Treasury Inflation-Protected Securities

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.4%  in December on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 0.8%.

From August until the end of 2014, US prices fell 0.7%. December’s sharp decline was primarily caused by a massive 9.4% drop in the price of gasoline, which is down 21% in the last 12 months. Fuel oil was down 7.4%. Food prices, however, rose 0.3%. The shelter index rose 0.2%, and the index for medical care commodities was up a sharp 1.0%.

What this means for TIPS and I Bonds. Today’s inflation report isn’t welcome news for holders of Treasury Inflation-Protected Securities and I Bonds. Non-seasonally adjusted CPI-U – which fell 0.57% in December – is used to adjust the principal balance of TIPS and set future interest rates for I Bonds. The December inflation index was set at 234.812, below where it stood in March 2014 (236.293). In just three months, from September to December 2014, non-seasonally adjusted CPI has dropped 1.36%.

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

This is setting up a problem for I Bonds in 2015. I Bonds purchased through April 30 pay a fixed rate of 0.0% and an inflation-adjusted rate of 1.48% annualized. The next adjustment for the inflation -adjusted rate – on May 1 – will be determined by inflation from September 2014 to March 2015. Three months in, that’s running -1.36%, so it looks highly likely that I Bonds will get an inflation-adjusted rate of 0.0% on May 1, to go along with a fixed rate that may hold at 0.0%. In other words, zero + zero = zero.

What this means: Do not plan on buying your 2015 allocation of I Bonds ($10,000 per person per calendar year) until late in the year, after the Nov. 1 adjustment.

Core inflation. Even when you strip out food and energy, US inflation was unchanged in December and rose 1.6% over the last 12 months. This is well below the Federal Reserve’s target of 2.0% annual inflation, and should allow the Fed to continue holding the line on near-zero short-term interest rates.

Year in review. CPI-U rose 0.8% in 2014 after a 1.5% increase in 2013. This is the second-smallest December-December increase in the last 50 years, trailing only the 0.1%  increase in 2008. The BLS noted it is considerably lower than the 2.1% average annual increase over the last ten years. This chart shows the deflationary trend as gasoline prices fell sharply in the second half of the year:

The Treasury just announced next week’s TIPS auction: CUSIP
912828H45, a new issue with the coupon rate to be determined at  auction.

This auction will come amid a lot of turmoil in financial markets, with Treasury yields plummeting while the stock market shows a lot of volatility. Our current trend of very low inflation (and even deflation) is also reducing demand for Treasury Inflation-Protected Securities, an investment that hedges against unexpected future inflation.

So this isn’t shaping up to be an attractive auction for buyers. Here’s what we know today:

• Bloomberg’s Current Yields page shows a 9-year, 6-month TIPS currently trading with a yield to maturity of 0.23%.
• The Wall Street Journal’s TIPS Closing Prices page shows that same TIPS closed yesterday with a yield of 0.24%.
• The Treasury’s Real Yields Curve page estimates that a full-term 10-year TIPS would yield 0.29%.

So at this point, with the auction a week away, it appears this new TIPS issue will get a coupon rate of 0.250% and a real yield (after inflation) a bit higher than that. A year ago, a 10-year TIPS went off with a yield of 0.661% – about 37 basis points higher. In fact, only one auction of a 9- to 10-year TIPS in the last nine went off with a yield below 0.30% – on July 24, 2014, with a yield of 0.249%.

Interesting side note. Next Thursday’s auction will create two TIPS maturing on Jan. 15, 2025, and I believe it will be the first time ever the Treasury had two TIPS maturing on the same day. It looks like this in the Wall Street Journal’s chart:

This is CUSIP 912810FR4, a 20-year, 6-month TIPS that was first issued July 15, 2004. If you bought that 10 years ago (I didn’t, unfortunately) you are loving that 2.375% coupon, which you earn in addition to inflation. I’ll just note that a 30-year nominal Treasury is yielding about 2.47% this week. This TIPS might yield slightly higher than the new one coming next Thursday, but it comes at a lofty cost: About $120 per $100 of value plus 25% in inflation appreciation. Ouch. And I wouldn’t want to be buying inflation appreciation at a time when we face several months of deflation, which will reduce the accrued principal.

Inflation breakeven rate. With the 10-year nominal Treasury currently yielding 1.87%, a TIPS yield of 0.29% would create a 10-year inflation breakeven rate of 1.58% – which puts this TIPS solidly into the ‘cheap’ zone versus a 10-year Treasury. If inflation averages higher than 1.58% over the next 10 years, it will outperform the nominal Treasury. As you can see from this chart, breakevens are approaching their lowest levels of the last five years. And you can also see they don’t stay this low for long:

SOURCE: Federal Reserve of St. Louis

But ‘cheap’ doesn’t necessarily equate to ‘attractive.’ A yield of 0.29%, plus inflation, on a 10-year TIPS isn’t very attractive. In fact, just two months ago, a 4-year, 4-month TIPS went off with a yield of 0.395%, 10 basis points higher.

It will be interesting to see how demand develops for this auction. Here is a chart of recent 9- to 10-year TIPS auctions to study until then:

As the stock market tumbles a bit from all-time highs, the Treasury market is soaring, with yields dropping to 1.96% yesterday on the 10-year nominal Treasury. It is hard to believe that the US is seeing: 1) better-than-average economic growth, 2) the stock market near all-time highs, 3) ultra-low inflation, and 4) Treasury yields on the decline.

And the market is pricing in very low inflation well into the future. You can see that by calculating the ‘inflation breakeven rate’ – a measure of future inflation expectations –  using this simple formula:

10-year Treasury yield – 10-year TIPS yield = 10-year breakeven rate

Here is where inflation breakevens stand today:

• 5 year. 1.47% – 0.31% = 1.16%
• 10 year. 1.96% – 0.39% = 1.57%
• 30 year. 2.52% – 0.68% = 1.84%

While writing about Treasury Inflation-Protected Securities over the last three years, I have devised a simple formula: When the 10-year breakeven rate falls below 2%, TIPS are cheap, when it rises above 2.5%, TIPS are expensive. Here is the breakeven trend for each of the maturities for the last five years:

It’s rare to see inflation breakeven rates this low, and so either the world has permanently changed and inflation will permanently be extremely low, or … TIPS are a bargain right now when compared to nominal Treasurys.

I’d argue that inflation expectations are way too low, especially for the longer maturities. Take a look at this chart of the history of inflation from 1961 to today. Over five-year periods, inflation has never averaged lower than 1.3%; for 10 years, 2.3%, and for 30 years, 2.8%. The chart also shows the US has been in a multi-decade trend of declining inflation. At some point – possibly in the next 10 years and definitely in the next 30 – that trend could change toward gradually rising inflation. Or possibly, sharply rising inflation.

A margin of safety. TIPS investors can take comfort in these extremely low inflation breakeven rates. Why? They provide a margin of safety against rising interest rates. Let’s say the 10-year Treasury rises over the next year to 2.75%, an increase of 79 basis points. At the same time, the inflation breakeven rate rises to 2.2%, a fairly routine number. The 10-year TIPS would then be yielding 0.55%, a rise of only 16 basis points.

When the inflation breakeven trend reverses to ‘more normal’ levels, TIPS are going to outperform traditional Treasurys and probably the overall bond market.

That hasn’t been the case over the last 6 months, as shown in this chart, which is a perfect depiction of the effect of a declining inflation breakeven rate on TIPS:

The TIP ETF has underperformed the Treasury market (shown by IEI, intermediate Treasurys) and AGG (total bond market) over the last six months. SOURCE: Yahoo Finance.

After suffering through a miserable 2013, holders of mutual funds based on Treasury Inflation-Protected Securities enjoyed a rather pleasant 2014. The TIP ETF – a big fund that is diversified through maturity dates – started the year on Jan. 2  at $110.26  and closed Dec. 31 at $112.01. That’s a capital gain of about 1.6% – on top of any interest distributions. (Morningstar reports TIP’s total return as 3.59% for 2014.)

Nevertheless, the TIP ETF underperformed the overall bond market, as shown in this graph comparing the one-year performance of TIP, IEI (intermediate-term Treasurys) and AGG (the overall bond market):

SOURCE: Yahoo Finance / Click on image for larger version

For buy-and-hold investors of TIPS, this year’s auctions included several unique buying opportunities, even though yields on mid- to longer-term TIPS slid throughout the year. Here’s a recap of each of the issues and reopenings:

10-year TIPS, CUSIP 912828B25

• First auctioned: Jan. 23, with a coupon rate of 0.625% and a yield to maturity of 0.661%, plus inflation. This was the highest yield for any 9- or 10-year TIPS at auction since May 2011 and ended up being the highest yield of any of the six auctions for this term in 2014.
• Reopened: March 20, with a yield of 0.659%, just under the initial auction.
• Reopened: May 22, with a yield of 0.339%, a big drop from the initial auction, resulting in an adjusted price of about $103.96 per $100 of value.

30-year TIPS, CUSIP 912810RF7

• First auctioned: Feb. 20, with a coupon rate of 1.375% and a yield to maturity of 1.495%, plus inflation.  This ended up being the highest yield of the year for this term. This auction set a 30-year inflation breakeven rate of 2.23%.
• Reopened: June 19, with a yield to maturity of 1.116%. Buyers paid an adjusted price of $108.34 for $100 of value – showing the volatility of 30-year issues.
• Reopened: Oct. 23, with a yield to maturity of 0.985% and an adjusted price of $112.17 per $100 of value. The 30-year inflation breakeven rate fell to 2.065% — and has continued falling to 1.92% on Dec. 31.

5-year TIPS, CUSIP 912828C99

• First auctioned: April 17, with a coupon rate of 0.125% and a yield to maturity of -0.213%, plus inflation. The negative yield resulted in an adjusted price of $101.87 for $100 of value. The 5-year inflation breakeven rate was set at 1.91%.
• Reopened: Aug. 21, with a yield of -0.281%.
• Reopened: Dec. 18, with a yield to maturity of 0.395%. This was the highest yield – and first positive yield – for any 4- to 5-year TIPS since April 2010. The 5-year inflation breakeven rate fell to a remarkable 1.26%. I was a buyer at this auction.

10-year TIPS, CUSIP 912828WU0

• First auctioned: July 24, with a coupon rate of 0.125% and a yield to maturity of 0.249%, plus inflation. This was the lowest yield of any 9- to 10-year TIPS auction since May 2013. The 10-year inflation breakeven rate was set at 2.26%.
• Reopened: Sept. 18, with a yield to maturity of 0.610%, a big jump over the initial auction. That dropped the adjusted price to $95.72 per $100 of value and set the inflation breakeven rate down to 2.02%. I was a buyer at this auction.
• Reopened: Nov. 20, with a yield to maturity of 0.497% and an adjusted price of $96.73 per $100 of value. The inflation breakeven rate fell to 1.853% – it closed on Dec. 31 at 1.68%.

The Treasury just announced that its reopening of CUSIP 912828C99 – creating a 4-year, 4-month Treasury Inflation-Protected Security – auctioned with a yield to maturity of 0.395%. This is the highest yield – and first positive yield – for any 4- to 5-year TIPS since an April 2010 auction generated a yield of 0.550%.

Because this reopened TIPS has a coupon rate of 0.125%, buyers got it at discounted price of $98.85 for $100 of value. However, adding in 8 months worth of inflation appreciation creates an adjusted price of $100.17.

The auction capped a remarkable month of surging yields for shorter-term TIPS. On Dec. 1, this TIPS traded on the secondary market with a yield of -0.048%.

Inflation breakeven rate. With a 5-year nominal Treasury trading to at 1.66%, this sets up an inflation breakeven rate of 1.26% for this TIPS. If inflation averages more than 1.26% over the next five years, this TIPS will outperform a nominal Treasury.

That low breakeven rate indicates the market is pricing in very low inflation in the short term. In addition, the market was aware that November’s 0.54% drop in non-seasonally adjusted inflation will mean a future ding in this TIPS’ accumulated principal.

Reaction to the auction

The broadly-based TIPS ETF (ticker TIP) had been declining all morning, indicating that yields were on the rise. Once the auction closed at 1 p.m., the TIP ETF made a move higher, which generally shows a positive reaction.

SOURCE: Yahoo Finance

Bloomberg’s report on the auction noted the first positive yield in four years on this TIPS maturity helped drive demand from big-money investors like foreign central banks:

“There was strong customer demand, likely showing bargain-hunting by the investor base,” said Ian Lyngen, a government-bond strategist at CRT Capital Group LLC in Stamford, Connecticut. “It seems to be less about inflationary fear and more about asset managers who have money to put to work in the sector taking advantage of the first positive yield on the five-year since April 2010.”