Treasury Inflation-Protected Securities

In a bit of a surprise, the US Treasury just announced it is dropping the I Bond fixed rate from 0.2% to 0.1% for I Bonds purchased from May 1 to Oct. 31, 2014. The fixed rate will be paired with an inflation rate of 1.84% to result in a six-month combined rate of 1.94% (annualized) for I Bonds purchased during this period.

From the announcement:

I Bond Earnings Rate of 1.94% includes a Fixed Rate of 0.10%
The earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the life of the bond, and the semiannual inflation rate. The 1.94% earnings rate for I bonds bought from May 2014 through October 2014 applies for the first six months after the issue date. The earnings rate combines a 0.10% fixed rate of return with the 1.84% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 234.149 in September 2013 to 236.293 in March 2014, a six-month increase of 0.92%.

What this means. The Treasury dropped the fixed rate from 0.2% to 0.1%, disappointing buyers who were hoping the rate would continue at 0.2%. On the other hand, the inflation-rate component is getting a nice boost from 1.18% to 1.84% for the next six months.

• If you bought your 2014 allocation before May 1, you’ll get a combined rate of 1.38% for six months and then 2.04% for six months.
• If you buy anytime from May to October, you’ll get a combined rate of 1.94% for six months, and then 0.1% plus the next inflation rate, which will be set Nov. 1.

Series EE Bonds get a boost

The Treasury also announced it was bumping the base interest rate of Series EE Bonds from 0.1% to 0.5% for bonds sold from May to October 2014. Here is the announcement:

Series EE Bonds Issued May 2005 and Later
Series EE bonds issued from May 2014 through October 2014 earn today’s announced rate of 0.50%. 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.

What it means. This does make EE Bonds slightly more attractive as a short-term investment. You can sell them after a year, with a three-month interest penalty and after five years with no penalty. But you can probably do better in a bank savings account, such as the 0.87% offered by Ally.

The real appeal of EE Bonds comes when you hold them for 20 years and get double your original investment, in effect earning 3.5%. At that point, cash them in.

The Treasury just announced that a new 5-year TIPS, CUSIP 912828C99, auctioned with a yield to maturity of -0.213% and a coupon rate of 0.125%. The combination of negative yield and positive coupon rate means that buyers paid an adjusted price of $101.87 for $100 of value, which includes about 5 cents of inflation adjustment through April 30.

Read the announcement.

The yield of -0.213% continued a string of 11 consecutive 4- to 5-year TIPS auctions that produced a yield negative to inflation. Because the principal balance of a TIPS grows with inflation, buyers today accepted a return 0.123% less than inflation over the next five years.

When you look at the 5-year inflation breakeven rate, you can see why some buyers would find this issue attractive. A 5-year nominal Treasury is trading right now at 1.70%,  setting up an inflation breakeven rate of 1.91%, meaning that this TIPS will outperform a traditional Treasury if inflation averages more than 1.91% over five years.

Even if this 5-year TIPS under-performs, it probably won’t be by much, so TIPS buyers aren’t giving up much yield to get the inflation protection.

Two weeks ago, this TIPS looked likely to carry a positive yield, but Treasurys  strengthened as the stock market weakened and turmoil rose again in Ukraine. The TIP ETF was up strongly in the minutes after the auction closed, indicating a positive reaction to the auction.

At 11:14 a.m., before the auction closed, Bloomberg forecast a yield of -01.62%, based on a survey of primary dealers.

So it looks like the Treasury is the winner in today’s auction.

Reaction to the auction

The Wall Street Journal’s Cynthia Lin noted ‘a strong turnout’ for this auction, noting that the yield of 0.213% was less than the market rate at the time of the sale,  “reflecting strong demand.”

Bloomberg’s Cordell Eddings noted strong demand from overseas buyers, which include central banks.

The bid-to-cover ratio, which gauges demand by comparing the amount bid with the amount offered, was 2.7, matching the highest level since December 2012. “The stats were off the charts,” said Stanley Sun, a New York-based strategist at Nomura Holdings Inc., a primary dealer.

 

 

• Update: 5-year TIPS auctions with a yield of -0.213%

The U.S. Treasury will announce results of its auction of a new 5-year Treasury Inflation-Protected Security, CUSIP 912828C99, just after 11:30 a.m. Non-competitive bids have to be placed by 11 a.m., if you are buying at TreasuryDirect. The times are earlier for this auction because of the Easter weekend.

What to expect. This TIPS has been a hard one to call, with possible yields falling all over the place. A few weeks ago, it looked like this TIPS would generate a positive yield to maturity (plus inflation), but that looks unlikely now. The coupon rate will almost certainly be 0.125%, the same rate for the last nine 4-to 5-year TIPS auctions, because that is the lowest coupon rate the Treasury allows on TIPS.

Combine a negative yield at auction with a coupon rate of 0.125% and you get an above-par price for buyers at today’s auction, possibly $102 or more for $100 of value.

• The Treasury’s chart of Daily Treasury Real Yield Curve Rates is currently showing a 5-year TIPS yielding -0.06%. This is usually my preferred source for new issues, but the number looks a little suspect because …
• Bloomberg’s Current Yields chart this morning is showing a yield of -0.50% for the newest 5-year TIPS currently trading. But this TIPS was issued a year ago, so it is actually a 4-year TIPS and that skews the number. You’d expect a shorter-maturity TIPS to yield less, especially in a time of very low inflation.
• The Wall Street Journal’s closing prices chart shows TIPS bracketing the maturity date of this new TIPS yielding -0.401% and -0.365%, and you have to go out to a maturity of July 2020 to find a yield of -0.118%

So, at this point, the Treasury seems to be predicting one number (-0.06%) and the market points to another (maybe around -0.385%). That’s a 32-basis point swing – an unusual amount of uncertainty.

The 5-year nominal Treasury closed Wednesday at 1.67%, setting up a 5-year inflation breakeven point of 1.73% (if you trust Treasury’s low prediction) or 2.05% (if you trust the market numbers).

If this TIPS goes off with a yield of -0.06%, it will be a pretty good bargain for buyers. We’ll see what happens at 11:30 a.m.