Treasury Inflation-Protected Securities

A 10-year TIPS is yielding 0.34% (plus inflation) today on the secondary market, a drop of 27 basis points since the last auction Sept. 18, which resulted in a yield of 0.61%.

That’s a pretty big turnaround for TIPS. The chart below shows three months of price changes for the TIP ETF, which hold a broad range of maturities, versus the SPY ETF, which hold the S&P 500 stocks. The turnaround began on Sept. 18 – the very day of the 10-year TIPS reopening – when the yield reached its highest point in five months. That is also the day that the S&P 500 hit its three-month high.

The TIP ETF is down slightly today, trading at $113.51 at mid-afternoon, on a day that the stock market is faring very badly. The S%P 500 is down about 1.7%.

So TIPS are benefiting from a flight to safety, but not as much as might be expected. The reason? The market is pricing in very low future inflation, and that is putting a cap on demand for TIPS.

At yesterday’s close, a traditional 10-year Treasury was yielding 2.35%, according the US Treasury daily estimate. A 10-year TIPS was yielding 0.39%, creating a 10-year inflation breakeven rate of 1.96%. So a 10-year TIPS will outperform a 10-year Treasury if inflation runs higher than 1.96% over the next 10 years. That is a low breakeven rate, and it indicates demand for TIPS hasn’t really increased much as the stock market has declined.

Here is a chart of 10-year breakeven rates since January 2012, and it demonstrates the very steep and very fast decline in inflation expectations:

My general feeling is that TIPS are attractive – at least versus traditional Treasurys – when the breakeven rate drops below 2%, as it has now. But yields have also dropped in recent weeks, making TIPS a little less attractive overall.

Back on Sept. 4 I posted ‘Why TIPS aren’t a good buy right now: A story in charts‘, in which tried to explain why the TIPS market looked a little out-of-whack, with TIPS yields dropping too low (and TIPS prices rising too high) against similar investments.

A LOT has happened since Sept. 4: 1) A weak inflation report, 2) the Federal Reserve hinting at higher interest rates possible by the end of next year, 3) a weak 10-year TIPS auction on Sept. 18, 4) a rise in Treasury yields and 5) a modest drop in the U.S. stock market.

No. 5 is especially interesting because Treasurys usually run counter to the stock market, especially during a strong decline. When stocks suddenly drop, fear rises and that usually pushes up demand for Treasurys, and results in lower yields.

So here is a comparison of how stocks (represented by the Standard and Poors 500 ETF) have performed over the last month versus TIPS (represented by the TIP ETF):

Remarkably, the overall performance has been very similar (down about 2% in a month), but the paths are pretty different. TIPS have gotten a small bump in the last few days as stocks dropped sharply. In fact, today’s trading, which isn’t reflected in that chart, has the TIP ETF down anther 0.5% and SPY is trading up 0.65%.

Inflation breakevens have been dropping. Investors seem to be signalling lower fear of future inflation, and that creates less demand for TIPS.  Right now, according to Bloomberg’s Current Yields, a 10-year Treasury is trading at 2.53% while a 10-year TIPS is yielding 0.56%, creating a breakeven rate of 1.97%.

A month ago, on Aug. 27, the 10-year Treasury yield was 2.37% versus 0.23% for a 10-year TIPS, creating a breakeven rate of 2.14%.

So inflation expectations have dropped 17 basis points in a month, and this has been during a time of rising interest rates. That’s a double whammy for investors in TIPS mutual funds, and explains the nearly 2.5% drop in a month.

For buyers of TIPS, though, prices are beginning to look a lot more attractive.

The Treasury just posted results of today’s reopening of CUSIP 912828WU0, which went off with a yield to maturity of 0.610%, plus inflation. Just before the auction closed, Reuters’ survey of primary dealers predicted a yield of 0.577%.

Because this TIPS has a coupon rate of 0.125% based on its original July auction, buyers today are getting it at a substantial discount, about $95.72 per $100 of value. That is the adjusted price, which includes a very small amount of accrued inflation. This is the biggest discount generated by any 9- to 10-year TIPS at auction since October 2008.

10-year inflation breakeven rate. With the 10-year traditional Treasury now trading at 2.63%, this sets up an inflation-breakeven rate of 2.02% for this TIPS. If inflation averages more than 2.02% over the next 10 years, this TIPS will outperform a traditional Treasury.

When this TIPS first auctioned on July 24, it generated a yield of 0.249% and a breakeven rate of 2.26%. That’s an increase of 36 basis points in yield and a drop of 24 basis points in breakeven rate in two months. Today’s auction therefore was much more attractive for buyers, but the higher-than-expected yield also indicates lukewarm demand.

The reaction is shown well in this chart of the TIP ETF, which dropped sharply after the close of the auction at 1 p.m.:

Reaction to the auction

Bloomberg’s story on the auction noted “the lowest demand since the financial crisis” for inflation-protected debt.

“The likelihood of higher short-term real interest rates typically hit TIPS much faster than conventional Treasuries,” said Jim Vogel, head of agency-debt research at FTN Financial in Memphis, Tennessee. “If the Fed is not going to wait till it sees the whites in the eyes of inflation before it moves, there’s a far lower chance inflation gets out of control while the Fed waits for the economy to normalize.”

While a 10-year TIPS is in the mid-range for maturity, yields on 5-year TIPS have also been rising at an impressive clip. The Treasury’s Real Yields page estimates a 5-year TIPS was yielding -0.07% on Sept. 2, and now is at 0.29%, a whopping 36-basis-point increase.

TIPS of all maturities lost investors 2.7 percent in September, cutting their returns this year to 4.2 percent, according to Bank of America Merrill Lynch indexes. The securities lost investors 9.4 percent last year, according to the index.

The TIPS market is looking fairly sedate this morning, so we should be able to get a pretty good idea of how today’s reopening of CUSIP 912828WU0 will go. This will be a 9-year, 10-month TIPS with a coupon rate of 0.125%, plus inflation.

• Bloomberg’s Current Yields page is showing this TIPS – which trades on the secondary market – with a yield to maturity of 0.55% and a price just short of $96 per $100 of value. This TIPS will go at a discount because its auctioned-determined yield will be well above the coupon rate.
• The TIP ETF is currently (11:40 a.m.) trading at $111.97, down very slightly from yesterday’s close.
• The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in July 2024 ended yesterday with a yield of 0.531%.

Based on this data, I’d say the yield should come in right around 0.55%, and I think that is attractive enough for a small investment. I placed my order a few minutes ago.

Non-competitive bids need to be placed before noon.

I’ll be back after 1 p.m. with the auction results.

While we’re waiting for more data on today’s 10-year TIPS reopening, I thought I’d take a look at the minutes statement issued Wednesday by the Federal Reserve. It came on the same day as a weak inflation report, causing double tension in the Treasury markets.

Here is how the TIP ETF (which holds a broad range of TIPS through all maturities) reacted to the Fed minutes, which were released at 2 p.m.:

What did the Fed say that caused this reaction? You can read the minutes for yourself, but here is my summary:

• Economy is improving, jobs are still a problem.  “(E)conomic activity is expanding at a moderate pace. On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.”
• Inflation isn’t high enough. “Inflation has been running below the Committee’s longer-run objective.”
• Bond-buying stimulus is nearly complete. “Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month.”
• But the Fed is still influencing the bond market. “The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates …”
• Short-term interest rates will remain near zero. “The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”

The market reaction yesterday was pretty simple: Stocks up, bonds down. The Wall Street Journal noted that the stock market was rejoicing:

“The Fed cheered the market a little bit yesterday with keeping in the ‘considerable time’ language,” said Karyn Cavanaugh, senior market strategist at Voya Investment Management.

In the bigger picture, Ms. Cavanaugh said the improving economy, which could translate into higher corporate profits, and accommodative monetary policy in other regions should continue to lift stocks.

The bond market, though. found things to worry about, as noted in this separate Wall Street Journal report:

But what spooked bond investors was that Fed officials expect the official interest rate to end higher by the end of next year compared with their predictions in the June meeting. The median forecast from Fed officials sees the fed-funds rate at 1.375% by the end of 2015, compared with a 1.125% forecast in June.

The latest forecasts suggest “a faster pace of rate increases next year,” which sent bond yields higher, said Todd Hedtke, vice president of investment management for Allianz Investment Management, which manages more than $600 billion in assets globally.

Mr. Hedtke said the Fed’s message was “confusing” to bond investors, causing the gyrations in bond prices. He expects volatility in bond prices to rise as the Fed moves closer to raising interest rates.