Treasury Inflation-Protected Securities

The Federal Reserve just released its FOMC statement for it October meeting, noting that the Fed will continue its bond-buying stimulus program despite signs that the economy is improving. This was universally expected, especially in view of  upcoming budget and debt-limit showdowns in Congress.

” … the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

“Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. “

The Fed also noted that the current rate of inflation (just 1.2% over the last 12 months) is below its target of 2%.

“The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.”

The Bureau of Labor Statistics today released its shutdown-delayed September inflation report, showing that ‘headline’ inflation increased a seasonally-adjusted 0.2% in September, a number matching expectations.

Over the last 12 months, this index, known as the Consumer Price Index for All Urban Consumers (CPI-U), has ticked up just 1.2%, far below the Federal Reserve’s target of 2.o% and potential danger level of 2.5%.

The non-seasonally-adjusted CPI-U, which is used to adjust the principal balance of TIPS and set future inflation-adjusted interest rates on I Bonds, rose just 0.1% for the month and 1.2% for the last 12 months.

I Bond interest. The September number was the last piece of data needed to set the I Bond inflation-adjusted interest rate for November 2013 to April 2014. Based on my quick calculation, it looks like the new annualized interest rate will remain close to the current 1.18%. I’ll update when I find this number.

I Bonds also carry a permanent interest rate, which has been set at zero since May 2010. It is highly unlikely that the rate will rise above zero on Nov. 1.

Looking at September inflation. Inflation remained muted despite a fairly strong up-tick in the cost of gasoline (0.8%), fuel oil (0.9%) and piped gas service (1.8%). Food prices were flat and apparel dropped 0.5%.

‘Core’ inflation, which strips out food and energy and is closely watched by the Federal Reserve, increased just 0.1% in September, the same as in August, and is up a mild 1.7% for the 12 months ending in August.

The September numbers continue a trend of very mild inflation, especially since March 2013, a trend that leaves the door open for continued bond-buying stimulus by the Federal Reserve. The short-term effect is likely to be mildly positive for TIPS, meaning lower yields. However, longer-term, TIPS will lose support from investors if inflation is a non-factor and the Federal Reserve ever hints at stopping its bond-buying.

The U.S. Treasury just posted the results of its reopening of CUSIP 912810RA8, which auctioned with a yield of 1.33% for the 29-year, 4-month remaining term. Because the coupon rate on this TIPS is 0.625% – set in the original February auction – buyers will be paying about $84.37 for $100 of value, but this includes about $1.33 of inflation adjustment since the original auction on Feb. 28, 2013.

View the auction results.

Today’s yield of 1.33% is slightly less than the 1.42% this same TIPS generated in a reissue auction on June 20. TIPS and Treasury yields have been sliding lower since the Federal Reserve backed on tapering its bond-buying stimulus program in September.

Inflation breakeven rate. The nominal 30-year Treasury is trading today at 3.61%, creating an inflation breakeven rate for this TIPS of 2.28%. If inflation averages higher than 2.28% for the next 29 years, this TIPS will outperform the Treasury.

Reaction to the auction results – announced at 1 p.m. – looks positive, based on the move up in the TIP ETF right after the news:

Cynthia Lynn of the Wall Street Journal noted the ‘solid demand’ for this TIPS:

Direct bidders, a group that submits their bids straight to the government, bought 19.1% of the total offering—the most since June 2012. This group of buyers nearly vanished at the last 30-year TIPS sale held in June 2013.

Bloomberg’s Susanne Walker also noted that the auction was well received, even at a time of muted inflation.

“The auction went better than expected,” said Dan Mulholland, head of Treasury trading at BNY Mellon Capital Markets in New York. “There has definitely been a reach for yield and a reach for the long end. There’s a desire for inflation protection with QE in place probably for a little longer than most people expected.”

I’ve raised this issue before, and I hope this is actually the last time I need to raise it, since yields on TIPS have risen dramatically since February 2013.

But here is the problem: If you bid on CUSIP 912810RA8 at Thursday’s auction, in a taxable account (such as TreasuryDirect), you will very likely be cash-flow negative until the TIPS matures 29 years, 4 months from now.

Here are the facts:

• CUSIP 912810RA8 was originally auctioned on Feb. 21, 2013, with a coupon rate of 0.625%. That coupon rate, the actual interest you receive each year, will never change over the next 29 years.
• On Thursday, you can buy CUSIP 912810RA8 at a substantial discount, because the yield to maturity is now running about 1.30%. That means you can buy this TIPS at about $83.10 for $100 of value.
• However, buying at a discount means you are more or less buying a zero-coupon TIPS, so you pay $83 today and get $100 in February 2043.
• So, let’s say you buy $100,000 of this TIPS at auction Thursday, in a taxable account. You’ll pay maybe $83,000 for that $100,000 value. (I am ignoring any adjustment for accrued principal since February.)
• For the next 29 years, you will be getting about $625 of income from the TIPS coupon rate of  0.625%. The yearly payout will grow with inflation, as the TIPS principal rises.
• Also, the TIPS principal balance will climb with the rate of inflation. So if inflation averages 2.5%, your principal will increase about $2,500 a year, rising with inflation.

And there is the problem …

• The IRS views the inflation adjustment to principal a taxable event for the current year. So you’ll owe income taxes on $3,125 a year ($625 + $2,500) in 2014. If you are in a 38% federal tax bracket you would owe $1,187.50.
• But your coupon rate gives you only $625 a year.
• You are cash-flow negative $562.50. If inflation averages higher than 2.5%, then you’d be even more cash-flow negative.
• That will continue for 29 years until the TIPS matures and you get your zero-coupon payout of $100,000 plus inflation.
• At that point, all the money comes to you tax-free, except for the small final interest payment. But it was a long time to wait to go cash-flow positive.

The solution

• Don’t buy this TIPS in a taxable account.
• Wait until February 2014, when a new 30-year TIPS will be issued with a coupon rate (hopefully) at 1.54% or higher. That would push your return to tax-flow positive, even in a taxable account, assuming inflation of 2.5%.
• At 1.54%, you’d get $1,540 in income each year, rising with inflation. At 2.5% inflation you’d get $2,500 in principal adjustment. You’d owe taxes on $4,040. At at 38% tax bracket you would owe $1,535.
• You are cash flow positive.

Well, it’s actually a reopening of CUSIP 912810RA8, so buyers will be getting a 29-year, 4-month TIPS with a coupon rate of 0.625%. It will be going off at a huge discount, showing how volatile 30-year Treasurys can be.

Right now, it’s looking like the yield will come in at 1.38%, plus inflation. That’s where this TIPS was trading on the secondary market Monday. Today’s rather weak jobs report – read the Reuters report – could give TIPS and Treasurys a boost, pushing the yield lower.

That 1.38% yield means this TIPS will be priced around $81.25 for $100 of value. That’s a fall of 18.7% since the original issue in February.

Does it make this issue attractive? Somewhat. Getting a TIPS with a yield above 1% has been very rare in the last three years. I think I counted 26 of the last 27 TIPS auctions with a yield below 1% – the only exception was when this same TIPS was reopened in June at 1.42%.

But the June (1.42%) to October (1.38%) trend shows that TIPS yields have stalled after the strong move upward beginning in May 2013. So the price buyers pay might actually be higher Thursday than it was in June.

With a 30-year nominal Treasury trading at 3.68%, the inflation breakeven rate for this TIPS stands at 2.3%, not particularly cheap. That means if inflation averages more than 2.3% over the next 30 years, this TIPS will outperform the traditional Treasury.

I do think inflation is likely to be higher than 2.3%, and I’d definitely buy this TIPS over a 30-year Treasury, just to get the inflation protection.

The key issue is: Will rates be rising by mid-2014? I suspect they will be, and so I’m going to be patient. The Federal Reserve can’t continue bond-buying forever, can it? (Ummm …) But the bigger problem is a dysfunctional U.S. government that can’t make even short-term budget decisions, let alone addressing giant spending issues arising in the next 25 years.

Inflation is a definite threat for the future.