into 2017.
But hey, we have actually seen 5-year real yields tick higher this month, possibly triggered by the Fed’s other announcement: That is is preparing to raise short-term interest rates in 2022, potentially three times to range of 0.75% to 1.00%. The 5-year TIPS is the maturity most sensitive to increases in the Federal Funds Rate. Here is the trend we’ve seen, using Treasury estimates of 5-year real yields:
- Aug. 1. 5-year real yield -1.85%
- Sept. 1. -1.70%
- Oct. 1. -1.58%
- Nov. 1. -1.66%
- Dec. 17. -1.47%
Another reason for the tick higher in the 5-year real yield is that inflation expectations are falling, slightly, in reaction to the Fed’s hawkish stance. That means real yields have room to move higher as nominal rates also increase. Sometime in the near future, will we see a strong surge to higher real yields, as we did in the two years from December 2012 to December 2014?
Notice that the 5-year yield started that period at -1.44%, very close to where it is today, and ended the period at 0.46%, 190 basis points higher. And this happened a full year before the Fed began raising the Federal Funds Rate in December 2015. The funds rate didn’t reach 0.75% — where it is expected to be next year — until March 2017. All of this shows the accelerated path today’s Fed is taking under our current threat of looming inflation.
Just out of curiosity, I looked to see where the 5-year real yield was on March 16, 2017, just after the Fed’s third rate increase in that tightening cycle:
- 5-year TIPS: 0.18%
- 5-year Treasury note: 2.05%
- 5-year inflation breakeven rate: 1.87%
Clearly, we should be seeing higher real yields in coming months, making TIPS more attractive. The 5-year TIPS will be the most sensitive, rising the fastest in the wake of Fed actions. Longer-term real yields, however, could be suppressed as fears of recession rise and the yield curve flattens.
Wednesday’s reopening auction
Oh, well, back to the mundane reality of Treasury auctions. CUSIP 91282CDC2 trades on the secondary market, so you can check its current real yield to maturity and price on Bloomberg’s Current Yields page. As of Friday’s market close, it was trading with a real yield of -1.54% and price of about $108.36 for $100 of value.
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.
CUSIP 91282CDC2 has a coupon rate of 0.125% but a real yield to maturity of -1.54%, so investors have to pay about an 8.4% premium to par value to purchase this TIPS. In addition, it will have an inflation index of 1.01192 on the settlement date of Dec. 31, meaning investors will be buying an additional 1.19% in principal over par.
So, add this up. An investor putting in an order for $10,000 of this TIPS will actually be purchasing $10,119 in principal. Tack on the 8.4% premium, and the adjusted cost of this investment will be about $10,969 for $10,119 in principal.
Of course, real yields can change before Wednesday’s auction closes at 1 p.m. EDT. If you are investing in this TIPS auction, keep an eye on Bloomberg’s Current Yields page, which shows real-time trading.
Here is the trend in 5-year real yields over the last five years, showing how real yields have been creeping higher since mid November:
Inflation breakeven rate
With a 5-year nominal Treasury currently trading with a yield of 1.17%, this TIPS currently has a five-year inflation breakeven rate of 2.71%, which seems like a reasonable number. Here is the trend in the 5-year inflation breakeven rate over the last five years, also showing how inflation expectations have been waning a bit as the Fed prepares to ease off on economic stimulus:
I was a buyer at only one TIPS auction this year, on June 17 when a 5-year reopening got a real yield to maturity of -1.416%, which seemed “decent” at the time. Wednesday’s auction could see a real yield rising to that level; it will depend on investor demand. I’m not particularly interested this time around, however, because I see the potential for higher real yields in the future.
OK, full disclosure, my track record as a “predictor of the future” is pretty poor. I will be reporting the auction results soon after the close at 1 p.m. Wednesday.
As a side note, if you haven’t purchased your full allocation of U.S. Series I Bonds this calendar year — $10,000 per person — you should do that before you invest in a 5-year TIPS. The I Bond is clearly the better investment, with a 150-basis-point advantage over a 5-year TIPS.
Here’s a history of recent TIPS auctions of this term:
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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.