Treasury Inflation-Protected Securities

Beautiful limestone cliffs in southern Corsica, near the city of Bonifacio.

I’ve returned from a couple of weeks vacationing in the Mediterranean island of Corsica. It is French, the birthplace of Napoleon, and amazingly scenic, with high mountains rising out of the sea. There are no ‘easy’ hikes or drives on this island, but the views are fantastic.

Corsica is a small place with French attitudes,  Swiss landscapes and Italian city names. The people are friendly; the food and wine are delicious. It is a motorcyclist’s paradise, but I was driving a Renault Twingo on steep, narrow roads. A great place for vacation — especially since I rarely had access to the Internet, TV or world news. So I came away from Corsica with zero investment ideas.

Now that I’m back, I see that interest rates have climbed slightly in the last couple of weeks. The 10-year Treasury was at 2.54% on May 23, now it is 2.65%. A 10-year TIPS was yielding 0.31% on May 23 and now is 0.43%.

Just as I was leaving, the European Union committed to negative interest rates on excess bank reserves, which sent Euro interest rates tumbling and strengthened the dollar. (Too late for me, unfortunately.) This has caused rates to tumble in Europe, with a Spanish 10-year note now yielding 2.70%, just barely more than a 10-year US Treasury, despite the higher risk. I would expect this to increase demand for US Treasurys, which will keep a lid on yields.

Up next: Reopening of a 30-year TIPS on Thursday, June 19, 2014

I’ll be posting an analysis of this auction tomorrow (I hope), but the Treasury did announce today that is is reopening CUSIP 912810RF7, creating a 29-Year 8-Month TIPS with a coupon rate of 1.375%.

This TIPS was first auctioned Feb. 28, 2014, with a yield to maturity of 1.495%. This TIPS is currently trading on the secondary market with a yield of 1.13%, substantially below the coupon rate and creating a price of about $106 per $100 of value.

More on this issue tomorrow.

The Treasury just announced that the reopening of CUSIP 912828B25 auctioned with a yield to maturity of 0.339%, plus inflation. This is a 9-year, 8-month TIPS with a coupon rate of 0.625%.

That yield, which was expected, is a big drop from the 0.661% this same TIPS yielded when it was first auctioned Jan. 23. It was reopened in March with a yield of 0.659%. Since then, however, Treasurys have rallied and yields have declined.

Buyers at today’s auction paid about $102.70 per $100 of value, but when accrued inflation is added in, the resulting adjusted price is about $103.96. Read the announcement for details.

Inflation breakeven rate. With the nominal 10-year Treasury currently trading at 2.55%, this sets up a 10-year inflation breakeven point of 2.18%. This means that if inflation averages more than 2.18% over the next 10 years, this TIPS will outperform a traditional Treasury. An inflation breakeven point below 2.2% is fairly attractive.

The initial market reaction to the auction was positive, with the TIP ETF getting a strong boost today when the auction results were announced. (A higher price indicates lower yields for TIPS.)

Reaction to the auction. The Wall Street Journal’s Min Zeng reported ‘strong demand‘ for this TIPS.

The highlight of the day was a $13 billion sale of 10-year Treasury Inflation-Protected Securities, known as TIPS, which drew the biggest overall demand in two years. A gauge of demand from foreign investors, known as indirect bid, surged to a record of 66.3%. The results suggested some investors believe inflation in the long term may rise even if price pressures in the U.S. have remained tame amid an uneven pace of economic growth.

“It was very aggressive bidding,” said Marcus Huie, interest-rate strategist at Bank of America Merrill Lynch. “Some investors bet inflation is going to trend up,” especially as comments from some Fed policy makers suggested the central bank would keep interest rates low for longer.

I would note, however, that the ‘aggressive bidding’ ended up with a yield that was actually higher than it had been a week earlier, when this TIPS was trading at 0.291%. This auction went almost exactly as expected.

More from the WSJ report:

Economists at Barclays PLC said the tide of inflation is turning and they expect the U.S. inflation rate to rise to 2.4% by December.

“The last two CPI reports have swayed investor sentiment toward a greater probability of inflation acceleration,” said Keith Price, head of inflation trading at Citigroup Global Markets in New York.

Bloomberg’s Cordell Eddings also noted investor wariness about future inflation.

“Break-evens were cheap going into the auction, and that is why the auction went so well,” said Michael Pond, the New York-based head of global inflation-linked research at the primary dealer Barclays Plc. “Given the realized inflation backdrop, break-evens offer value as realized inflation continues to tick up.”

The U.S. Treasury is reopening CUSIP 912828B25 in an auction today, creating a 9-year, 8-month Treasury Inflation-Protected Security with a coupon rate of 0.625%.

I wrote about this last week and noted that the likely yield to maturity on this TIPS is not going to be very enticing. Here’s an update on market conditions this morning for this TIPS, which trades on the secondary market:

• Bloomberg’s Current Yields is flashing a yield of 0.34% and a price of about $102.65 per $100 of value. (This TIPS carries a coupon rate of 0.625%, so buyers will need to pay up at auction to get the higher coupon rate.)
• The Wall Street Journal’s bond prices chart shows this TIPS closed Wednesday at 0.329% and a price of about $102.80.
• The Treasury’s Daily Yield Curve chart estimates a full-maturity 10-year TIPS would had a yield of 0.36%.
• The TIP ETF, which holds a broad range of maturities, is trading right now at $114.60, down slightly today (meaning yields have risen slightly).

All of that adds up to a wild guess of a yield of about 0.34% at auction today, well below what buyers got when this TIPS first auctioned on Jan. 23 with a yield of 0.661%.

Noncompetitive bidding closes at noon and competitive bidding ends at 1 p.m.

I will post the result of the auction shortly after 1 p.m.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.3% in April on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. This number, which was expected, resulted in an inflation rate of 2.0% over the last 12 months.

Holders of TIPS and I Bonds have a key interest in the non-seasonally adjusted number, which is used to set increases in the principal of TIPS and the inflation-adjusted interest rate on I Bonds. In April,  the non-seasonally adjusted CPI-U also rose 0.3%, and 2.0% over the last 12 months.

Behind the increase. The costs of fuel and energy were volatile. The price of gasoline rose 2.3% in April after falling 3.4% over the last two months. But the cost of fuel oil fell 3.0%, and electricity dropped 2.1%. Food prices rose 0.4%.

The Federal Reserve has stated repeatedly it would like to see inflation rise to 2.0% and with April’s increase this ‘headline’ number finally reached the goal. Core inflation – which strips out food and energy – rose 1.8% over the last 12 months.

You can read more about inflation in Michael Ashton’s excellent E-piphany blog, and he was on fire today:

So, with the wonderful perfection of timing that is only possible from elite policymakers, the Fed has begun to chirp about deflation fears at just exactly the time that core inflation is turning higher. Do recall that core inflation never got below 1.6% – very far from “deflation” …

This chart from the BLS shows the trend of gently increasing inflation over the last 12 months:

I have updated the Tracking Inflation and I Bonds page with the new numbers. This page tracks non-seasonally adjusted inflation.