Treasury Inflation-Protected Securities

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.”

This is the auction of CUSIP 912828C99, creating a 4-year, 4-month Treasury Inflation-Protected Security with a coupon rate of 0.125%. Non-competitive bids must be placed before noon. Here is what we know as of 10:05 a.m.:

• Bloomberg’s Current Yields page shows this TIPS trading with a yield to maturity of 0.36% and a price of $99 for $100 of value. (But this price does not include about 1.3% of inflation appreciation that will be figured into the final cost.)
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in April 2019 – closed Wednesday with a yield to maturity of 0.294%.
• The Treasury’s Real Yields Curve page estimates that a full-term 5-year TIPS would have yielded 0.39%.
• The broad TIPS ETF (ticker TIP) is trading down 0.43% this morning at $112.02, indicating that TIPS yields are on the rise today.

I’d say it’s going to be pretty hard to predict the auction yield for CUSIP 912828C99. Yesterday’s deflationary inflation report could have dampened demand for a short-term TIPS. Non-seasonally adjusted CPI fell 0.54% last month, and that drop will be factored into this TIPS’ built-up principal (it has eight months of history). So buyers will pay for inflation appreciation that they will quickly lose.

However, sharply falling gasoline prices have a way of turning around quickly. When that happens, this TIPS will earn back its inflation appreciation.

I would guess this one is going to auction with a yield of about 0.37% and an adjusted price slightly above par, when inflation appreciation is factored in.

• Update: This auction resulted in a yield of 0.395% and an adjusted price of $100.17.

The inflation breakeven rate – versus a nominal 5-year Treasury – is going to come in about 1.29%, which I consider very attractive.

Even if inflation averages 1.5% over the next five years, this TIPS will out-perform a 5-year Treasury and most 5-year bank CDs. I will be a buyer.

I’ll report the results of the auction soon after it closes at 1 p.m., and then return later with market reaction.

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.3% in November on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index – also called ‘headline inflation’ – increased 1.3%.

The BLS noted that the gasoline index – which fell a whopping 6.6% – posted its sharpest decline since December 2008 and was the main cause of November’s deflation. Food prices were up a moderate 0.2%, but apparel prices fell 1.1%. Medical care commodities were up 0.6%, and shelter costs were up 0.3%.

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 November, the CPI-U index fell to 236.151, a drop of 0.54%. For the last 12 months, non-seasonally adjusted inflation rose 1.3%. I have updated my Tracking Inflation and I Bonds page to reflect these new numbers.

‘Core inflation’ – which strips out food and energy – rose 0.1% in November and 1.7% over the last 12 months. This demonstrates that even without the sharp decline in gasoline prices, inflation is running below the Federal Reserve’s implied target of 2.0%. Until inflation becomes a threat, the Fed has little reason to act quickly to raise short-term interest rates.

Here is a chart of the one-year trend for U.S. inflation, showing the sharply deflationary move since mid-2014: