Treasury Inflation-Protected Securities

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.

The US Treasury just announced that it is raising the the fixed rate on Series I Savings Bonds to 01.%, up from 0.0%. This creates a composite rate of 1.64% for I Bonds purchased from today through April 30, 2016. Here is the announcement:

The composite rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the 30-year life of the bond, and the semiannual inflation rate. The 1.64% composite rate for I bonds bought from November 2015 through April 2016 applies for the first six months after the issue date. The composite rate combines a 0.10% fixed rate of return with the 1.54% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 236.119 in March 2015 to 237.945 in September 2015, a six-month change of 0.77%.

Although no one will get rich earning 0.1% above inflation, this is welcome news for I Bond investors. The fixed rate has been 0.0% since November 2014. In the six months ending Oct. 31, the inflation-adjusted rate for I Bonds was -1.60%, resulting in a composite rate of 0.0%.

Also, the Treasury said that EE Savings Bonds issued from today through April 30, 2016,  will earn a permanent fixed rate of 0.1%. This is down from 0.3% offered for the last six months. Most importantly, however, the Treasury retained its policy of double-principal if held for 20 years, creating a 20-year term that pays 3.5%, very generous in today’s market. Here is the announcement:

All Series EE bonds issued since May 2005 earn a fixed rate in the first 20 years after issue. At 20 years, the bonds will be worth at least two times their purchase price. The bonds will continue to earn interest at their original fixed rate for an additional 10 years unless new terms and conditions are announced before the final 10-year period begins.

Today’s announcement adds to the appeal of I Bonds and retains the appeal of EE Bonds. Pretty good news for investors.

I’m not much an expert on Social Security (I am not collecting it at the moment), but I was planning to use the widely-encouraged ‘file and suspend’ strategy when my wife reached age 66 in a few years.

Under that strategy, at full retirement age, the higher earner in a couple would file for Social Security benefits, then immediately suspend benefits. The other spouse could then claim the ‘spousal benefit’ – half of the filing spouse’s benefit. That would continue until both spouses reach age 70 and both collect the highest-possible benefit.

While I considered ‘file-and-suspend’ to be a questionable loophole, it was legal and a lot of savvy people were planning to use it to maximize Social Security benefits. There was even a recent book that used file-and-suspend as a core strategy: ‘Get What’s Yours: The Secrets to Maxing Out Your Social Security.‘

But in the new two-year budget deal just hammered out by Congress, this strategy will be gutted. This is from the story in the Wall Street Journal:

Congress is putting an end to two Social Security filing strategies that many couples have used to add tens of thousands of dollars to their retirement incomes. ….

The strategies under fire—known as file-and-suspend and a restricted application for spousal benefits—have made it possible for both members of a couple who are 66 or older to delay claiming benefits based on their own earnings records while one pockets a so-called spousal benefit based on the other’s earnings.

While the new law shuts down the two strategies, some people can still take advantage of them—provided they act fast. For those for whom the strategies will be off limits, meanwhile, claiming decisions may become less complicated but also less lucrative.

I’d advise reading more on this topic, because if you and your spouse are currently 66 (full retirement age) you may have a six-month window to use the strategy. Otherwise, it looks like the loophole is closing.

I am sure we will be hearing more about this in coming days.