Treasury Inflation-Protected Securities

I was listening to NPR’s Marketplace last night, a story about the gentrification of a Los Angeles neighborhood. And then came this quote from Steve Jones, the owner of a house-flipping business, on how he attracts investors:

“All these people out there that have so much money, it’s sitting in a stupid money-market account making, you know, 2 percent or 3 percent, or whatever their horrible rates are right now …”

Steve Jones may know a lot about house-flipping, but he certainly knows nothing about investing in a money-market account. Fidelity’s main general-purpose money market account is yielding 0.01%, as is Vanguard’s Prime Money Market account. This has been true for more than six years. Vanguard’s fund has returned 0.04% annually over the last five years, and only 1.67% over the last 10 years.

So when someone calls 2% or 3% returns ‘horrible’ …. well, I would say those returns look pretty desirable, and almost impossible to find today in a super-safe investment.

A year ago, I wrote about a great 5-year CD offered by the Pentagon Federal Credit Union, paying 3.04%. It was offered only in December 2013 and January 2014; I speculated it was designed to draw new customers. It worked for me, and I jumped aboard.

I also have a set of 5-year CDs paying 3.0% from my local credit union, Truliant. These mature in various months of 2015. This was also part of a ‘special offer’ and well above market rates of 2010.

But, here we are in December 2014, and these are the rates being offered for Treasurys and non-jumbo CDs (the jumbos pay just slightly higher):

• 0.01% Vanguard Prime Money Market
• 0.14% 1-year Treasury
• 0.26% National average 1-year CD
• 0.30% Truliant 1-year CD
• 0.80% Penfed 1-year CD
• 0.84% National average 5-year CD
• 1.00% Ally Bank 1-year CD
• 1.20% Penfed 5-year CD
• 1.40% Truliant 5-year CD
• 1.69% 5-year Treasury
• 2.32% Nationwide Bank 5-year CD

Just as a side note — it’s outrageous that a 5-year Treasury is out-yielding most 5-year bank CDs. There are no state income taxes on Treasurys, and these low rates indicate banks and credit unions are not making any attempt to sell 5-year CDs.

Now, let’s assume that inflation averages 2.0% over the next five years. My feeling is that this is a low number, but inflation has been very muted in recent years, so let’s go with 2.0%. Here are the ‘real’ returns – after inflation – for those investments:

• – 1.99% Vanguard Prime Money Market
• -1.86% 1-year Treasury
• -1.74% National average 1-year CD
• -1.70% Truliant 1-year CD
• -1.20% Penfed 1-year CD
• -1.16% National average 5-year CD
• -1.00% Ally Bank 1-year CD
• -0.80% Penfed 5-year CD
• -0.60% Truliant 5-year CD
• -0.31% 5 year-Treasury
• 0.32% Nationwide Bank 5-year CD

Let’s compare this to I Bonds and TIPS. I Bonds purchased through April 30, 2015, will carry a fixed rate of 0.0%. This means they have a real return of 0.0% – and while that sounds bad, it makes I Bonds better than all the investment options on the above list, other than the Nationwide offering.

A five-year TIPS is currently yielding 0.21%. This translates to a real return of 0.21% – better than every investment on our list except for the Nationwide CD.

In addition, TIPS and I Bonds offer ‘inflation protection.’ If inflation rises to unexpected levels, the effective return on these investments also rises. You’re covered – and that is valuable insurance for investors.

A year ago, a 5-year TIPS was yielding -0.17%, 38 basis points lower than it is today. A 5-year Penfed CD was yielding 3.0%, 180 basis points higher than it is today. That is a massive swing – 218 basis points! – in favor of TIPS.

Last year, I argued that a 5-year CD was a better investment than a 5-year TIPS and at least competitive with I Bonds, which were then yielding 0.2% above inflation.

That’s no longer true as we approach 2015.

The Treasury just announced that its reopening of CUSIP 912828WU0, creating a 9-year, 8-month Treasury Inflation-Protected Security, auctioned with a yield to maturity of 0.497% (plus inflation).

Because this TIPS carries a coupon rate of 0.125% – set at the original auction in July – today’s buyers got it at a discount – about $96.73 per $100 of value, figuring in a small amount of inflation appreciation since July.

Inflation breakeven rate. With the 10-year traditional Treasury trading today at 2.35%, this sets up an inflation breakeven rate of 1.853% for this TIPS. If inflation averages more than 1.85% over the next 10 years, it will outperform a traditional Treasury. This is a pretty attractive number – any breakeven rate below 2.0% for a 10-year TIPS indicates that TIPS are cheap against traditional Treasurys.

Here’s a chart of 10-year breakevens dating back to 2010:

I’ll be updating this post later today with reaction to the auction, but the quick reaction in the TIP ETF after the auction closed at 1 p.m. seems to indicate it went well for the Treasury, with yields dropping this afternoon:

Reaction to the auction

The Wall Street Journal pointed out that this morning’s inflation report helped boost demand for this auction, because the flat number was slightly higher than expected:

The CPI report gave a boost to a $13 billion sale of 10-year Treasury inflation-protected securities on Thursday afternoon. The decent auction demand was a sign buyers deemed the recent selloff has turned the asset class into a bargain for inflation protection.

“The recent underperformance of TIPS seems to have started to attract some interest, especially given a better than expected CPI number,” said George Goncalves, head of U.S. interest rates strategy at Nomura Securities International in New York.

Bloomberg’s report noted strong demand for this auction, pointing out that the yield came in below 0.50% – hah!, which I had predicted:

“There was a lot of customer demand,” said Thomas Simons, a government-debt economist in New York at Jefferies LLC, one of the 22 primary dealers that are obligated to bid at Treasury sales. “All things considered, it was a bulls-eye.” … The notes were sold at a yield of 0.497 percent, compared with an average forecast of 0.504 percent in a survey of six primary dealers.

Reuters pointed out (in a paragraph that places way too much importance on 2 basis points) that 10-year breakevens rose after the auction as TIPS prices rose and yields declined (very slightly):

This gauge of investors’ long-term inflation expectations, as measured by the yield gap between 10-year TIPS and regular 10-year Treasury notes widened as much as 2 basis points to 1.86 percent after the 10-year TIPS auction.

The Treasury today is reopening CUSIP 912828WU0 at auction, creating a 9-year, 8-month Treasury Inflation-Protected Security with a coupon rate of 0.125%. Here’s where this auction stands at 10:15 a.m.:

• Bloomberg’s Current Yields page shows this TIPS trading on the secondary market with a yield of 0.490% and a price of about $96.59 per $100 of value. This discount is caused by the 0.125% coupon rate, which was locked in when this TIPS first auctioned in July.
• The Wall Street Journal’s Closing Prices page shows this TIPS ended yesterday with a yield of 0.493% and a price of about $96.10.
• The Treasury’s Real Yields Curve page shows a full-term 10-year TIPS would have yielded 0.53% at the close yesterday.
• The TIP ETF is currently trading at $112.59, up 0.14%, which indicates that yields are slightly declining.

Put this together and you can estimate that today’s auction in going to result in a yield slightly under 0.50%, let’s say 0.49%. With the 10-year nominal Treasury trading today at 2.33%, you’re looking at an inflation breakeven rate of 1.84%. That’s very low, and in the buy range, at least versus a traditional Treasury. You could see a lot of interest in this issue from big-money central bands, hedge-funds, etc., and that would push the yield down.

The auction closes at noon for non-competitive bids (such as those placed at TreasuryDirect and at 1 p.m. for competitive bids. I’ll post again after 1 p.m. with the auction result.

The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in October on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, inflation increased 1.7%.

This was slightly ‘higher’ than the expected number of -0.1%. October continued a string of months with sharply falling energy prices: Gasoline was down 3.0% in the month and fuel oil was down 4.0%. Also falling were prices for used cars and trucks (-0.9%) and apparel (-0.2%). These declines were balanced off by rises in the cost of shelter (0.2%), electricity (0.5%) and transportation services (0.8%). The food index rose 0.1% in October, its smallest increase since June.

Holders of I Bonds and TIPS 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 October, the CPI-U index number fell to 237.433, a drop of 0.25% from September’s 238.031. I have updated my Tracking Inflation and I Bonds page to reflect these new numbers.

Core inflation, which strips out food and energy, rose 0.2% in October and is up 1.8% over the last 12 months.

Here is the trend in CPI-U (also called ‘headline inflation’) over the last 12 months. Note that inflation has been essentially flat over the last four months:

While inflation remains very mild, October’s slightly higher-than-expected numbers could influence today’s reopening of a 10-year TIPS at auction. If investors see this as an uptick in inflation, it could cause higher demand. I’ll be checking in on this auction after the markets open and then again when it closes at 1 p.m.

The Treasury later today will announce it is reopening CUSIP 912828WU0 at auction Nov. 20, creating a 9-year, 8-month Treasury Inflation-Protected Security with a coupon rate of 0.125%. Update: Here’s the announcement. This TIPS has a history:

• It was first auctioned July 24, 2014, with a yield of 0.249% (plus inflation), just below the mark that would have set the coupon rate at 0.250%. So it ended up with the lowest possible coupon rate, 0.125%.
• It was reissued Sept. 18, 2014, with a yield of 0.610%. Buyers at that auction – I was among them – got this TIPS at a big discount – about $95.72 per $100 of value.

Because it trades on the secondary market, we can track the current pricing for this TIPS, from our usual reference sources:

• Bloomberg’s Current Yields chart shows it trading with a yield of 0.43% and a price of about $97.03 per $100 of value.
• Wall Street Journal’s Closing Prices Chart shows it closed yesterday with a yield of 0.416%.
• The Treasury’s Real Yields chart estimates that a full-term 10-year TIPS would auction today with a yield of 0.46% (a full-term TIPS would generate a slightly higher yield, so this looks accurate.)

As I noted, I was a buyer of this TIPS back in September because its yield made a bold move higher in the days before the auction. A few days before the auction, the TIPS was yielding 0.46%, about where it is today. But on Sept. 17, the day before the auction, August inflation came in a -0.2%, setting off deflation fears and roiling the TIPS market.

Yields rose 15 basis points, and I bought. (But I was expecting a yield of about 0.55%, not the resulting 0.610%. I’ll take every basis point I can get.)

I probably won’t be a buyer at next Thursday’s auction, but a lot can happen in a week. The October inflation report will be issued Thursday morning at 8:30 a.m. That should make things interesting.

I’ll be checking in on this auction next Thursday morning, along with the inflation numbers for October. Meanwhile, study this chart of all 9- to 10-year TIPS auctions since 2008: