By David Enna, Tipswatch.com
Opinion: Nominal and real yields for mid- to longer-term Treasurys are lower than they should be. The Federal Reserve is aggressively tightening, sending clear signals it wants interest rates heading higher. But the result is lower yields on 5- to 30-year Treasurys.
Why is this happening? Some guesses: 1) The bond (and stock) markets are beginning to price in a slowdown in U.S. economic growth, most likely leading to a recession in 2023; 2) The markets don’t fully buy the Fed’s determination to keep fighting inflation no matter what; and/or 3) The markets believe that U.S. inflation is under control and will slip much lower in 2023.
Since Nov. 1, the nominal yield on a 5-year Treasury note has declined 57 basis points, from 4.18% to 3.61%. The real yield on a full-term 5-year Treasury Inflation-Protected Security has declined 15 basis points, from 1.61% to 1.47% as of Friday’s market close, based on Treasury estimates.
That’s significant. TIPS yields have been holding at higher levels than comparable nominal Treasurys. When that happens, the market is pricing in lower future inflation. And when that happens, TIPS go on sale versus their nominal counterparts. TIPS are attractive right now.
Thursday’s 5-year TIPS reopening
On Dec. 22, the Treasury will offer $19 billion in a reopening auction of CUSIP 91282CFR7, creating a 4-year, 10-month TIPS. (FYI, that $19 billion size is the largest in history for any 5-year TIPS reopening, up from $17 billion in last December’s comparable auction.)
CUSIP 91282CFR7 had an originating auction on Oct. 10, 2022, which at the time I called a “unicorn event” because of a slew of factors making that offering attractive. It ended up auctioning with a real yield of 1.732%, highest for this term in 15 years, and the coupon rate was set at 1.625%, also the highest for this term in more than 15 years.
And now it will be reopened Thursday. This TIPS trades on the secondary market, and you can track its current real yield and price in real time on Bloomberg’s Current Yields page. At Friday’s close it was trading with a real yield of 1.46% and a price of $100.76 for $100 of value. The price is at a premium because the real yield is now below the coupon rate of 1.625%.
Definition: The “real yield” of a TIPS is its yield above official future U.S. inflation, over the term of the TIPS. So a real yield of 1.46% means an investment in this TIPS will exceed U.S. inflation by 1.46% for 4 years, 10 months. If inflation averages 2.2%, you’d get a nominal return of 3.66%, on par with a nominal U.S. Treasury. But if inflation averages 4.5%, you’d get a nominal return of 5.96%.
Pricing. This TIPS will carry an inflation index of 1.00576 on the settlement date of Dec. 30. That means investors at Thursday’s auction will be paying roughly $101.34 for about $100.58 of accrued principal, along with an additional 34 cents of accrued interest. Put another way, an investor placing an order for $10,000 of par value of this TIPS will be paying about $10,134 for $10,058 of principal. That’s a rough estimate and things could change by Thursday.
Here’s the trend in the 5-year real yield over the last 4 1/2 years, showing how yields have declined since peaking in October, but remain historically attractive:
Inflation breakeven rate
With a 5-year nominal Treasury note closing Friday with a yield of 3.62%, this TIPS currently has an inflation breakeven rate of 2.16%, a rate that seems surprisingly low for a short-term investment in a time of 7.1% U.S. inflation. Over the last five years, inflation has been averaging about 3.9%.
So we come back to my point that real yields on TIPS have been declining much less than those on nominal Treasurys of the same term. Why? Investors are betting that U.S. inflation will decline to historical levels very quickly. I’ll take the other side of that bet: I think inflation will average more than 2.16% over the next five years, so this TIPS is an attractive investment.
Here is the trend in the 5-year inflation breakeven rate over the last 4 1/2 years, showing that inflation expectations have been sliding lower since March 2022.
Although I have loaded up on TIPS maturing in 2027 this year, I am likely to be a buyer at Thursday’s auction. A real yield of 1.46% is historically attractive. Yes, yields could climb higher, but this TIPS is a safe hold-to-maturity investment. I will also be looking with strong interest at the new 10-year TIPS to be auctioned Jan. 19, filling a 2033 spot in my TIPS ladder.
Some TIPS investors don’t like buying additional principal at a premium price, but I think a real yield of around 1.46% — if it holds through Thursday — is good enough to overcome that objection. Since October 2009, there have been 41 TIPS auctions of the 4- to 5-year term and only two have generated a real yield above 1%. Real yields could eventually head even higher, but I feel the need to nibble away at these while they are available.
One note: I do think U.S. inflation (specifically non-seasonally adjusted inflation) could hit a brief, illusionary low-inflation or deflationary spell early in 2023. The year-ago inflation numbers will be hard to beat: January, 0.84%; February, 0.81%; March, 1.34%, April, 0.56%, May 1.10% and June, 1.37%. That will mean the annual inflation number should be declining, even as U.S. prices continue to increase. It’s something to be aware of if you fret about your TIPS investments month to month.
When this auction closes at 1 p.m. Thursday, I am likely to be on the road to visit relatives for the holiday. I won’t be able to post the results immediately. You can find results on this page soon after the auction closes.
Non-competitive bids at TreasuryDirect must be placed by noon Thursday. If you are putting an order in through a brokerage, make sure to place your order Wednesday or very early Thursday, because brokers cut off auction orders before the noon deadline.
Here’s a history of recent 4- to 5-year TIPS auctions, highlighting the only two auctions over the last 13 years with real yields higher than 1%.
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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 be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.