Treasury Inflation-Protected Securities

As an experiment, I wrote this article as an exclusive for the SeekingAlpha.com Website, so I can’t repeat it in full here. But I can say that this is my advice: Don’t buy I Bonds in January. I’d suggest waiting at least until mid-April.

Story summary:

• Rates could rise before the Treasury’s next fixed-rate reset on May 1.
• Threat of deflation could bring a 0.0% return for six months.
• Wait at least until mid-April to buy, or possibly before or right after the Nov. 1 reset.

Read the full article on SeekingAlpha.com

The ‘bond bubble’ didn’t burst in 2015, but it did fizzle a little. Vanguard’s Total Bond Market ETF (BND) started the year at $82.65 and ended at $80.76, a decline of 2.3%. But when you add in dividends the fund paid, it eked out a tiny positive return for the year.

TIPS didn’t fare as well, as inflation breakeven rates fell to extremely low levels against traditional Treasurys. That indicates investors are shunning TIPS, causing yields to rise. The broadly diversified TIPS ETF (TIP) started the year at $112.73 and ended at $109.68, a decline of 2.7%. The fund’s total return after distributions was -1.75%.

At the end of the year, the TIP ETF finally fell below the $110 level, which I have been predicting would be a positive indicator for buy-and-hold-to-maturity TIPS investors. It was as high as $123.15 in December 2012.

What does it mean? The TIPS market is a lot more attractive going into 2016 than it has been for nearly five years. Here’s a rundown of all the TIPS auctions of 2015:

CUSIP 912828H45: 10-year TIPS

First auction, Jan. 22: Auctioned with a yield to maturity (after inflation) of 0.315% and a coupon rate of 0.250%. The inflation breakeven rate was 1.57%.

Reopened, March 19: Auctioned with a real yield to maturity of 0.2%, the lowest yield for an 9- to 10-year TIPS at auction since May 2013. The inflation breakeven rate rose to 1.77%. The auction was a bit of a disappointment, coming one day after Fed chair Janet Yellen declared the Fed would move slowly on increasing short-term interest rates.

Reopened, May 21: Auctioned with a real yield to maturity of 0.358%. The inflation breakeven rate was 1.852%.

CUSIP 912810RL4: 30-year TIPS

First auction, Feb. 19: Auctioned with a coupon rate of 0.750% and a yield to maturity of 0.842%. This was the lowest yield for any 29- to 30-year TIPS auction since February 2013, and the yield of 0.842% was far below the previous year’s 30-year TIPS, which auctioned on Feb. 20, 2014, with a yield of 1.495% and a coupon rate of 1.375%. In my preview article on this auction, I cautioned against this auction, which I predicted could be a ‘time bomb.’

Reopened, June 18. Auctioned with a real yield to maturity of 1.142%. The unadjusted price was $90.16 for $100 of value, because the yield was much higher than the 0.750% coupon rate. This TIPS lost nearly 10% of its value in four months.

Reopened, Oct. 22. Auctioned with a real yield  to maturity of 1.20% and an unadjusted price of $88.91 for $100 of value. The inflation breakeven rate was 1.66%, ultra-low for a 30-year issue.

CUSIP 912828K33, 5-year TIPS

First auction, April 23: Auctioned with a real yield to maturity of -0.335%. The coupon rate was set at 0.125%, the lowest the Treasury allows on a TIPS. This is the lowest yield for any 4- to 5-year TIPS at auction since Dec. 19, 2013. In my preview article, I suggested that investors ‘look for better alternatives.’

Reopened, Aug. 20: Auctioned with a real yield to maturity of 0.305%, a huge jump – 64 basis points – over the April 23 original auction. The unadjusted price was $99.17 for $100 of value and the inflation breakeven rate was a remarkably low 1.16%. In my preview article, I noted this auction was ‘a lot more attractive‘ than April’s.  I was a buyer.

Reopened, Dec. 17: Auctioned with  real yield of 0.472%, the highest for any 4- to 5- year TIPS auction since April 2010. The unadjusted price dropped to $98.52 for $100 of value and the inflation breakeven rate rose to 1.25%. I was a buyer.

CUSIP 912828XL9, 10-year TIPS

First auction, July 23: Auctioned with a coupon rate of 0.375% and a real yield to maturity of 0.491%. The unadjusted price was $98.87 per $100 of value, and the inflation-breakeven rate was 1.79%.

Reopened, Sept. 18: Auctioned with a real yield to maturity of 0.60% and an unadjusted price of $97.86 for $100 of value. The yield of 0.60% was the highest for any 9- to 10- year TIPS since an auction in September 2014. The inflation breakeven point dropped to 1.56%. I was a buyer.

Reopened, Nov. 19: Auctioned with a real yield to maturity was 0.664%, just barely beating a couple of 2014 auctions to become the highest yield for any 9- to 10-year TIPS auction since May 2011. The unadjusted price was $97.31 per $100, and the inflation breakeven rate was 1.60%.

The trend in inflation

‘Headline’ inflation has remained stubbornly low, held down by a collapse in gasoline prices in 2014. As of November, 12-month inflation was running at 0.5%, but core inflation – which strips out energy and food – has climbed to 2.0% over the last 12 moths. If energy prices rise or even stabilize, we could see higher headline inflation in 2016. Here is the trend over the last year:

A reopening auction today of a 5-year TIPS generated a real yield of 0.472%, the highest for any 4- to 5- year TIPS auction since April 2010. This is CUSIP 912828K33, with a coupon rate of 0.125% and a maturity date of April 15, 2020.

Because the yield was much higher than the coupon rate, this Treasury Inflation-Protected Security auctioned at a discount – the unadjusted price was $98.53 for $100 of value. After accrued inflation-adjusted principal was added in, the adjusted price became about $100.07 for $101.56 of principal.

In other words, if you bought $10,000 of this TIPS at this auction, you paid $10,070 for $10,156 in principal and will earn 0.125% on that principal going forward. The principal will rise and fall with inflation until maturity.

This TIPS has an interesting story, since it originally auctioned in April with a yield to maturity of -0.335%. Buyers at that auction paid $102.52 for $100 of value. That means this TIPS has dropped almost 4% in value since the original auction – a big drop for a 5-year maturity. But it also means buyers today got a good price.

Inflation breakeven rate. A nominal 5-year Treasury is trading right now with a yield of 1.72%, setting up an inflation breakeven rate of 1.25% for this TIPS. If inflation averages more than 1.25% over until April 2020, this TIPS will outperform the nominal Treasury. This rate is very low, indicating the TIPS was ‘cheap’ versus a traditional Treasury.

Reaction to the auction. The TIP ETF has been trading up slightly all morning, and it hasn’t budged with the close of this auction at 1 p.m. That indicates all went as expected.

For the first time since December 2008, the Federal Reserve is raising its Federal Funds Rate from zero to a range of 0.25% to 0.50%. If you like, you can read the Fed’s press release detailing its thoughts on the move, which was extremely well telegraphed.

Here is the key paragraph:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In other words, the Fed knows that a base short-term interest rate of 0.25% remains well below the likely rate of inflation in the coming year. And this remains a time of ‘easy money,’ which can continue to spur economic growth.

The Fed also released a chart of projections for the economy and the Federal Funds Rate. It sees inflation rising to 1.6% in 2016, 1.9% in 2017 and 2.0% in 2018 and beyond. And it projects the Federal Funds Rate climbing to 1.4% in 2016, 2.6% in 2017 and 3.3% in 2017. As you can see from the chart, those numbers are slightly lower than the Fed was projecting in September. In actuality, the Fed is saying it expects a ‘normalized’ short-term interest rate of 3.5% when inflation is 2.0% in 2018 and beyond. It’ll take several years – and a steady economy – to see if that is true.

Back in April 2014, I wrote a blog theorizing on where yields for Treasury Inflation-Protected Securities would be heading when the Fed began raising its short-term rate. At the time, I speculated that the rate would rise gradually to 2.5%, which is where the Fed is now projecting it will be in 2017. Here is what I found:

I am going to toss out the high and low numbers in each column, and say that in 2017:

• A 5-year TIPS could be yielding in a range of 0.79% to 0.97%.
• A 10-year TIPS could be yielding in a range of 1.49% to 1.74%.
• No data for 30-year TIPS, so no prediction.

However, one caution: This assumes the Fed will carry out future rate increases. That is certainly not a sure thing.

Checking in on Thursday’s 5-year TIPS reopening

This is a reopening of CUSIP 912828K33, creating a 4-year, 4-month TIPS with a coupon rate of 0.125%, plus inflation.

I am working Thursday morning and I won’t be able to post then, so here we go. If I were buying at this auction – and I definitely might be – I’d want to check these numbers in the morning, because things could be volatile. Non-competitive bids must be placed by noon; the auction closes at 1 p.m.

•  Bloomberg’s Current Yields page shows this TIPS trading with a yield of 0.50% and a price of $98.37 per $100 of value. (It is going at a discount because the yield is higher than the coupon rate.)
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in April 2020 – closed Wednesday with a yield of 0.46% and a price around $98.50.
• The Treasury’s Real Yields Curve page estimates that a full-term 5-year TIPS would have yielded 0.55% at the close today. (The yield on a full-term 5-year should be slightly higher than that of a 4-year, 4-month TIPS.)

Thursday morning, check those links and also track the price of the TIP ETF, which closed today at $109.15. If you see the price dropping, that means yields are rising. If the price is rising, yields are dropping.

If this auction generates a yield of 0.4%, it would be highest yield for any 4- to 5-year TIPS at auction since April 2010 – more than five years.

Also, keep in mind that this TIPS will have an inflation index of 1.01563 on the settlement date of Dec. 31. That means buyers will be purchasing about 1.5% of additional principal.

If all stays the same, tomorrow’s auction should net a yield of about 0.48%, which I would consider very attractive. The nominal 5-year Treasury is yielding 1.75%, creating an ultra-low inflation breakeven rate of 1.27%, well below the Fed’s projections. As you can see from this chart of the 5-year breakeven since 2007, this is rare territory:

The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in November on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 0.5%.

Both food prices (down 0.1%) and gas prices (down 2.4) contributed to the flat inflation number. Core inflation – which strips out food and energy – was up 0.2% in November and now has increased 2.0% over the last 12 months. That’s right on the Federal Reserve’s target, although the Fed tracks a slightly different index.

Today’s numbers shouldn’t sidetrack the Federal Reserve’s expected move to slightly raise short-term interest rates after its meetings conclude Wednesday afternoon.

Holders of Treasury Inflation-Protected Securities and I Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust the principal balance on TIPS and set future inflation-adjusted interest rates for I Bonds. In November, the CPI-U inflation index fell to 237.336, down 0.21% from October’s number.

For the current I Bond adjustment period (September 2015 to March 2016) inflation is  running at -0.25%.

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