Treasury Inflation-Protected Securities

As stock markets wavered violently over the last week, the market for Treasury Inflation-Protected Securities has been remarkably sedate, and surprisingly, there is no apparent demand for TIPS as a ‘safe harbor.’

This chart shows the 5-day market results for TIPS, represented by the TIP ETF in blue, versus the overall stock market, represented by the SPY ETF in red:

This is surprising because TIPS for years have been the safe harbor investment of choice: 1) for safety, and 2) for inflation protection against possible monetary moves to stimulate the markets.

Remember the last correction? It had been more than four years since the stock market suffered a decline of more than 10%. In fact, the last stock market correction – which began in July 2011 – was the starting point for an explosion in the value of TIPS, pushing yields negative to inflation for years. I wrote about this in my April 25, 2103, article titled, ‘The TIPS earthquake: When did it happen, and why?’

That article included this chart, showing the huge move up for Treasurys and TIPS which began at the exact moment the stock market plummeted (oddly enough, in reaction to Standard & Poors downgrading US Treasurys):

You can see in that chart that TIPS greatly outperformed the overall bond market for the remainder of 2011 (represented by the AGG ETF in red). But this time – the 2015 correction – that isn’t happening. As the stock market plummeted this week, TIPS values actually declined. And this chart shows that TIPS aren’t out-performing the overall bond market:

A final thing to note: TIPS have also been lagging the overall Treasury market, meaning that inflation breakeven rates have been falling over the last week. That happens when TIPS yields rise more than Treasury yields. Here are the numbers:

Conclusion. What can we take from this? 1) That the market does not fear inflation and does not expect the Federal Reserve to rush in with economic stimulus, 2) That the market is viewing the current stock market volatility as a correction and not the beginning of a major bear market, and 3) that the market still believes higher interest rates are coming, if not in 2015, then early in 2016.

TIPS are not going to be the ‘safe harbor’ investment in 2015. If yields continue to climb, we could see buying opportunities.

The US Treasury just announced that its reopening of CUSIP 912828K33 resulted in a real yield to maturity (after inflation) of 0.305%. This creates a 4-year, 8-month Treasury Inflation-Protected Security.

Because this TIPS has an already-established coupon rate of 0.125%, investors today got it at a discount – an adjusted price of $99.17 per $100 of par value. However, because this TIPS carries about 1.9% of inflation appreciation since April, its adjusted price rises to $101.05 for about $101.90 of adjusted value.

The real yield of 0.305% was a huge jump – 64 basis points – over the April 23 original auction for this TIPS, which resulted in a yield of -0.335%. Today’s result was the second-highest yield in the last 14 4- to 5-year TIPS auctions, dating back to October 2010.

Short-term interest rates have been rising recently as the market adjusts to expected short-term rate increases from the Federal Reserve. It’s interesting to note that a 10-year TIPS is trading around 0.50% today, less than 20 basis points higher than a 5-year.

Inflation breakeven rate. With the nominal 5-year Treasury trading today at 1.47%, this sets up a ‘5-year’ inflation breakeven rate of 1.16%. That is remarkably low and indicates that the market expects continued very weak inflation. It also makes this TIPS very cheap against a nominal Treasury. Here is the trend for the 5-year breakeven over the last five years:

Reaction to the auction. The TIP ETF had been trading down (slightly) all morning but took a very large move up after the auction closed, indicating declining yields. In fact, Bloomberg’s Current Yields page is showing this same TIPS currently trading at 0.27%, lower than the auction yield.

That’s a pretty strong statement in reaction to the auction, but what’s the message? Not sure, but I would say this auction was quite friendly to today’s buyers.

Reuters’ Richard Leong noted very strong demand for this 5-year TIPS reopening, which set a record high of 76.36% sales to indirect bidders, such as fund managers and foreign central banks.

TD Securities interest rate strategist Gennadiy Goldberg assigned an “A+” grade to the TIPS auction in a note, “suggesting that the recent selloff managed to attract some end-user demand.”

Let’s take a quick look at today’s auction of CUSIP 912828K33, creating a 4-year, 8-month Treasury Inflation-Protected security. This TIPS – originally issued in April – carries a coupon rate of 0.125%.

Because this TIPS currently trades in the secondary market, we can get a decent idea of its market value today, as of 10 a.m.:

• The Wall Street Journal’s Closing Prices page shows it ended Wednesday with a real yield to maturity of 0.248% and a price of about $99.44 per $100 of current value.
• The real time quote this morning from Bloomberg’s Government Bonds page shows it yielding 0.30% and a price of $99.17.
• The Treasury’s Real Yields Curve page estimates that a full-term 5-year TIPS would yield 0.33%. (A full-term TIPS should yield slightly higher than a shorter-term issue.)
• The TIP ETF – which holds a broad range of maturities – is trading slightly lower this morning, indicating a slight increase in yields.

Whirl up this data and you get the idea this TIPS could go off with a real yield (after inflation) to maturity of somewhere around 0.30%. That’s 63 basis points higher than the -0.335% yield generated at the creation auction on April 27.

If your TIPS ladder could use a rung maturing in April 2020, I think this looks like a reasonable investment. It’s only a 4-year, 8-month commitment.

Keep in mind that this TIPS will have an index ratio of 1.01892 on Aug. 31, so investors will be buying about 1.9% of accrued principal at this auction. That will push the adjusted price higher.

Noncompetitive bids need to be placed by noon. I will be reporting on the results when the auction closes at 1 p.m.

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

I am at work today (yes, I have a job!) and can’t post a full analysis. But I have updated my Tracking Inflation and I Bonds page to reflect these new numbers.

Holders of TIPS and I Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust the principal balance of TIPS and set future interest rates for I Bonds. In July, the inflation index rose 0.01% – essentially unchanged – to 238.654, and is up 0.2% over the last 12 months.

The next I Bond interest rate adjustment will come November 1, based on non-seasonally adjusted CPI-U from March to September. With two months remaining in that period, inflation is up 1.07%, indicating a new annualized rate of 2.14%, but two months remain. With gas prices declining, that number could move lower.

Here is the 12-month inflation trend:

The US Treasury will announce later this morning that it is reopening CUSIP 912828K33 at auction next Thursday, creating a 4-year, 8-month Treasury Inflation-Protected security with a coupon rate of 0.125%.

The real yield (after inflation) will be set at the auction, but here is what we can say right now about this TIPS, which trades on the secondary market:

• The Wall Street Journal’s Closing Prices page shows it ended Wednesday with a real yield to maturity of 0.147% and a price of about $99.91 per $100 of current value. But the listing also showed a very wide bid and asked spread of about 30 cents.
• The real time quote this morning from Bloomberg’s Government Bonds page shows it yielding 0.24%, a pretty wide spread from yesterday’s close. The price at that yield is down to $99.43.
• The Treasury’s Real Yields Curve page estimates that a full-term 5-year TIPS would yield 0.25%, more in line with the Bloomberg number.

NOTE: This TIPS will have an index ratio of 1.01892 on Aug. 31, so investors will be buying about 1.9% of accrued principal at this auction. That will push the adjusted price higher.

Yields on 5-year TIPS have been all over the map this year, starting the year at 0.31%, reaching a high of 0.34% as recently as Aug. 5, and a low of -0.37% on April 27, just a few days after this TIPS first auctioned with a miserable yield of -0.335%.

So … It’s possible that in just four months, the yield on this TIPS will have risen more than 60 basis points. And its cost will have dropped from $102.52 at the original auction to somewhere around $99.43.

It’s certainly a lot more attractive this time around.

Inflation breakeven rate. With the 5-year Treasury currently yielding about 1.56%, this sets up an inflation breakeven rate of 1.32% for this TIPS, meaning that it will outperform a 5-year nominal Treasury if inflation averages more than 1.32% over the next 5 years.

Although inflation has been running at 0.1% over the last 12 months, it has been climbing in recent months. This trend could be reversed by recently falling gasoline prices, but an inflation breakeven rate of 1.32% looks very attractive historically, as this chart shows:

Alternatives. The 5-year term sets up good comparisons with other ultra-safe investments. For example, this TIPS’ yield of 0.24% above inflation beats the current I Bond offering, which matches inflation. Another alternative is 5-year insured bank CDs, which are paying  2.25% right now at several banks. The 2.25% return sets up an inflation breakeven rate of 2.01% for this TIPS. If you don’t believe inflation will average higher than 2.01% over the next 5 years, the bank CD might be a better investment.

It will be interesting to watch where rates head in the next week. If you have need to park money for 4 years, 8 months, this TIPS could be an interesting investment.

Here is a chart of all 4- to 5-year TIPS auctions since 2007. Note that a yield of 0.24% would be the second highest for any 4- to 5-year TIPS since April 2010: