Treasury Inflation-Protected Securities

We are nearing the final days of tax season, so I am reposting a blog I wrote back on March 28, 2013, on investing in TIPS in a taxable account. In my case, my portfolio allocation works better that way, but I still contend it isn’t a horrible strategy. You prepay the taxes (horrors!) but get the full payout in retirement, no taxes due. The only problem is the 1099-OID tax form, which TreasuryDirect barely hints is available and makes as cryptic as possible. It is unlike any tax form provided by any investment company in the nation.

And so here is my post from 2013, minus some outdated stuff about 3o-year TIPS:

If you buy and hold Treasury Inflation-Protected Securities at TreasuryDirect, as I do, you’re violating a conventional wisdom rule of investing: Don’t hold TIPS in a taxable account.

I disagree with that conventional wisdom, more or less, but mainly because holding TIPS in a tax-deferred account generally means buying TIPS mutual funds instead of the actual issues. Or, a brokerage like Vanguard or Fidelity will allow you to buy TIPS at auction and hold them in an IRA account. But then you end up trying to find ways to invest and/or reinvest cash distributions and maturities.

So while holding TIPS in a tax-deferred account is preferable, I say holding them as a taxable investment at TreasuryDirect is also acceptable as part of your overall fixed-income asset allocation.

But, TIPS are different. TreasuryDirect, I have to say, is absolutely not user friendly. While every brokerage and investment firm on Earth mails you tax forms (or at least notifies you they are ready to download), TreasuryDirect does nothing. You will get nothing in the mail, you will not receive an e-mail alert. You are expected to remember to log in to TreasuryDirect.gov and retrieve your tax forms:

• Form 1099-INT shows the sum of the semiannual interest payments made in a given year. This income is generated by the TIPS’ coupon rate, and is taxable at the federal level but tax-fee at the state.
• Form 1099-OID shows the amount by which the principal of your TIPS increased due to inflation or decreased due to deflation. Increases in principal are taxable for the year in which they occur, even if your TIPS hasn’t matured, so you haven’t yet received a payment of principal.

So 1) you find your own tax forms, and 2) you print them and 3) these Treasury forms are like no other you’ll see from Vanguard or Merrill Lynch. They just list the amounts paid for each TIPS and give you a total. At the bottom are some definitions for IRS box numbers that are never specified on the form itself. Very weird. The Treasury could do better.

Form 1099-OID is the one behind the conventional wisdom to invest in TIPS in tax-deferred accounts. You are paying tax on money you have not yet received. This is often called ‘phantom income.’ However, if you have a Total Bond Fund or GNMA Fund in a taxable account and reinvest the dividends, or have a 5-year CD at a bank and are reinvesting interest, you are doing exactly the same thing. You are paying tax on money you have not yet received.

(Read this for a scholarly treatise, including incomprehensible formulas, debunking the conventional wisdom about holding TIPS in a taxable account.)

When the TIPS matures, here’s the good thing: You don’t owe any tax on the accumulated inflation-adjusted principal, because you’ve prepaid it. So if you bought a $10,000 10-year TIPS in 2010 and it matures in 2020 with a 23% inflation boost to principal, you get $12,300 and you owe no tax. This could work in your favor for allocating spending money in retirement.

But the dreaded 1099-OID is the big reason I Bonds are preferable to TIPS, especially when they offer a favorable return, as they do now for seven years up the maturity ladder. With I Bonds, your principal keeps increasing by the rate of inflation plus the base interest rate (which is currently 0.2% for new I Bonds). You owe no tax on I Bonds until you redeem them, and you can hold them for 5 to 30 years before redeeming without any penalty. (This paragraph was updated for 2014.)

I Bonds also offer a strategic advantage for retirement spending money because you could redeem them gradually to space out the tax owed. They are the ultimately flexible super-safe investment: 1) inflation protected, 2) deflation protected, 3) tax protected and 4) you choose the maturity date.

In response to reader questions, I have added this to my ‘Q&A about TIPS‘ page on the site. It’s linked in the top navigation. There are two key questions: 1) is this a new TIPS or a reopening? and 2) Will the yield to maturity end up above or below the TIPS’ coupon rate?

What is the difference between new and reissued TIPS?

While they are all Treasury Inflation-Protected Securities, there are slight differences.

New issue. The Treasury does a TIPS auction each month, and sometimes it is a new issue. That means the base interest rate (coupon rate) and yield to maturity will be set at auction. So for a new issue, you won’t know coupon rate for certain, and the yield you get will end up close to the coupon rate, as long as the yield is positive. The price you pay for the TIPS will be close to par value, as long as the yield is positive.

Reissue. When the Treasury reissues (also called ‘reopens’) a TIPS, it carries the coupon rate from the original auction. A few months will have passed, so the yield could have moved up or down from the coupon rate, meaning the price you pay for the TIPS could be less or more than par value.

Once a TIPS is issued, it trades on the secondary market, so it is easier to estimate its likely value at auction. With a new issue, the price can be a little harder to estimate.

Take a look at this post for a recap of all the new and reissues of 2013 and you can see the pattern: https://tipswatch.com/2013/12/25/recapping-2013-the-year-in-tips/

When I buy a TIPS, how can I tell if I am going to pay a premium or discount to par value?

For a new TIPS issue going to auction, the coupon rate will be set slightly below the yield to maturity that results from the auction. Coupon rates rise in 0.125% increments. So if the TIPS auctions with a yield of 0.661%, the coupon rate will be set at 0.625% and the buyer will get it at a slight discount to par.

But this does not hold true when the yield to maturity is negative. In that case, the coupon rate is set at 0.125%, the lowest it can go, and the buyer pays a premium to make up the difference.

For reopening auctions, a buyer can look at sources of secondary-market information on the current market yield of the TIPS being auctioned. That can give the buyer an indication of whether the TIPS is going to go off at a discount or premium to par.

A reliable source is the Wall Street Journal’s chart of closing TIPS prices. You need to know the maturity date of the TIPS that’s being auctioned, then check the price on that chart. Here is an example for a TIPS with a coupon rate of 0.625%:

In this case, the yield is 0.583%, so a buyer today would need to pay a premium, which in this case is about $100.40 for $100 of value, based on the asked price of 100.13. By the way, the .08 and .13 in that chart actually mean 8/32 and 13/32, not cents. The Wall Street Journal explains this:

Figures after periods in bid and ask quotes represent 32nds; 101.26 means 101 26/32, or 101.8125% of 100% face value; 99.01 means 99 1/32, or 99.03125% of face value.

Also, the accrued principal will factor in what you pay for a reopened TIPS, because you are also getting the existing boost from inflation since the first auction. In this case, accrued principal of 1001 is very small and not much of a factor. If it is higher, it will factor into what you pay, but you are also getting the benefit of the additional principal.

In an auction that capped two days of turmoil in the market for Treasury Inflation-Protected Securities, the Treasury just announced that CUSIP 912828B25 was reopened with a yield to maturity of 0.659% plus inflation, just under the 0.661% this TIPS generated at its initial auction on Jan. 23.

View the Treasury announcement.

This is a 9-year, 10-month TIPS with a coupon rate of 0.625%, meaning today’s buyers are getting it at a slight discount, with an adjusted price of about $99.91 per $100 of value, including in a small amount of inflation appreciation since January.

Although this auction broke a string of of eight consecutive 9- or 10-year TIPS auctions with higher yields, buyers today benefited from an upswing in TIPS yields this week, in reaction to the Federal Reserve’s cloudy message on future interest rates. On Monday, this same TIPS closed on the secondary market at 0.493%. That’s a jump of 17 basis points in four days.

Inflation breakeven rate. The nominal 10-year Treasury closed Wednesday with a yield of 2.78%, and has barely budged this afternoon at 2.77%. The 2.77% yield sets up a 10-year inflation breakeven rate of 2.11%. This is a fairly attractive number, and down slightly from the 2.12% of the January auction. It means that if inflation averages more than 2.11% over the next 10 years, this TIPS will outperform a traditional Treasury.

Reaction to the auction. The Wall Street Journal noted ‘lackluster demand’ for TIPS at this auction, ‘reflecting uncertainty about the economy’s ability to generate inflation in the coming years.’ From the report:

After starting the year strong, TIPS have had a tough time in March, handing owners a 0.7% total loss so far through Wednesday. TIPS are a hard sell these days, with the combination of little inflation in the current economy and the Federal Reserve cutting down on stimulus.

The Bloomberg report also noted pointed at low inflation as the cause for the ‘below-average demand’ at this auction:

“It’s a negative environment for inflation right now,” said Aaron Kohli, an interest-rate strategist at primary dealer in New York BNP Paribas SA. … “Investors are not worried about inflation anytime soon. Any risk premium that had been built in is just going away. If the Fed is on a path to taper when inflation is low, it makes no sense to build in a risk premium.”

It looks like today’s reopening of CUSIP 912828B25, creating a 9-year, 10-month TIPS, could auction with a yield to maturity above 0.60%, much higher than looked likely just a few days ago.

Bloomberg’s Current Rates site is flashing a yield of 0.63% for this TIPS, a nice tick up from Wednesday’s closing price of 0.571%. On Monday, it closed at 0.493%.

This uptick in yields results from fears that the Federal Reserve will (eventually) begin raising short-term interest rates. Which of course it will. But when? The market seems to believe the rise could begin early instead of later in 2015.

If the yield of 0.63% holds for CUSIP 912828B25, buyers should be paying close to par value for this TIPS, which has a coupon rate of 0.625% and almost no inflation appreciation since the initial January auction.

Wednesday was certainly an interesting auction’s eve. On the day before the Treasury is reopening CUSIP 912828B25 – a 10-year Treasury Inflation-Protected Security – at auction, the Federal Reserve today issued a statement that certainly said nothing dire … but the market reacted.

The TIPS market was shaken when the statement was released at 2 p.m., as you can see from this chart, showing the one-day price of the TIP ETF, which holds a broad range of maturities:

So what did the Fed say? The big news, as reported in this Wall Street Journal report, is that the Fed affirmed that it would continue to hold short-term interest rates low well into the future. It also said, as expected, that it would continue to lower its bond-buying stimulus by $10 billion in April.

All of this appears to be good news for the bond market. So why the hit to TIPS, which were slammed harder that the overall bond market, the overall Treasury market, and even harder than long-term Treasuries?

Michael Ashton, who writes the E-piphany blog focusing on inflation, offers this explanation:

TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate” …

If you are searching for secret code words from the Fed, you can read its full statement. In very brief summary, it says:

1. The economy has slowed (slightly) because of the harsh winter.
2. Inflation is running below the Fed’s long-term objective. “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance.”
3. The Fed will continue tapering its bond-buying stimulus program in April, but it will still be buying $50 billion in bonds that month.
4. The Fed said it will continue to keep short-term interest rates very low, noting “that a highly accommodative stance of monetary policy remains appropriate.”
5. And well, forget about the numbers: “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

So there you go. If anything, this Fed policy is encouraging – practically begging for – higher inflation, and that should cause demand for TIPS to rise and yields fall. But the opposite happened Wednesday.

It will be interesting to see what happens Thursday morning. If TIPS continue on a sharp decline – meaning yields rise – Thursday’s auction could get a lot more desirable.

As of the market close Wednesday, CUSIP 912828B25 (the TIPS being reopened Thursday) was trading on the secondary market with a yield of 0.571%, substantially higher than Wednesday’s close of 0.480%, but still well below the 0.661% that this same TIPS drew at its original auction Jan. 23.

Keep an eye out in the morning.