Treasury Inflation-Protected Securities

Janet Yellen, the Federal Reserve chair, set off a lot of turmoil in the markets on March 19  by hinting that the federal funds rate – which sets a base for short-term interest rates – could begin rising ‘around six months, that type of thing‘ after the Fed’s bond-buying program ends later this year.

That comment, at a news conference, sent the bond and stock markets into a tizzy. Yellen’s off-the-cuff comment implied that rates could begin rising in mid 2015 instead of  late 2015 early 2016, as the markets expected.

Since then, Yellen and the Fed have backed off, saying there is no timetable for increases in the federal funds rate. But the Federal Reserve itself is forecasting that its benchmark rate – now close to zero – will rise at least to 1% at the end of 2015 and to 2.25% by the end of 2016.

So let’s assume that the federal funds rate does rise to 2.25% at the end of 2016. How will that affect the prices and yields of Treasury Inflation-Protected Securities?

No surprise. Rates are going up. No one can say this for certain, of course, and it depends on three things happening: 1) the U.S. economy must continue to improve, 2) the inflation rate must reach or at least approach the target level of 2%, and 3) the Federal Reserve must have the courage to raise rates when 1 and 2 are achieved.

But if these three things happen – and this is the most likely scenario, in my opinion – we will see the federal funds rate at 2.25% at the end of 2016 (or earlier), and we will see yields rise for both nominal Treasurys and TIPS.

So let’s take a look at the history of the federal funds rate; I have included some numbers from the past in the chart at the right. If you want to see the data, check out this site. What you will find is that 2.25% is a historically low rate. Today’s ultra-low fed rate – at a time when the stock market is hitting all-time highs – looks as out of place as that 20.06% number from January 1981.

So, the point is, there would be nothing extraordinary about a 2.25% fed rate, and in fact, it historically would have been a rate meant to spur economic growth, not deter it.

My next step was to look at times when the fed rate stood at 2.25% and cross-check the then-current yields for nominal Treasurys and TIPS. Here is what I found when I did the calculations on March 27:

Yes, the data are limited for several reasons: 1) TIPS have been in existence only since 1997, 2) a federal funds rate of 2.25% is relatively rare and 3) 30-year TIPS auctions were halted from October 2011 to February 2010, so there are no comparable data for 30-year TIPS.

But using these numbers as guidelines, I think we can make predictions about where interest rates are headed (not precisely, but an estimate) when the fed funds rate reaches 2.25%. I am using the average of each range to determine these numbers:

• 5-year Treasury yields will increase 149 basis points
• 5-year TIPS yields will rise 82 basis points
• 10-year Treasury yields will rise 120 basis points
• 10-year TIPS yields will rise 97 basis points
• 30-year Treasury yields will rise 82 basis points
• 30-year TIPS yields will rise an undetermined amount

Continuing on with this premise, let’s say the 10-year TIPS yield rises 97 basis points by the end of 2016, reaching a level of 1.53%. That’s perfectly reasonable by historical standards (probably even conservative), and it would equate to a 10-year nominal Treasury rate of 3.89%, creating an inflation breakeven point of 2.36%, also perfectly reasonable.

This sort of rise – 97 basis points – is definitely possible. In fact, we saw that happen in less than three months in 2013, when the 10-year TIPS yield rose from -0.74% on April 5 to 0.29% in June 19, a rise of 103 basis points.

What does this mean? If you are invested in a diversified TIPS mutual fund and this scenario plays out, you are going to see a drop in net asset value of about 8%. At the same time, you would benefit from a higher yield in the future.

The TIP ETF, which invests in a broad range of maturities, has a duration of 7.65, meaning its net asset value should decline by 7.65% when yields rise 100 basis points. That played out just as predicted during the 103 basis point rise in the 10-year TIPS from April 5, 2013 to June 19, 2013:

Looking into the future. The TIP ETF currently trades at $111.67, up about 1% so far this year. If it took an 8% hit, its net asset value would drop to $102.75, about where it was trading on Oct. 5, 2009, when a 10-year TIPS was yielding 1.51%.

I repeat: Perfectly reasonable. Will this happen? Who knows? But no one should be surprised if it does.

We are nearing the final days of tax season, so I am reposting a blog I wrote back on March 28, 2013, on investing in TIPS in a taxable account. In my case, my portfolio allocation works better that way, but I still contend it isn’t a horrible strategy. You prepay the taxes (horrors!) but get the full payout in retirement, no taxes due. The only problem is the 1099-OID tax form, which TreasuryDirect barely hints is available and makes as cryptic as possible. It is unlike any tax form provided by any investment company in the nation.

And so here is my post from 2013, minus some outdated stuff about 3o-year TIPS:

If you buy and hold Treasury Inflation-Protected Securities at TreasuryDirect, as I do, you’re violating a conventional wisdom rule of investing: Don’t hold TIPS in a taxable account.

I disagree with that conventional wisdom, more or less, but mainly because holding TIPS in a tax-deferred account generally means buying TIPS mutual funds instead of the actual issues. Or, a brokerage like Vanguard or Fidelity will allow you to buy TIPS at auction and hold them in an IRA account. But then you end up trying to find ways to invest and/or reinvest cash distributions and maturities.

So while holding TIPS in a tax-deferred account is preferable, I say holding them as a taxable investment at TreasuryDirect is also acceptable as part of your overall fixed-income asset allocation.

But, TIPS are different. TreasuryDirect, I have to say, is absolutely not user friendly. While every brokerage and investment firm on Earth mails you tax forms (or at least notifies you they are ready to download), TreasuryDirect does nothing. You will get nothing in the mail, you will not receive an e-mail alert. You are expected to remember to log in to TreasuryDirect.gov and retrieve your tax forms:

• Form 1099-INT shows the sum of the semiannual interest payments made in a given year. This income is generated by the TIPS’ coupon rate, and is taxable at the federal level but tax-fee at the state.
• Form 1099-OID shows the amount by which the principal of your TIPS increased due to inflation or decreased due to deflation. Increases in principal are taxable for the year in which they occur, even if your TIPS hasn’t matured, so you haven’t yet received a payment of principal.

So 1) you find your own tax forms, and 2) you print them and 3) these Treasury forms are like no other you’ll see from Vanguard or Merrill Lynch. They just list the amounts paid for each TIPS and give you a total. At the bottom are some definitions for IRS box numbers that are never specified on the form itself. Very weird. The Treasury could do better.

Form 1099-OID is the one behind the conventional wisdom to invest in TIPS in tax-deferred accounts. You are paying tax on money you have not yet received. This is often called ‘phantom income.’ However, if you have a Total Bond Fund or GNMA Fund in a taxable account and reinvest the dividends, or have a 5-year CD at a bank and are reinvesting interest, you are doing exactly the same thing. You are paying tax on money you have not yet received.

(Read this for a scholarly treatise, including incomprehensible formulas, debunking the conventional wisdom about holding TIPS in a taxable account.)

When the TIPS matures, here’s the good thing: You don’t owe any tax on the accumulated inflation-adjusted principal, because you’ve prepaid it. So if you bought a $10,000 10-year TIPS in 2010 and it matures in 2020 with a 23% inflation boost to principal, you get $12,300 and you owe no tax. This could work in your favor for allocating spending money in retirement.

But the dreaded 1099-OID is the big reason I Bonds are preferable to TIPS, especially when they offer a favorable return, as they do now for seven years up the maturity ladder. With I Bonds, your principal keeps increasing by the rate of inflation plus the base interest rate (which is currently 0.2% for new I Bonds). You owe no tax on I Bonds until you redeem them, and you can hold them for 5 to 30 years before redeeming without any penalty. (This paragraph was updated for 2014.)

I Bonds also offer a strategic advantage for retirement spending money because you could redeem them gradually to space out the tax owed. They are the ultimately flexible super-safe investment: 1) inflation protected, 2) deflation protected, 3) tax protected and 4) you choose the maturity date.