Treasury Inflation-Protected Securities

Yields on Treasury Inflation-Protected Securities are plummeting, making TIPS you own (and TIPS funds) more valuable, but making TIPS a far less attractive investment in the near term.

US Treasurys of all sorts are booming because of a strong dollar, a new program of quantitative easing bond-buying in Europe, and general weakness in the equity markets. This is a flight to safety. Consider:

• A 10-year US Treasury is yielding about 1.68%.
• A 10-year German bond is yielding 0.30%.
• A 10-year French bond is yielding 0.55%.
• A 10-year Spanish bond is yielding 1.40%.
• A 10-year Italian bond is yielding 1.60%.

So, where is the money going to flow? To higher yield and a stronger currency. Since January 1, the yield on a 10-year TIPS has fallen 38 basis points, from an already-low 0.41% to 0.03% yesterday. The yield on a 5-year TIPS has fallen 44 basis points, from 0.31% to -0.13%.

And while in recent months TIPS were under-performing the overall bond market (making TIPS cheaper as a relative investment), they are now outperforming, as shown in this year-to-date chart:

The TIP ETF, shown in blue, is now outperforming the intermediate Treasury ETF (IEI) and the overall bond market (AGG). This means that inflation breakeven rates are rising, making TIPS more expensive against nominal Treasurys.

Right now the 10-year inflation breakeven rate stands at 1.65%, up 8 basis points from the 1.57% on Jan. 8 when I wrote on this topic.

There’s a 30-year TIPS auction coming up Feb. 19. A 30-year TIPS is currently yielding 0.54%, down 22 basis points since Jan. 1. This low a yield on a 30-year TIPS carries a danger: If held in a taxable account, it could end up cash-flow negative until maturity. The reason? The coupon rate may not cover the current-year taxes owed on inflation adjustments to principal. That makes a 30-year TIPS – at this yield  – a lousy investment in a taxable account.

My thinking is that TIPS aren’t going to be a very attractive buy-and-hold investment in the first half of 2015 – joining a pack of other flawed investments at the moment, I Bonds and bank CDs among them.

The Treasury just announced that its auction of CUSIP 912828H45 – a new 10-year Treasury Inflation-Protected Security – resulted in a yield to maturity of 0.315% and a coupon rate of 0.250%.

Buyers at the auction got a much better yield than looked likely earlier Thursday, when a similar TIPS was trading on the secondary market with a yield of just 0.18%. Later in the morning, however, TIPS yields began climbing. As the auction was closing at 1 p.m., Bloomberg’s survey of dealers predicted a yield of 0.346%.

Because the Treasury sets the coupon rate one notch below the yield, buyers at today’s auction are getting this TIPS at a slight discount to par, about $99.02 per $100 of value.

Inflation breakeven rate. With the 10-year nominal Treasury currently trading at 1.89%, this TIPS is getting a breakeven rate of 1.57%, which is very low by historic standards. This indicates the markets are pricing in very low inflation over the next 10 years. Generally, a breakeven rate below 2% indicates that a 10-year TIPS is ‘cheap’ against a nominal Treasury of the same term. This rate is among the lowest seen in the last five years:

Reaction to the auction.  TIPS yields were fluctuating Thursday, first dropping and then rising.  After the auction, the TIP market is reacting well. This chart shows the day’s activity in the TIP ETF, which holds a broad range of maturities. It started the day up (with yields down) and then moved negative as yields rose. After the auction, the trend was back up, which usually indicates a positive reaction:

The Treasury today will create a new 10-year Treasury Inflation-Protected Security – CUSIP 912828H45, with the coupon rate to be determined at  auction. Non-competitive bids, like those placed at Treasury Direct, must be made by noon; competitive bids need to be placed before the auction’s close at 1 p.m.

Here is how the auction is shaping up this morning, as of 9:35 a.m.:

• Bloomberg’s Current Yields page shows a 9-year, 6-month TIPS currently trading with a yield to maturity of 0.18%.
• The Wall Street Journal’s TIPS Closing Prices page shows that same TIPS closed yesterday with a yield of 0.213%.
• The Treasury’s Real Yields Curve page estimated yesterday that a full-term 10-year TIPS would yield 0.260%.
• The TIP ETF – which holds the full range of maturities – is trading at $113.95 this morning, up 0.22%. This indicates that TIPS yields are declining.

