Treasury Inflation-Protected Securities

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.

The US Treasury just announced that the fixed rate on Series I Savings Bonds will remain at 0.0% from May to October, meaning I Bonds purchased in this period will earn a composite rate of 0.0% for six months. In addition, the Treasury raised the EE Bond fixed rate to 0.3% and left intact the guarantee that EE Bonds will double in value if held for 20 years.

The earnings 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, also called the variable rate.

The new I Bond variable rate of -1.60% (annualized) was set in stone when the Bureau of Labor Statistics released the March inflation number. This May 1 adjustment is determined by non-seasonally adjusted CPI-U for September to March. Here are the numbers, from my Tracking Inflation and I Bonds page:

The composite I Bond rate is determined by adding the variable rate (-1.60%) to the fixed rate (depends on when the I Bond was issued). Any I Bond with a fixed rate of 1.60% or less – and that is every I Bond issued in the past 13 years – will get a composite rate of 0.0% for six months. This is because I Bonds cannot pay negative interest; the lowest they can go is 0.0%. The starting date of that 0.0% period depends on which month you purchased the I Bond, but they will all get six months of it.

One point to consider: Since inflation fell at an annual rate of 1.60% over the last six months, your I Bond paying 0.0% is beating inflation by 1.60%. This is one of the benefits of I Bonds: They lose no value in times of deflation, which isn’t true of the principal balance of TIPS, which declines with each deflationary month.

Should you dump your I Bonds paying 0.0%? One word answer: No. Since you are limited to I Bond purchases of $10,000 a year per person (plus $5,000 as a tax refund), I don’t think selling your I Bonds is a good idea. Unless: 1) you need the money today to meet current expenses, or 2) the I Bond has reached its 30-year maturity (none have as of yet, of course). The idea in I Bond investing is to build as large a cache of inflation-protected money as possible, to use as a resource in the future. Selling out of I Bonds will keep you from reaching that goal. Just be patient; wait out the six lousy months.

Should you buy I Bonds paying 0.0%? One word answer: No. It makes no sense to buy I Bonds in this May to October period. Instead, wait until the November 1 adjustment, which could bring a positive variable rate and the possibility of a fixed rate higher than 0.0%. You’d still have two months to buy your 2015 allocation. Inflation has already started ticking up, rising 0.6% in March on a non-seasonally adjusted basis. There is a good chance I Bonds will be paying a decent variable rate starting November 1.

What about EE Bonds? The Treasury’s decision to pump the fixed rate from 0.1% to 0.3% was a nice gesture, but in effect it is meaningless. The key to EE Bonds is this clause:

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 Treasury kept intact the 20-year doubling of value, which in effect creates a 20-year, tax-deferred Treasury bond paying 3.5%. This is an outstanding value, given that a 30-year traditional Treasury is currently paying 2.75%, and a 20-year is paying 2.49%, more than 100 basis points lower. That is a huge difference in a 20-year investment.

EE Bonds are the investment of choice in mid-2015, if … and only if … you can afford to hold them for the full 20 years.

A new five-year Treasury Inflation-Protected Security – CUSIP 912828K33 – auctioned today with a real yield (after inflation) to maturity of -0.335%. The coupon rate was set at 0.125%, the lowest the Treasury allows on a TIPS.

This is the lowest yield for any 4- to 5-year TIPS at auction since Dec. 19, 2013, when a 4-year, 4-month TIPS auctioned with a yield of -0.375%. Because the yield ended up well below the coupon rate, buyers at today’s auction had to pay about $102.52 for $100 of value.

Inflation breakeven rate. With a nominal 5-year Treasury currently trading at about 1.41%, this sets up an inflation breakeven rate of 1.74% for this TIPS. That means if inflation averages higher than 1.74% over the next five years, this TIPS will outperform a nominal Treasury. Although this number is low by historic standards, inflation has been running at -0.1% over the last 12 months.

This chart shows the 5-year inflation breakeven rate since 2010, and shows that the 5-year TIPS have bounced off very low levels in recent months. The lower the breakeven rate, the ‘cheaper’ TIPS are against a nominal Treasury. It’s clear that TIPS are getting more expensive, and that indicates that inflationary fears are rising:

Reaction to the auction

We can get a quick read on reaction to the auction by looking at how the TIP ETF performed in the minutes after the 1 p.m. auction close. The ETF had been trading up slightly all morning, and took a minor move downward after the closing, indicating a trend of higher yields. This isn’t a significant move, however.

Bloomberg’s report on the auction noted that investors are again beginning to factor inflation into their investments:

“The market likes TIPS,” said Edward Acton, a U.S. government-bond strategist in Stamford, Connecticut, for Royal Bank of Scotland’s RBS Securities unit, one of 22 primary dealers obligated to bid at U.S. auctions. “This disinflationary pressure has eased off, and we’re just waiting to see how strong and how quickly inflation pressures can surprise to the upside.” …

Pacific Investment Management Co., which runs the world’s biggest bond fund, has been among the buyers of TIPS.

“With the oil price drop, we felt that break-evens in the Treasury Inflation-Protected Securities market were pricing in inflation that was too low,” New York-based portfolio manager David Braun said in a note published online Thursday. “So we prefer to own TIPS in lieu of nominal Treasuries.”

The Wall Street Journal also noted the gentle rise in inflation as a source for demand for TIPS, noting that “investors are piling into U.S. government bonds that protect against inflation at the fastest pace in three years.”

“The big picture is that the deflation scare may be behind us,’’ said Gemma Wright-Casparius, senior bond-fund manager at Vanguard Group, which has over $3.26 trillion in global assets under management. “The overall sentiment will be inflation moving higher over the next 12 months.”

A new 5-year Treasury Inflation-Protected Security – CUSIP 912828K33 – will be created today, with the coupon rate and real yield to maturity determined at auction. Non-competitive bids, like those placed through Treasury Direct, close at noon; competitive bids continue until 1 p.m. when the auction closes.

At 10:07 a.m., here is what we know:

• The coupon rate is going to be 0.125%, because this TIPS will auction with a negative yield to maturity, and 0.125% is the lowest coupon rate the Treasury allows.
• After yesterday’s close, the Treasury’s Real Yield Curve page estimated that a full-term 5-year TIPS would yield -0.19%. This should be the starting point for today’s auction, since the most recent 5-year TIPS on the secondary market has only four years remaining.
• That said, Bloomberg’s Current Yields page shows that 4-year TIPS trading today with a real yield to maturity of -0.51%. That’s substantially below the Treasury’s estimate.
• The Wall Street Journal’s TIPS Closing Yields page shows that 4-year TIPS, which matures in April 2019, closed yesterday with a yield of -0.470%. There is also a TIPS maturing in July 2020 with a yield of -0.448%, and one maturing in January 2020 with a yield of -0.428%.
• Finally, the TIP ETF – which holds a broad range of maturities – is trading up very slightly this morning at $114.41, indicating that yields could be dipping, but only slightly.

These numbers would lead me to guess that today’s auction will result in a yield below -0.20%. Will the number be closer to -0.45% or even -0.50%? Seems possible. That’s a pretty wide span of probabilities; I would guess a yield near -0.45% looks likely.

Since the coupon rate will be set at 0.125% on this new issue, buyers at today’s auction will have to pay up to generate a negative yield to maturity. If the yield comes in around -0.21%, the price will be about $101.85 per $100 of value. If it falls to -0.50%, the price will be closer to $103 per $100 of value, as a rough guideline.

I will be posting an update after the auction closes at 1 p.m., and then adding market reaction later in the afternoon.