Treasury Inflation-Protected Securities

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% in April on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, inflation declined 0.2%.

Falling energy prices were a key factor in April’s mild inflation. Gasoline prices, for example, fell -1.7% after rising in the two previous months. Gas prices are down -31.7% over the last 12 months. Fuel oil prices were down a very strong -8.4% in April, the BLS reported. Balancing off those declines were increases in medical care services (0.9%), shelter (0.3%) and used cars and trucks (0.6%). Overall food prices were unchanged in April.

Core inflation – which strips out energy and food – was up 0.3%, its largest increase since January 2013. Core inflation is up 1.8% over the last 12 months.

Holders of TIPS and I Bonds are also interested in non-seasonally adjusted inflation, which is used to determine the principal adjustments for TIPS and future interest rates for I Bonds. In April, the inflation index rose 0.2% to 236.599, but over the last 12 months inflation was negative at -0.2%.

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

Although overall inflation remains very muted, April’s core inflation number could give the Federal Reserve something to ponder. The Fed adopted a 2% inflation target in April 2012. Core inflation of 1.8% is approaching that number, but I still can’t see the Fed acting to raise short-term interest rates in the near term.

Here is the inflation trend for the last 12 months:

The US Treasury just announced that its reopening of a 10-year TIPS – CUSIP 912828H45 – auctioned with a real yield (above inflation) of 0.358%. This is a 9-year, 8-moth Treasury Inflation-Protected Security with a coupon rate of 0.250%.

Because the auctioned yield ended up higher than the coupon rate, buyers got this TIPS at a discount – an adjusted price of about $98.62 per $100 of value. The discount was a little greater because this TIPS has an inflation index of 0.99633, meaning it remains slightly below par value after several months of deflation. So technically buyers are paying $98.62 for $99.63 of value as of May 29, the issue date.

Inflation breakeven rate. Comparing the yield of 0.358% with the current yield on a 10-year nominal Treasury (2.21%), we get a 10-year inflation breakeven rate of 1.852%. This means that if inflation average higher than 1.852% over the next 10 years, this TIPS will outperform a nominal Treasury. This is a historically low number, but reflects the muted level of inflation over recent years.

Six months ago, a similar TIPS reopening resulted in a real yield to maturity of 0.497% and a very similar inflation breakeven rate of 1.853%. This indicates that TIPS yields are tracking closely with those of traditional Treasurys.

Reaction to the auction. In the minutes after the auction, the TIP ETF, which holds a broad range of maturities, had minimal reaction. TIPS had been trading slightly higher all morning, indicating that yields were trending slightly down.

Bloomberg’s Alexandra Scaggs noted that the auction “attracted the lowest demand since September 2014.”

“We’re just simply not too wrought up about inflation expectations at the moment,” said Jim Vogel, interest-rate strategist with FTN Financial in Memphis, Tennessee. …

’’There was some concern that the market was beginning to doubt the Fed’s ability to get inflation back up, but that fear has dissipated a little bit,’’ said Joshua Feinman, New York-based global chief economist with Deutsche Bank Asset & Wealth Management, which oversees $1.3 trillion. But now, “most of the impact has already been priced into the market.”

Noncompetitive bids close at noon for CUSIP 912828H45, a 9-year, 8-month Treasury Inflation-Protected Security with a coupon rate of 0.210%. Competitive bids close at 1 p.m. when the auction ends. Here’s what we can say at 10:06 a.m.:

• Bloomberg’s Current Yields page shows this TIPS trading this morning with a real yield (after inflation) of 0.34% and a price of about $99.15 per $100 of value. This TIPS will go at a discount because its yield is higher than the coupon rate.
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in January 2025 – closed Wednesday with a yield of 0.336% and a price right around $99.19.
• The US Treasury’s Real Yields Curve page estimates that a full-term 10-year TIPS closed Wednesday with a yield of 0.38%
• Finally, the TIP ETF is trading this morning at $112.69, up about 0.3%, which indicates that yields are declining slightly.

All of this information seems to point to an auction yield today of about 0.33%, well below the 0.497% that a similar auction drew six months ago.

I’ll return after the auction closes at 1 p.m. to post the results and then later to add some reaction.

It’s been an interesting couple of weeks for Treasury Inflation-Protected Securities, and all government bonds. Yields are rising – the 10-year German bund, for example, is currently yielding 0.73%, up from 0.07% just three weeks ago. In that same time, the yield on a 10-year US Treasury rose from 1.87% to 2.27%. And the yield on a 10-year TIPS rose from -0.02% to 0.41%.

So rates are on the rise, and while this makes TIPS more appealing as an investment, it strikes hard at TIPS mutual funds. The price of the broadly invested TIP ETF, for example, has fallen from $115.49 on April 17 to $112.16 on May 13, a decline of 2.9%.

All of this is leading up to a reopening auction next week of CUSIP 912828H45, which first auctioned on Jan. 22 with a real yield to maturity (after inflation) of 0.315% and a coupon rate of 0.250%. It reopened on March 19 with a real yield of 0.2%, the lowest yield for an 9- to 10-year TIPS at auction since May 2013.

Thursday’s 9-year, 8-month auction will be the final reopening of this TIPS, and it could end up being a fairly attractive offering. Here is where things stand today:

• This TIPS is currently trading on the secondary market. Bloomberg’s Current Yields page shows it trading at 0.37% this morning – with a price of about $98.88 per $100 of par value. It is priced at a discount because the yield is higher than that coupon rate of 0.250%.
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures on Jan. 15 2025 – closed Wednesday with a yield of 0.370% and the same price, about $98.88 for $100 of par value.
• You can also see on that WSJ chart that this TIPS has an inflation index of 0.993, which means it hasn’t yet risen to par value after several months of deflation. This index will rise to 0.996 on the auction closing date of May 29, which will also slightly lower its adjusted price at auction. View detailed index data.
• Finally, the US Treasury’s Real Yields Curve page, which estimates the yield of a full-term 10-year TIPS, showed a yield of 0.41% yesterday.

This auction is a week out, and a lot can happen in a week. But at this point it looks like this TIPS could end up with an after-inflation yield in the 0.35% to 0.45% range, and it will be priced at a discount.

Inflation breakeven rate. If we peg this TIPS at 0.37% and the 10-year nominal Treasury at 2.27%, we get an inflation breakeven rate of 1.90%, still in the cheap range but creeping toward the neutral area (2.0% to 2.5%). This means if inflation averages more than 1.9% over the next 10 years, this TIPS will outperform at traditional Treasury. And I’d say that number will make this TIPS attractive for many investors. Here is a five-year chart of breakeven rates for the 10-year TIPS:

Key question. Are higher yields coming? Who knows. The Treasury will offer a new 10-year TIPS in July and that one will reopen in September and November. An investor who thinks yields will be rising can afford to wait for that new July issue.

Here is the history of all 9- to 10-year TIPS auctions since January 2008. Study this chart, and you can see it has been a wild ride. Is 0.40% a ‘normal’ after-inflation yield for a 10-year TIPS? It might be today, but not in the past.

My philosophy for investing in Treasury Inflation-Protected Securities is to buy them at auction when the yield is attractive, and then hold them to maturity. At the very least – in almost every case –  you will get the original investment back at maturity, along with the biannual coupon payments.

But there are cases where a TIPS investment can backfire. Although rare, this generally involves buying a TIPS at a reopening auction where the yield is set well below the coupon rate. Or, buying a new TIPS at auction where the yield is strongly negative to inflation. Since TIPS carry a coupon rate of 0.125% at the very least, buying TIPS at a time of negative yields can be expensive, and create added risk.

An example. Take the most recent auction of a new 5-year TIPS on April 23. The yield at auction was -0.335% and the coupon rate was 0.125%, so buyers wanting to invest $10,000 in this TIPS paid about $10,252 for $10,000 of par value and a 0.125% coupon rate, which generates about $12.50 a year in income.

So, roughly, five years of coupon rates are going to pay the investor $62.50 (this will rise slightly with inflation). That leaves a shortfall of about $189.50 that the investor needs to make up in the next five years. In theory, rising inflation will push up the principal balance and will make up the difference. But if it doesn’t, the investor will never make back that original investment. Remember, par is $10,000, and that is all the investor will get back if there is zero inflation or deflation during the five-year term.

An extreme case. While working on an analysis of that April auction, I noticed a particularly ugly example: The 4-year, 4-month reopening of CUSIP 912828SQ4 on Dec. 20, 2012. This TIPS has a coupon rate of 0.125% and auctioned with a yield to maturity of -1.496%. Here’s the fact sheet.

Back on December 20, 2012, I looked at this TIPS and wrote: “I mean, who really cares? Who is actually buying this thing?” On December 10, 2012, I advanced the auction and tried to steer buyers toward I Bonds instead. In other words, I wasn’t a fan. But I had no idea how much of stinker this would become, because it was issued just before a period of deflation in the US economy.

This TIPS matures on April 15, 2017. Let’s see how it has performed so far:

Because of the spread between the coupon rate and the negative yield to maturity, the buyer of this TIPS paid $10,918 for adjusted principal of $10,184 and a par value of $10,000. When this TIPS matures on April 15, 2017, only the par value is guaranteed.

So far, the combination of months of deflation and inflation has caused the inflation index to rise from 1.o1844 in December 2012 to 1.03898 in May 2015, but that isn’t enough to make up for the initial $733.60 extra cost of this TIPS. Adjusted principal has risen from $10,184 to $10,390, still far below the initial cost of $10,918.

This particular TIPS is a ‘horror story’ – it was expensive and purchased just before an extended time of deflation. Even if inflation averages 2% a year for the next two years – best case scenario? – its principal value will rise only to about $10,810, still a bit below the original cost.

The lesson. Be wary of buying TIPS when the yield to maturity is well below the coupon rate. In today’s market, with a 5-year TIPS yielding -0.11%, the risk is minimal and acceptable.