Treasury Inflation-Protected Securities

The US Treasury formally announced yesterday that it will reopen CUSIP 912810RF7 on Thursday, Oct. 23, creating a 29-year 4-month Treasury Inflation-Protected Security with a coupon rate of of 1.375%.

This TIPS initially auctioned on Feb. 20, 2014, with a yield to maturity of 1.495%. It reopened on June 19, 2014, with a yield of 1.116%, meaning buyers had to pay $108.34 for $100 of value to collect that coupon rate of 1.375%.

A lot has happened in the TIPS market in 2014. It’s been a roller-coaster ride, with the 30-year TIPS yield starting the year on Jan. 2 at 1.58% (the highest yield of 2014), declining to 0.98% on May 28, rising to 1.17% on June 10, falling to a 2014-low of 0.82% on Aug. 28, rising to 1.17% on Sept. 18, and closing yesterday at 0.89%.

What those numbers mean. CUSIP 912810RF7 is going to be expensive. Buyers at Thursday’s auction may be paying a nearly 13% premium to collect a coupon rate of 1.375%. In other words, $10,000 of this TIPS will cost a buyer $11,300. At maturity 29 years from now, the buyer will get back $10,000, plus inflation, while collecting $137.50 a year in interest (which will also rise with inflation).

This TIPS seems very risky as a trading vehicle, because an uptick in interest rates will send its market value plummeting. It only makes sense as a buy-and-hold investment, and a buyer is going to have to live 29 years, 4 months to get a return.

Let’s look at the current market for CUSIP 912810RF7:

• Bloomberg’s Current Values chart shows it trading today at 0.89% with a price of about $112.40 per $100 of value.
• The Wall Street Journal’s Closing Values chart shows that it ended Thursday with a yield of 0.865% and a price of about $112.72.
• The Treasury’s Real Yields chart, which estimates the yield of a full-term 30-year TIPS, sets yesterday’s close at 0.89%

A lot can happen in a week, especially with the stock market showing plenty of volatility this month. But it’s not likely that this TIPS, which is currently trading just 7 basis points above its low for 2014, which get a lot cheaper before next Thursday.

One interesting factor in Oct. 2014, however, is the dramatic fall in inflation breakeven rates across all TIPS maturities. With a nominal 30-year Treasury yielding 2.94%, we’re looking at a 30-year inflation breakeven rate of just 2.05% – very low. That means this TIPS is actually a pretty good buy against a traditional Treasury.

What are the chances that inflation will average less than 2.05% over the next 30 years? It could happen, sure, but take a look at this chart of historical inflation ranges. Going back to 1961, the lowest 30-year inflation rate average was 2.8%, for the 30-year period ending in 2013.

Nevertheless, if I were in the market for a 30-year TIPS – which I am not – I probably would wait until the February 2015 auction of a new issue, when the yield and coupon rate will be aligned – lowering my upfront cost on a very long-term investment.

In a Sept. 11 post, I noted the screwed up state of interest rates on super-safe investments. My evidence was an offering from the Pentagon Federal Credit Union of a 1-year insured  CD, paying 1.06% with just a $1,000 minimum investment.

Pretty good, but the problem was that PenFed’s 2- and 3-year CD rates dropped to 1.05% and the 5- and 7-year CDs were paying a measly 1.21%.

Ridiculous, I noted. But now PenFed has attempted to repair that problem by upping its rates to more attractive levels, at least for 5- and 7-year CDs. These new rates are logical and competitive nationally.

According to BankRate.com, the national average for a 5-year CD is 1.87%, but you can find higher, such as:

• 2.30% at Synchrony Bank
• 2.53% at Chartway Federal Credit Union
• 2.25% at Barclays
• 2.25% at GE Capital Bank

My hometown credit union, Truliant, is paying just 1.40% for a 5-year CD with a minimal deposit. It shows how important it is to shop around when you have a CD maturing.

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.