Treasury Inflation-Protected Securities

The Treasury announced last week it will hold its first-ever auction of Floating Rate-Notes (FRNs) on Thursday, Jan. 29. This is the first new Treasury product in 17 years, following the launch of Treasury Inflation-Protected Securities in 1997.

I’ve already noted that these FRNs look like a bad deal for small investors, and are actually designed for the large-scale holdings of hedge funds, money-market funds, pension funds and foreign governments, where they could lower volatility of short-term investments.

Here is info from that previous post to fill in some basic facts on FRNs:

What is an FRN? The Treasury says: “An FRN is a security that has an interest payment that can change over time.  As interest rates rise, the security’s interest payments will increase.  Similarly, as interest rates fall, the security’s interest payments will decrease.” Read the Treasury’s term sheet for FRNs.

So it is important to note that inflation is not part of the picture for FRNs. While TIPS and I Bonds are tied to future inflation, the FRN is tied to future interest rates, specifically short-term rates.

What will be the index for FRNs? The Treasury says, “FRNs will be indexed to the most recent 13-week Treasury bill auction High Rate, which is the highest accepted discount rate in a Treasury bill auction.” Depending on demand at auction, the FRN could end up yielding a few basis points more than the 13-week Treasury.

The current yield on a 13-week Treasury is a whopping 0.04% and that is down ‘substantially’ from  0.07% on Jan. 2, 2014. Obviously, no one gets rich investing in 13-week Treasurys.

But the new FRNs are expected to get a yield premium over a 13-week Treasury. How much of a premium? That’s the key question. The current 2-year Treasury yield is 0.37% so we know the premium won’t be more than 33 basis points. It will probably be a lot less, as noted in this Wall Street Journal story from Jan. 23:

Pricing of the new notes will be based off a yield spread over the rate on three-month Treasury bills, so as the bill yield rises, so will the rate on the two-year floater.

Some bond analysts expect the notes to offer about eight to nine basis points in extra yield. At the current 0.035% rate on three-month bills, that means an all-in yield of about 0.11% to 0.12%.

Investors will get a higher yield over time if the rate on a  13-week Treasury rises, but that doesn’t look likely in 2014 or 2015, based on the Federal Reserve’s commitment to keep short-term rates near zero.

The Wall Street Journal speculates there could be strong demand for these FRNs (which would lower the yield even more if bidding is strong):

The new notes also come at a time the Treasury has been scaling back supply of shorter-dated debt, given reduced cash needs with a lower government deficit. That has meant a group of investors fighting for a shrinking pool of Treasurys.

“Pricing will be determined by the combination of limited supply and strong investor demand, given the opportunity to maintain Treasury exposure but earn a spread over bills,” said the rate strategists at Bank of America Merrill Lynch.

The new notes are expected to be particularly attractive to conservative money-market funds, where money must be invested in high-quality and shorter-term securities.

Even if you are interested in these FRNs, there is no need to jump aboard in this first auction. The Treasury will auction FRNs each month, with original issues in January, April, July, and October, and reopenings in the other months.

Or … just buy the TIPS maturing in January 2016 and you’ll get a yield of -1.34%, plus inflation. Not great, but if inflation averages 2% over the next 2 years, you’d get 0.66%, about 29 basis points higher than a 2-year Treasury.

View a .pdf of the Treasury announcement

The U.S. Treasury just announced that its auction of a new 10-year Treasury Inflation-Protected Security, CUSIP 912828B25, resulted in a coupon rate of 0.625% and a yield to maturity of 0.661%, plus inflation.

This was the highest yield for any 9- or 10-year TIPS at auction since May 2011, when a 9-year, 8-month reopening auctioned with a yield of 0.89%, and it marks the 8th consecutive auction for this term with a higher yield.

Since the yield is higher than the coupon rate, today’s buyers are getting this TIPS at a slight discount, about $99.55 per $100 of value, before  accrued interest is added in.

Buyers should be pleased with the 0.661% yield, on a day when Treasury prices are rising and yields are dropping, possibly because of a weak jobs report. A week ago, this TIPS auction looked likely to go off at 0.61%, and yields slipped a bit in recent days.

The TIP ETF, which holds TIPS in a wide range of maturities, is trading up today about 0.4%, joining the overall Treasury upsurge, and this price has held steady since the auction closed at 1 p.m., indicating today’s result went at expected.

Inflation breakeven rate. With the nominal 10-year Treasury currently trading at 2.78%, this new 10-year TIPS has an inflation breakeven rate of 2.12%, a fairly attractive number. This means that if inflation averages more than 2.12% over the next 10 years, this TIPS will outperform a traditional Treasury.

This also indicates that TIPS – a much-unloved investment since mid 2013, are now outperforming traditional Treasuries, as you can see in this chart comparing the TIP ETF with IEI, an ETF holding intermediate Treasurys:

Since the beginning of 2014, the TIP ETF has outperformed IEI, an ETF that holds intermediate-term Treasuries. Both funds have a similar duration.

Reaction to the auction

From Carolyn Cui of the Wall Street Journal:

Demand was evidently weak among all bidding groups, as buyers submitted $2.31 in bids for every dollar of debt being auctioned off, the lowest bid-to-cover ratio seen since April 2009. As a result, the Treasury was forced to pay a high interest rate for the new 10-year TIPS of 0.661%, the highest yield since a 0.887% rate was offered in May of 2011. …

“We believe…the strong real yield performance pre-auction kept some buyers on the sidelines,” wrote analysts with Nomura Securities.

In the world of Treasury Inflation-Protected Securities, the 10-year issues hit the ‘sweet spot’ — providing a better yield than shorter-term TIPS and a lifespan that is reasonable for holding to maturity. They are ideal for adding another rung to a ladder of TIPS holdings, stretching out into retirement years.

On Jan. 23, the Treasury will auction a new 10-year TIPS, CUSIP 912828B25. Because this is a new issue, the coupon rate and yield will be determined at the auction, and they should be closely aligned, since this TIPS will go off with a positive yield.

What to expect. Right now, the Treasury’s Resource Center shows the 10-year TIPS yielding 0.61%, plus inflation, down about 19 basis points from where it closed 2013 and 31 basis points below the high yield of 2013. Bloomberg’s Current Yields shows a recent 10-year TIPS trading at 0.56%.

While TIPS and Treasurys have been getting tons of hate in the financial media recently, they’ve actually put on a decent rally so far in 2014, and that means lower yields. It also means that Thursday’s auction is a little less attractive.

But if Thursday’s auction results in a yield above 0.60%, it will be highest for any 9- to 10-year TIPS since July 2011, when a budgetary crisis in Congress roiled the markets and set the Federal Reserve on its bond-buying stimulus program, which continues today.

Inflation breakeven rate. The nominal 10-year Treasury is trading today at 2.86%, setting up a breakeven rate of 2.26% for a 10-year TIPS yielding 0.60%. This isn’t cheap, especially at a time when inflation is running just 1.5% over the last year. But it isn’t expensive either. (The breakeven rate means that if inflation averages 2.26% over 10 years, the TIPS will outperform a traditional Treasury. In recent years, breakeven rates below 2.0% meant TIPS were ‘cheap’ and above 2.5% meant they were ‘expensive.’)

This chart pretty well shows the TIPS breakeven rate trading in the neutral zone:

In conclusion. This TIPS auction should be attractive for anyone looking to add to TIPS holdings, especially after years of negative yields. It isn’t super attractive, though, and there will be two more opportunities to buy this TIPS at reopenings in March and May.

We may see higher yields by then, or not. I’ll wait this one out.

I’ll be writing more about this later, but I thought I’d give a heads up that the Treasury has formally announced it will auction a new-issue 10-year Treasury Inflation-Protected Security on Jan. 23, 2014. This is CUSIP 912828B25 and the coupon rate and yield to maturity will be set at auction.

A 10-year TIPS is currently yielding about 0.62%, down about 18 basis points since Dec. 31.

Read the announcement

U.S. ‘headline’ inflation – formally known as the Consumer Price Index for All Urban Consumers – rose 0.3% in December on a seasonally adjusted basis, the Bureau of Labor Statistics reported this morning.

The number – higher than in recent months – matched the consensus estimate and was triggered by higher costs for energy, apparel and shelter. Over the last 12 months, headline inflation increased 1.5%. Read the full BLS report.

Holders of TIPS and I Bonds are more interested in the non-seasonally adjusted CPI-U, which is used to determine principal adjustments on TIPS and future inflation-adjusted interest rates on I Bonds. Non-seasonally adjusted CPI-U was unchanged in December, and up 1.5% over the last 12 months.

The gasoline index rose 3.1%, and the fuel oil and electricity indexes also increased, resulting in a hefty 2.1% increase in the energy index. (Energy prices had fallen in October and November.) Apparel was up 0.9% and the shelter index rose 0.2% in December. Food was up a tame 0.1%.

Several factors helped to hold down inflation, such as a decline of 0.8% in medical care commodities and a drop of 0.2% for used cars and trucks.

Core inflation – which strips out energy and food – was up 0.1% in December and 1.7% for the last 12 months.

2012-13, years of weak inflation. The BLS reported: “CPI rose 1.5 percent in 2013 after a 1.7 percent increase in 2012. This is lower than the 2.4 percent average annual increase over the last ten years. This is the first time the CPI has gone up less than 2.0 percent for consecutive years since 1997-98.”

Here is the trend in headline inflation over the last year: