Treasury Inflation-Protected Securities

I am at work today so I can only post the facts:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2% in October on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 0.2% before seasonal adjustment.

Non-seasonally adjusted inflation – which is used to adjust the principal balance of Treasury Inflation-Protected Securities and set future interest rates on US Savings I Bonds – decreased a slight 0.04% in October, and was up 0.2% over the last 12 months.

I have updated my Tracking Inflation and I Bonds page to reflect these new numbers.

The US Treasury just announced that it will reopen CUSIP 912828XL9 at auction on Nov. 19, creating a 9-year, 8-month Treasury Inflation-Protected Security. This TIPS, which first auctioned on July 23, carries a coupon rate of 0.375%.

It will be going off at a discount, because yields on 10-year TIPS have risen a bit in recent months. Here is what we know from the secondary-market trading in CUSIP 912828XL9:

• Bloomberg’s Current Yields page shows it trading this morning with a real yield to maturity of 0.76% and a price of about $96.39 for $100 of value.
• The Wall Street Journal’s Closing Prices page shows that this TIPS – which matures 2025 Jul 15 – closed yesterday with a real yield of 0.725% and an ask price of about $96.75 per $100.
• The Treasury’s Real Yields Curve page estimates that a full-term 10-year TIPS would have closed yesterday with a yield of 0.77%.

Those numbers indicate that – a week out from the auction – this TIPS is yielding around 0.765%, plus inflation, resulting in a cost of around $96.50 for $100 of a value. But a lot can happen in a week. If you are interested in this TIPS, you should watch the three links above to judge its current value as Nov. 19 approaches.

Also, note that this TIPS will carry an inflation index of 1.00343 at the settlement date – Nov. 30. That will slightly increase an investor’s cost, but also slightly increase the principal purchased, since the TIPS will carry accrued inflation.

Yield milestone? If the yield of 0.75% holds through the auction, this TIPS will have the highest yield resulting from any 9- to 10-year auction since May 2011. That’s more than four years. I suspect there will be a lot of interest in this auction.

Inflation breakeven rate. A nominal 10-year Treasury is trading today with a yield of 2.32%, creating an inflation breakeven rate of 1.57% if this TIPS goes off at 0.75%. I consider this ultra low. It means this TIPS will outperform a nominal Treasury if inflation averages more than 1.57% over the next 10 years.

Investors are pricing in very low inflation, as shown in this chart, which tracks the 10-year inflation breakeven rate over the last five years:

You can see how rarely implied inflation drops below 1.6%. TIPS are a good buy when that happens, at least versus a nominal Treasury.

Here’s a chart of every 9- to 10-year TIPS auction since January 2009, showing the huge dip in yield beginning in mid-2011, then gradually reversing in 2013 and beyond.

I am not invested in TIPS mutual funds; my preferred strategy is to buy TIPS at auction and hold them to maturity. But I do follow the TIP ETF to check on the overall trend in TIPS, and I have said for a long time that TIPS values would be returning to a more ‘normal’ level when the TIP ETF dropped below $110.

That has happened a few times in the past five years, and it happened again this morning. Here is the five-year chart:

A lot has happened over those five years, as is reflected in the chart. In mid 2011, the Treasury began an aggressive bond-buying program, which lowered long-term yields and spurred fears of inflation. The value of Treasury Inflation-Protected Securities soared and real yields plummeted well below 0.0%. TIPS were in high demand.

Then, in June 2013, Fed Chairman Ben Bernanke announced a ‘tapering’ of the bond-buying, and inflation fears were doused. The Consumer Price Index began sliding down as oil prices began declining. TIPS were no longer in high demand. The TIP ETF lost about 8.5% of its value in 2013 – a shock for some investors who thought it was a bulletproof investment.

So where do we stand today? Of the 39 TIPS currently trading in the secondary market, only 3 still have yields negative to inflation. That is a far cry from April 12, 2013, when 35 of the 39 TIPS were trading with negative yields, all the way up to a TIP maturing in April 2032.

TIPS were a horrible investment in April 2013. They are a lot more attractive in November 2015, even after a year of zero inflation.

• A 5-year TIPS – if auctioned today – would yield 0.42% above inflation, according the Treasury’s Real Yield Curve estimates.
• A 10-year TIPS would yield 0.71%.
• A 30-year TIPS would yield 1.27%.

And TIPS remain cheap when measured against traditional Treasurys. The 10-year inflation breakeven rate, shown in the chart below, is currently running about 1.57%. Investors are pricing in very low expected inflation. Generally when the breakeven rate falls below 2%, TIPS are a bargain. This is well below 2%.

I am not recommending dumping your money into TIPS mutual funds, but I think they are a much safer investment now than they were in 2013. And I think upcoming TIPS auctions will be worth watching.

The next one is Thursday, Nov. 19, the reopening of a 10-year TIPS, CUSIP 912828XL9. It will be going off at a big discount. More on that later.

I wrote yesterday about how the lowly Series EE Savings Bond is actually a pretty attractive investment in today’s interest-rate environment, if held for 20 years. I didn’t expect many people to agree with me. So far, everyone seems to be much more interested in the new I Bond with a fixed rate of 0.1%. That’s OK, I am buying that I Bond, too.

But there’s a real possibility that the EE Bond will outperform the I Bond over the next 20 years, because if you pair off the two investments, the I Bond gets an inflation-breakeven rate of 3.4%. It will under-perform against the EE if inflation averages less than 3.4%.

I created this chart to show how an EE Bond will perform against other very safe investments, in different inflation environments:

The blue area shows that the EE Bond outperforms all the other options up to average inflation of 2.5%. At that point and above, the 20-year TIPS outperforms all the other investments. The EE Bond outperforms the I Bond up to an inflation rate of 3.0%, and just barely under-performs at 3.5%.

The 20-year Treasury is the big loser in this chart. It under-performs at all inflation rates. The I Bond is never a big loser or a big winner; it can’t outperform a 20-year TIPS yielding 0.92%, but it does offer tax advantages and a flexible maturity.

Last week I posted on both the Series I Savings Bond (which I have been buying for years) and the Series EE, which I haven’t bought – or even thought much about – since 1992. But that post on the EE Bond got me thinking: How is this not a good investment?

My advice last week was to buy the EE Bond before Nov. 1, because the Treasury might alter a key term of the bond: That your investment is guaranteed to double in value if held for 20 years. When the announcement came on Monday, the Treasury retained the double-in-20-years policy, but it dropped the permanent EE Bond’s fixed rate from 0.3% to 0.1%.

At the same time, it raised the fixed rate for inflation-adjusted I Bonds purchased from now to April 30, 2106, to 0.1% from 0.0%.

EE Bonds, really? This investment only makes sense if you are 99.999% sure you can hold it for 20 years. If you do, you will earn 3.5% on your money. If you don’t, you will earn 0.1%. So I am assuming anyone buying an EE Bond is committed to holding it 20 years. And remember, this money compounds tax-deferred. There is no tax liability until you sell.

[Update: One more thought on EE Bonds; a chart explains it all …]

Back in 1992 … The last time my wife and I bought EE Bonds was in August 1992, after we sold a house and had cash to put away. At the time, EE Bonds were guaranteed to double in value in 18 years, creating a yield of 4.0%. Because of a complex dual-track rate system on EE Bonds at the time, our EE Bonds have actually yielded 5.04% over 23 years. They are still earning 4.0% a year until maturity in 2022.

It’s was my wife’s idea to buy the EE Bonds. I thought it was a horrible idea. I argued but, hey, I had to admit it was a no-risk investment. Today, $10,000 of those EE Bonds are worth $31,432, and they are still growing at 4.0% a year, all tax deferred. Good move, wife.

One more fact to complete this idea: In August 1992, a 30-year nominal Treasury was yielding 7.64%, 364 basis points higher than the official yield of the EE Bond and 260 basis points higher than the resulting effective yield.

And in 2015? EE Bonds purchased today earn a pitiful 0.1% for 19 years, 11 months, and then one month later suddenly double in value, creating an effective yield of 3.5%. How does that compare with a 20-year nominal Treasury? It is yielding 2.65%, 85 basis points below the yield on an EE Bond. Even a 30-year nominal Treasury has a yield of 3.00%, 50 basis points below the EE Bond.

So in fact, in 2015, EE Bonds are a much more attractive investment versus Treasurys than the were in 1992.

EE Bonds versus I Bonds. I remain a huge fan of I Bonds was a way of pushing inflation-protected, tax-deferred money into the future. But I think EE Bonds could make a nice addition to the super-safe allocation of your retirement portfolio.

Think of it this way: I Bonds have a fixed rate of 0.1%, meaning they will out-perform inflation by 0.1%. EE Bonds held 20 years have a yield of 3.5%. So inflation will have to average higher than 3.4% over the next 20 years for I Bonds to beat EE Bonds as an investment. Will inflation average higher than 3.4%? Who knows! It could, and that is why I like I Bonds. It might not, and that is why I like EE Bonds.

I say, buy them both.

I Bonds, of course, are a much more flexible investment. They can be sold after one year with only a 3-month interest rate penalty (same with EE Bonds), and then after five years with no penalty. No need to hold an I Bond for 20 years.

And so, I’m making a weird move. Since the I Bonds I bought in 2013 with a fixed rate of 0.0% have been composite yielding 0.0% since July 2015, I decided to sell out of that position in Treasury Direct. The 3-month interest penalty is $0. When that money comes into my savings account (within a week?) I will then purchase the new I Bonds with a fixed rate of 0.1%, up to the limit ($10,000 per person).

And … I’ll be buying EE Bonds up to the limit for the first time since 1992.