Treasury Inflation-Protected Securities

You might ask: ‘How are you going to define ‘normal’? Good point. In the financial world, the going price for anything might be called the ‘normal’ price, set by free markets. But in the case of Treasury Inflation-Protected Securities, normal is very hard to define.

So, for today only, I am going to define ‘normal’ to mean ‘acceptable.’ In other words, attractive to buyers, a sensible investment, and in line with historical trends. Today, with a 10-year TIPS yielding about 0.52% above inflation, I don’t think we are there yet.

I have tried in the past to project a ‘sensible’ yield for a 10-year TIPS, and I came up with a yield of about 1.76%, plus inflation. We won’t be seeing that anytime soon, but read my analysis to see why TIPS yields will eventually return to that level, and probably higher.

So for today, I decided to declare the first auctions of 2011 – for 5-, 10-, and 30-year TIPS, to be about as ‘normal’ as we can expect to see in the next two years.

Why early 2011? The TIPS and Treasury markets dramatically changed in mid-2011, a fact I detailed in this post: The TIPS earthquake: When did it happen, and why? It’s strange, but the factor that triggered this upheaval was the crushing failure of Congress to address runaway government spending and spiraling deficits. Eventually, Standard & Poors downgraded U.S. debt – and the result was that U.S. debt skyrocketed in value. As weird as that seems, that’s the way it happened.

(True, it wasn’t the S&P downgrade of U.S debt that directly resulted in soaring Treasurys. But the fiscal crisis and resulting downgrade caused the stock market to plummet and suddenly the U.S. economy looked extremely dire. The Federal Reserve responded with an aggressive bond-buying stimulus program. That raised fears of inflation and that directly caused TIPS to soar, along with the stock market.)

I started this blog in April 2011 and at the time TIPS were as boring and conservative an investment as exists on Earth. Within a few weeks, I read a commentary that said: “The only reason to buy TIPS is for the capital gain.” I was horrified! No, TIPS are conservative! Not for trading! But the commentator was totally correct. TIPS were about to launch into massively lower yields and higher prices.

So let’s look back to the first auctions of 2011, before this turmoil began, in search of something ‘normal.’

• Jan. 20, 2011. A new 10-year TIPS, CUSIP 912828PP9, auctioned with a yield to maturity of 1.17% and a coupon rate of 1.125%. Since that date, no 9-to 10-year TIPS auction has generated a yield above 1%. The highest yield since then was 0.92% for the reopening of this same TIPS on March 24, 2011.
• Feb. 17, 2011. A new 30-year TIPS, CUSIP 912810QP6, auctioned with a yield to maturity of 2.19% and a coupon rate of 2.125%. The highest yield since that date for any 29- to 30-year TIPS was 1.42% in June 2013 for a reopening of CUSIP 912810RA8.
• April 21, 2011. A new 5-year TIPS, CUSIP 912828QD5, auctioned with a yield to maturity of -0.18% and a coupon rate of 0.125%. At the time, this auction made headlines: BUYERS ACCEPT NEGATIVE INTEREST ON TIPS! Several financial columnists derided buyers as fools. I was a buyer, and I didn’t feel foolish. Since that date, the best yield on any 4- to 5-year TIPS auction was -0.13% for a reopening of CUSIP 912828UX6 on Aug. 22, 2013, another auction where I was a buyer.

To recap, this is about as normal as we can expect in 2014 and possibly well into 2015:

• 5-year TIPS at -0.18%, plus inflation. The current yield is -0.25%
• 10-year TIPS at 1.17%, plus inflation. The current yield is 0.52%
• 30-year TIPS at 2.19%, plus inflation. The current yield is 1.35%

We have a long way to go, except for the short-term TIPS. If you think a move that large isn’t possible, I will close with this chart of all TIPS auctions in that momentous year of 2011. Study it:

I was on vacation last week in sunny Florida and had limited Internet access. But I wasn’t totally out of touch: I had satellite radio on my cheapo Hyundai rental car, and could listen to CNBC and Bloomberg Radio. So I spent Thursday morning, driving to Sarasota, listening for the January inflation number.

In a two-hour drive, I never heard the number. What I did hear was this: “Treasurys are weakening today on the January inflation number.” That perked my interest.  There’s a TIPS auction today! What was the inflation number? Never heard. What was happening to Treasurys? That I did hear: “The 10-year Treasury yield rose from 2.75% to 2.76%.” One basis point! That is not news, and inflation had nothing to do with it.

The inflation number, by the way, was 0.1% in January for the seasonally-adjusted Consumer Price Index for All Urban Consumers (CPI-U). Over the last 12 months, inflation was up a very mild 1.6%, still well below the Federal Reserve’s target of 2.0% and ‘danger level’ of 2.5%.

Read the full inflation report.

The non-seasonally adjusted CPI-U is used to determine the inflation adjustment to principal on TIPS and the future interest rate on I Bonds. In January, the non-seasonally adjusted number was 0.4%, but for the last 12 months the number remains at 1.6%.

Inflation is continuing at a very mild level. Gasoline prices fell 1.0% in January, but fuel oil prices increased 3.7% and natural gas was up 3.6%, the result of a wicked winter on the East coast.

Core inflation, which strips out food and energy, increased the same 0.1% in January and 1.6% for the last 12 months.