There is another TIPS that will share a maturity date with CUSIP 912828H45. It is CUSIP 912810FR4, a 20-year, 6-month TIPS that was first issued July 15, 2004. For what it’s worth, it closed yesterday at 0.287%, but it has lofty accrued inflation and a very high coupon rate of 2.375%. Is it comparable to today’s issue? Who knows? The Treasury hasn’t ever had two TIPS maturing on the same day (at least that I know of). This will be a first.

Adding it up. Both Bloomberg’s Current Yields and the TIP ETF are signaling lower yields this morning. A full-term 10-year TIPS should yield slightly higher than the 9-year, 6-month TIPS Bloomberg is following. Also, watch for volatility today as the European Central Bank unveils its quantitative easing plan, which will strengthen the dollar.

So let’s guess today’s auction will result in a yield to maturity of around 0.2% and a coupon rate of 0.125%, the lowest the Treasury allows. This will be lower than every 9- to 10-year TIPS auction of 2014 – there were six auctions with yields ranging from 0.249% to 0.661%.

It looks like a disappointing auction for buyers. Remember that this TIPS will be reopened in March and May, and could offer a higher yield then.

I’ll be posting the auction results soon after the close at 1 p.m.

Treasury Inflation-Protected Securities are often cited as being reasonably safe against deflation, because when held to maturity they will return the original ‘par’ value, even if deflation strikes with vengeance. In other words, the value can never go below ‘par’ – the original purchase allocation.

But TIPS do lose value when deflation strikes, because deflation eats away at the accrued principal each TIPS carries. If you buy a TIPS at a reopening auction or on the secondary market, you are paying for that accrued principal. When deflation strikes, you lose it, because it isn’t ‘par value,’ it’s an inflation adjustment that goes up with inflation, but will go down with deflation.

An example. To make this simple, I am going to talk about one TIPS – CUSIP 912828C99 – which I bought at a reopening auction on Dec. 18. This was a 4-year, 4-month TIPS with a coupon rate of 0.125%. It auctioned with a yield to maturity of 0.395%.

If you look at the auction results announcement, down at the bottom in tiny type you can see that this TIPS had an inflation index of 1.01337 on Dec. 31, the settlement date. Here it is, a little enlarged:

I bought $10,000 of this TIPS, and on Dec. 31 Treasury Direct withdrew $10,020.14 from my bank account. The par value was $10,000 and the inflation-adjusted value was $10,133.70, as of Dec. 31. I got it at a discount because the auctioned yield was higher than the coupon rate.

(In this article I am using ‘value’ to mean the current held-to-maturity value, not the value on the secondary market.)

CPI and the TIPS inflation index. The Treasury adjusts the value of TIPS based on the non-seasonally adjusted Consumer Price Index for All Urban Consumers. Each month’s CPI inflation index number establishes the TIPS inflation index two months into the future. So the Dec. 31 number was based on non-seasonally adjusted inflation in October, which was -0.25%.

The January inflation index was set by non-seasonally adjusted inflation in November, which was -0.54%. Because of that deflated number, on Jan. 31 the inflation index for this TIPS will drop to 1.00799 and the inflation-adjusted value of my TIPS will be $10,079.90.

The February inflation index was set by non-seasonally adjusted inflation in December, which was -0.57%. Because of that deflated number, on Feb. 28 the inflation index for this TIPS will drop to 1.00231 and the inflation-adjusted value of my TIPS will be $10,023.10.

So, in summary, here is what I received for my $10,020.14 purchase, one month after the auction: $10,023.10 and a 0.125% coupon rate.

Future deflation would continue to drop that inflation-adjusted number, but my value can never drop below $10,000. However, the inflation index can drop below 1.000, and would require future inflation to bring it back above that level. There is one TIPS – CUSIP 912828WU0 – currently trading with an index of 0.997 and that will drop to 0.989 on Feb. 28. This TIPS originated in July 2014, just before the current deflationary swoon.

You can track these inflation index numbers on the Treasury Direct site. Here are the numbers for CUSIP 912828C99.

I Bonds do have an advantage. I Bonds pay a fixed rate for the 30-year life of the holding – currently 0.0% – and an inflation-adjusted rate that changes each May and November – currently 1.48% annualized. The principal of an I Bond grows with each interest payment and can never go down. Deflation could mean six months of zero interest payments, which looks likely beginning May 1. But even at a time of severe deflation, the value of I Bonds will never go down. It’s an advantage they hold over TIPS.

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: