Treasury Inflation-Protected Securities

It hasn’t been a pretty year for the TIPS ETF. Click on the image for a larger version.

Holders of mutual funds investing in Treasury Inflation-Protected Securities won’t be sad to see 2013 fade away: It’s been the worst year for TIPS values since the Treasury instrument was launched in 1997. The TIP ETF – which holds a wide range of maturities – started the year at $120.03 and closed Dec. 24 at $109.86, a decline of 8.5%.

And so you are probably seeing a lot of negative press about Treasurys and TIPS in particular, with headlines like these:

• TIPS Poised for Worst Year Ever
• Is Your Inflation Protection Really Protecting You?
• Low Inflationary Pressures Left TIPS ETFs Feeling the Pinch
• The Sad Story of TIPS and Why There’s No Silver Bullet to Fight Inflation

But here’s the thing: If you are a buy-and-hold-to-maturity investor in TIPS and I Bonds, both these investments are a lot more attractive in December 2013 than they were in December 2012. And that is why I would say that 2013 was a good year – a much needed year – in TIPS history. Yields are creeping up, back to more-normal levels. At the same time, the once-inflated value of the TIPS you are holding to maturity is declining, but so what? You are holding to maturity.

And 2014 is going to offer some buying opportunities for those of us who have been sitting on the sidelines since mid-2011. Here’s a recap of the year’s TIPS auctions:

10-year TIPS, CUSIP 912828UH1

First auctioned: Jan. 24, with a yield to maturity of -0.630% (plus inflation), well above the record-low yield of -0.750% for any 9- to 10-year TIPS. This was an early indication of yields creeping higher. I took a negative view of this auction.

Reopened: March 21, with a yield to maturity of -0.602%, very close to the original auction. At the time, the 10-year inflation breakeven point was 2.54%, pretty expensive.

Reopened: May 23, with a yield of -0.225%. I took a positive view of this auction, and in fact, this is one of three TIPS I bought at auction in 2013. At this point the 10-year breakeven rate had dropped to a more reasonable 2.255%.

30-year TIPS, CUSIP 912810RA8

First auctioned: Feb. 21, with a coupon rate of 0.625%, and a yield to maturity of 0.639%. Although the yield was above the record low, TIPS traders who bought this issue were going to see a massive decline in market value over the course of 2013.

Reopened: June 20, with a yield to maturity of 1.42%, capping a spectacular run-up in yield as the Federal Reserve began raising the possibility of tapering its bond-buying economic stimulus. This TIPS had been trading at 0.750% one month earlier. The market value of this TIPS had fallen 17.9% since it was first auctioned.

Reopened: Oct. 24, with a yield to maturity of 1.33%. This auction came after the Fed backed off tapering, and yields had backed off from early-September highs.

5-year TIPS, CUSIP 912828UX6

First auctioned: April 18, with a yield to maturity of -1.311%, which broke a string of record lows for 5-year TIPS. Before the auction I had asked: Is buying a 5-year TIPS the most insane move ever?, suggesting that I Bonds were clearly a superior investment.

Reopened: Aug. 22, with a yield to maturity of  -0.127%, the highest yield for any 4- or 5-year TIPS issued in more than three years. I was a buyer at this auction, mainly because I needed a 5-year maturity to fill a hole in my TIPS ladder. The Federal Reserve gave the yield a boost by hinting at tapering in a statement one day before the auction.

Reopened: Dec. 19, with a yield to maturity of -0.375%. This auction came after the Federal Reserve officially announced it would slow down its bond-buying, but the yield still didn’t reach the Aug. 22 high.

10-year TIPS, CUSIP 912828VM9

The master manipulator

First auctioned: July 18, with a yield to maturity of 0.384%, the highest in two years for any 9- to 10-year TIPS. This auction looked very promising until Fed Chairman Ben Bernanke – on the eve of the auction – tried to scale back fears of future Fed ‘tapering’ of its aggressive bond buying. The result was that the yield dropped in a few days from an expected 0.64% to the resulting 0.384%. I was a buyer at this auction.

Reopened: Sept. 19, with a yield to maturity of 0.5%, the highest yield for any 9- or 10-year TIPS auction since July 2011. I was on vacation in remote Nova Scotia during early September when the Treasury market was roiled by fears of tapering. TIPS yields hit their high point for the year on Sept. 5, 0.92% for a 10-year TIPS. And then … Ben Bernanke – again on the eve of the TIPS auction – stepped in to rule out tapering in the near term. The result was a drop of 30+ basis points in the yield for this TIPS.

Reopened: Nov. 21, with a yield to maturity of 0.560%, slightly higher than the September auction’s 0.5%.

Where we stand now

A lot has happened this month, with the Federal Reserve announcing on Dec. 18 that it will indeed launch tapering – in a minimal form – in January. Yields for both TIPS and Treasurys have been inching up over the last week.

• The 5-year TIPS is yielding 0.05%, according to the Treasury’s Daily Treasury Real Yield Curve Rates, below its high for the year of 0.14%.
• The 10-year TIPS is yielding 0.80%, still off its high of 0.92% for the year.
• The 30-year TIPS is yielding 1.61%, just below its high of 1.64%.

The Treasury just announced the results of today’s reopening of CUSIP 912828UX6, a 4-year, 4-month TIPS that auctioned with a yield to maturity of -0.375%, plus inflation.

Because this TIPS carries a coupon rate of 0.125% – the lowest the Treasury allows on TIPS – buyers today will be paying up, about $103.22 for $101 of value, after accounting for about $1 of inflation-boosted principal since April.

The yield was slightly higher than the recent market on this TIPS on the secondary market, but yesterday’s tapering announcement from the Federal Reserve probably helped boost the number, at least a bit.

Today’s yield fell between the very low -1.311% of the original auction on April 18 and the more attractive -0.127% for the first reissue on Aug. 22. It’s interesting to note that the high-point of yield came during fears of tapering; now that tapering is official, the yield remains lower. Fear affects markets.

Inflation breakeven rate. With the 5-year nominal Treasury trading today at about 1.65%, this sets up an inflation breakeven rate of 2.025% for this TIPS, meaning that it will outperform a traditional Treasury if inflation averages more than 2.025% over the next five years. Inflation is currently running a very low 1.2% over the last 12 months.

Reaction to the auction. The TIP ETF is trading down very slightly today at $110.19, down 0.25%, and the market barely budged with the auction announcement.

From the Wall Street Journal report:

One positive reflection of the auction, however, was that end-investors bought nearly 60% of the total offering. That included 44.5% taken by indirect bidders and 14.3% taken by direct bidders, who often represent domestic fund interest.

Still, the market’s overall appetite for the new government debt was weighed down by the Fed’s decision to start trimming its asset purchases. In addition, overnight selling by money managers in Asia and Europe “started us on a negative tone to begin the trading session,” said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC.

The Federal Reserve, in an announcement that slightly surprised the financial markets, announced today that it will reduce its $85 billion a month in bond purchases by $10 billion starting in January.

The move was anticipated, but most market-watchers expected the Fed to make the move early in 2014 instead of now. This week’s inflation  report – with CPI running at just 1.2% over the last 12 months – kept the pressure off the Fed for immediate action.

The immediate effect on TIPS and Treasurys appeared minimal, with the TIP ETF trading at $110.69 at 2:45 p.m., down just 0.23% for the day.

The move is important, however, because it demonstrated that the Federal Reserve is willing to cut back and possibly end its program of bond-buying, which has been used to suppress long-term interest rates.

The TIPS market began pricing in this move six months ago, and so it is possible we won’t see a dramatic move upward in yields. I suspect, though, that yields will begin gradually rising in 2014.

Inflation – as measured by the Consumer Price Index for All Urban Consumers (CPI-U) – was unchanged in November on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, this index – often called ‘headline’ inflation – has increased just 1.2 percent.

Energy prices overall fell 1.0% in the month, aided by a 1.6% drop in the price of gasoline. Food prices were up just 0.1% and shelter costs increased 0.3%.

Holders of TIPS and I Bonds watch the unadjusted CPI-U, which is used to set the inflation-adjusted interest rate on TIPS and future interest rates on I Bonds. This unadjusted number was -0.2% in November, but remains 1.2 percent for the last 12 months.

‘Core inflation’ – stripping out food and energy – rose 0.2% in November and 1.7% over the last 12 months. This is the number most watched by the Federal Reserve, which has set an implicit goal of 2.0% for annual inflation and a ‘danger level’ of 2.5%.

Today’s numbers still leave the door open for the Fed to continue economic stimulus, a hot issue at today’s Fed meetings.

This chart of the seasonal-adjusted CPI-U shows the dramatic slowdown in inflation since the middle of 2013:

The Treasury announced Thursday it is reopening CUSIP 912828UX6, creating a 4-year 4-month TIPS with a coupon rate of 0.125%. Because of upcoming holidays, the auction on Thursday, Dec. 19, will end earlier than usual: 11 a.m. for noncompetitive bids and 11:30 a.m. for competitive bids.

Scoping out the auction. Since this TIPS trades on the secondary market, we can get a pretty good idea of its likely yield at auction, currently about -0.44%, plus inflation. While that definitely is a modest return, it is much better than the -1.311% this same TIPS generated at its original auction on April 18, 2013.

(Side note: The Treasury’s Resource Center is showing a much higher yield for a full 5-year TIPS, -0.11%. I would take this as a strong hint that buyers at Thursday’s auction will get a better yield than -0.44%.)

The record low for any 5-year TIPS at auction was -1.496% on Dec. 20, 2012. This shows how much the Treasury market has changed in one year, with yield rising 105 basis points. While TIPS are being scorned by many investors, they certainly are a much better bargain today than they were a year ago.

The problem with a 4-year, 4-month TIPS is that it creates a small window for inflation to begin rising, and inflation protection is the reason you buy a Treasury Inflation-Protected Security. Right now, inflation has been running just 1% over the last 12 months. So buyers at the original auction in April – who paid $107.82 per $100 of value – are collecting a 0.125% coupon on $100 of value and getting paltry appreciation from inflation. For them, CUSIP 912828UX6 has been a horrible investment.

Yeah, I own it. I was a buyer of 912828UX6 at the August reopening, a small amount to fill a gap in my TIPS ladder. That auction generated a yield to maturity of  -0.127%, the highest yield for any 4- or 5-year TIPS issued in more than three years. Soon after, the Fed backed off on tapering and yields declined again.

You have alternatives. There are other great, super-safe, super accessible 5-year investments out there, and you should judge this TIPS against those. For example:

• I Bonds are paying inflation plus .2%, which beats -0.44% by 64 basis points. You can sell an I Bond after five years with no penalty. No brainer, buy I Bonds up to the limit.
• The 5-year Treasury is yielding 1.55%, up a dramatic 85 basis points from a year ago. This sets up an inflation breakeven point of 1.99%. If inflation continues to average less than 2%, a traditional Treasury will be the better investment.
• Bank CDs are paying about 2% (and a whopping 3.04% at the Pentagon Federal Credit Union). But let’s say 2%. You’d do better with a bank CD if inflation averages less than 2.44% over the next five years.

I always have one good thing to say about 5-year TIPS: They mature in 5 years. Or in this case, 4 years, 4 months. It’s not a long-term commitment. Buyers at the Dec. 19 auction will still be paying up to get that 0.125% coupon rate, about $102 for $100 of value. That premium is at risk if inflation continues at extremely low rates, but I think that is unlikely.