30-year TIPS auction

Of course, CNBC didn’t report on the TIPS auction. No mainstream media report on TIPS auctions, especially in the hour after the close. Thursday’s auction for a new 30-year TIPS, CUSIP 912810RF7, went off with a coupon rate of 1.375% and a yield to maturity of 1.495%. That result was slightly higher than expected; a week earlier I had noted a yield of 1.42% looked likely. But, no big surprises.

Read the TIPS auction announcement.

However, this was the highest yield for any 29- to 30-year TIPS at auction since June 2011, when a 29-year, 8-month TIPS went off at 1.744%. That was just before the beginning of a 24-month boom in Treasurys, which eventually deflated (a bit) in mid 2013.

Over the week, TIPS weakened as yields increased, but you can see from this chart that the Thursday auction, which closed at 1 p.m., was a rallying point for TIPS:

The TIP ETF is shown here in blue. It holds the full range of TIPS maturities. Over the last week, it lagged behind IEI (intermediate Treasurys) and AGG (the overall bond market). This means TIPS yields were rising faster than the overall bond market, resulting in a lower price.

When you see a chart like this, you can conclude that TIPS yields are increasing at a higher rate than the overall bond market, and that should mean a lower inflation breakeven rate. Thursday’s auction resulted in an inflation breakeven rate of 2.23%, in the ‘normal range’ but 5 basis points less than looked likely a week earlier. A lower breakeven rate means that TIPS are cheaper against a nominal 30-year Treasury.

When you are a buyer, cheaper is better.

Reaction to the auction.

The Wall Street Journal noted that demand for the 30-year TIPS was ‘tepid,’ possibly because inflation continues to be muted:

(P)aying for inflation protection is a hard sell these days. The latest CPI reported Thursday morning showed consumer prices gaining just 0.1% last month and 1.6% over the year. Core prices, which exclude volatile food and energy costs, also rose a mere 0.1%. These measures fall well short of the Federal Reserve’s 2% long-run inflation goal. …

The massive amount of bets that piled up against TIPS in 2013 actually helped the market bounce back in January. But bond traders now say that for TIPS to keep buyers around, the economy will have to start showing more substantial signs of inflation.

I am away from a computer today, and in fact don’t have Internet access. (It’s called vacation!)

Sorry I can’t post a full analysis until Sunday. Inflation report was also mild today, more on that to come.

The U.S. Treasury formally announced yesterday that it will auction a new-issue 30-year Treasury Inflation-Protected Security on Feb. 20. This is CUSIP 912810RF7, and the coupon rate and yield to maturity will be determined at auction. Here’s the fact sheet.

How this shapes up. Because this is a new issue with a positive yield, the coupon rate and yield to maturity should be fairly close. If the auction were today, the coupon rate might be 1.50% and the yield to maturity around 1.42%. But a lot can happen in a week. Here are some data sources to check before the auction:

• The Treasury’s Daily Real Yield Curve Rates, which right now are indicating a yield of 1.42%. That’s down about 16 basis point from where we opened the year.
• Bloomberg’s Current Yields, which reflects current trading but can be a little misleading. It shows the longest-term TIPS trading at the same 1.42%.
• The Wall Street Journal’s closing price list for TIPS, which shows that the TIPS maturing 2043 Feb 15 closed Thursday at 1.40%.

The yield trend line. The Treasury offers only three 30-year TIPS auctions a year – one new issue in February and two re-openings (June and October). In 2013, we saw just how volatile 30-year Treasurys can be. CUSIP 912810RA8 auctioned on Feb. 21, 2013, with a yield to maturity of 0.64%. It was reissued in June with a yield of 1.42% and in October at 1.33%. In just five months, this TIPS lost almost 19% of its value on the secondary market.

But the trend also indicates that 30-year TIPS yields have been fairly stable since mid-2013. Buyers at the June 2013 auction are sitting on a slight gain.

What is normal? My opinion: In ‘normal’ times a long-term TIPS should pay at least 2% above inflation. As the Federal Reserve ends its bond-buying stimulus and the economy continues to improve, we might start to see hints of ‘normal.’ To make my case, I present the history for every 29- to 30-year TIPS auction:

Inflation breakeven rate. The 30-year nominal Treasury is yielding 3.70% and with the 30-year TIPS yielding 1.42%, plus inflation, this sets up a breakeven rate of 2.28%. That means this TIPS will outperform a traditional Treasury if inflation averages more than 2.28% over the next 30 years. Not expensive, not cheap, as this chart shows:

Best purchased in a tax-deferred account. I have noted before that a 30-year TIPS can end up being a cash-flow drain until it matures. The reason: You have to pay taxes on the inflation-adjusted interest in the year it is earned, but you don’t see that money until maturity. This TIPS, with a coupon rate of around 1.5%, is going to be close to cash-flow neutral if inflation averages 2.5% over 30 years.

Example: Let’s say you buy $10,000 of this TIPS and the coupon rate is 1.5% and the inflation rate averages 2.5%. In the first year you will get $150 of interest and $250 in inflation-adjusted principal. That’s $400 total, and if your marginal tax rate is 38%, you would owe $152 in taxes. The TIPS paid you $150, so you are $2 cash flow negative.

My philosophy on TIPS is to buy and hold to maturity as a way to push inflation-protected money forward into retirement.  Although I have bought 30-year TIPS in the past (and still own them), they no longer are in my target range. So I’ll pass on this. (Go ahead, Treasury, tempt me with 3.5% above inflation and watch me change me mind.)