Treasury Inflation-Protected Securities

Here’s a 1969 menu from a restaurant in my hometown, Rockford IL. It’s a reminder about why we need protection from inflation. Click on the image to see it larger.

I was updating my TIPS Q&A page today and I realized that I never really answered this question: Who should buy TIPS? So here we go …

First off, I want to state loudly that TIPS are for preserving wealth, not building wealth. If you are in the early stages of investing and far from your long-term needs for buying a house or for paying for college or especially for retirement, TIPS aren’t going to be a great investment. That’s especially true when yields are less than 1% over inflation. You probably won’t build enough wealth to meet your goals.

(There was a time, in the late 1990s when the stock market was bubbling, that TIPS paid nearly 4% above inflation. That was a screaming buy, no matter your situation, as a long-term buy-and-hold investment, or even as a speculation. Those days are long past.)

So who should buy TIPS?

If you are nearing retirement, or in retirement, and have an adequate nest egg, then TIPS make sense as part of your investment portfolio – especially if you buy and hold them to maturity. That strategy is risk-free, and you can protect a part of your savings from the dangers of unexpected inflation.

I think of TIPS as a way of punting money into the future. You will need it then. With TIPS paying a positive yield, you can preserve the current value against the threat of inflation. If you buy and hold to maturity, you have a lot of certainty – X dollars coming on X date.

But even then, I think TIPS, I Bonds and bank CDs should make up no more than 30% of your portfolio. Put the rest in stock and bond index funds, whatever matches your risk tolerance. In the past, I have suggested something like:

• 10% Highest risk: International, small cap stock index funds
• 30% Higher risk: U.S. stock index funds
• 35% Lower risk: Broadly diversified bond funds, municipal bonds
• 25% No risk: TIPS, I Bonds, insured bank CDs, Treasuries held to maturity

I Bonds are a special case, since there is a limit on purchases of $10,000 per person per year. If you want to build a large stake, you need to start early. I think I Bonds could work well for almost any investor. They are flexible enough to be a 1-year savings account, or a 30-year investment, with taxes deferred.

The U.S. Treasury just announced that its auction of a new 10-year Treasury Inflation-Protected Security resulted in a yield to maturity of 0.384%, the highest in two years for any 9- to 10-year TIPS.

This is CUSIP 912828VM9 and it will have a coupon rate of 0.375%.  That means buyers will pay very slightly less than par, but when accrued interest is added in the price will be nearly exactly $100 for $100 par. Here is the announcement.

This is the highest auction yield for any 9- to 10-year TIPS since July 2011, when a new issue 10-year TIPS went off with a yield of 0.639%. It is also the first positive yield for this term of TIPS since November 2011. (TIPS pay a base coupon rate, plus the principal grows at the rate of inflation until maturity.)

Although 10-year TIPS yields have backed off a recent high of about 0.64% on July 10, they’ve still seen a remarkable surge in 2013. Remember, a 10-year TIPS auctioned in January at -0.630% and was reissued in March at -0.602%. This is a gain of about 97 basis points in four months.

Inflation breakeven rate. The 10-year Treasury closed yesterday at 2.52%, so this TIPS has a breakeven rate of 2.136%. That means it will outperform a nominal Treasury if inflation averages more than 2.136% over the next 10 years. (As recently as March the breakeven rate was 2.54%.) Today’s number, while still relatively good, has been creeping up in the last two weeks. after dipping below 2.0%. This indicates stronger recent demand for TIPS than traditional Treasurys.

(And by the way, did you ever wonder how often inflation has averaged less than 2.2% over 10-year periods in the last 50 years? Check out this chart, looking at the columns on the right. Since 1961, the lowest-ever 10-year inflation average was 2.4%.)

Did I buy it? Yes. While I was disappointed with the recent swoon in yield, I wanted to lock in a 10-year TIPS with a positive yield. This was only my second TIPS purchase in two years.

Reaction to the auction. Bloomberg’s report says the yield was expected to be 0.399%, based on its survey of primary dealers. It quotes this negative viewpoint on TIPS from Aaron Kohli, an interest-rate strategist in New York at BNP Paribas SA:

“The TIPS market got ahead of itself and is still too rich and has overpriced demand. … “The economy hasn’t seen inflation pressure to justify TIPS strength.”

The article also quotes Michael Pond, head of global inflation-linked research at Barclays Plc, as saying today’s positive yield helped draw investors:

“TIPS got to very cheap levels relative to fundamentals and are now starting to offer some value. … The Fed has brought the dual back to the dual mandate by increasing communication around inflation which should bolster the idea that the Fed is serious about pushing inflation up.”

The Wall Street Journal‘s report notes the auction drew “robust demand from end-investors, with indirect bidders purchasing 57.7% of the notes, compared with an average of 49.6% for the past six sales.”

The TIPS market overall appeared pleased by the auction, which closed at 1 p.m. Here is the one-day chart for the TIP ETF, showing a sharp move upward after the auction:

I have pretty much lost my appetite for Thursday’s auction of a new issue 10-year Treasury Inflation-Protected Security. Why? It’s hard to swallow a jawbone.

The jawboning has been coming from Federal Reserve Chairman Ben Bernanke, who last Wednesday afternoon tried to scale back fears of future Fed ‘tapering’ of its aggressive bond buying. Again today, speaking to Congress, Bernanke went dovish on quantitative easing. From the Wall Street Journal report:

Federal Reserve Chairman Ben Bernanke amplified his efforts to calm markets about the end of the Fed’s easy-money policies, pointing to a variety of economic risks that could persuade the central bank to keep its large bond-buying program going in the months ahead. …

“Because our asset purchases depend on economic and financial developments, they are by no means on a preset course,” he said. … In fact, if necessary, the Fed “would be prepared to employ all of its tools, including an increase [in] the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”

The result. Last Wednesday, by Treasury estimates, a 10-year TIPS was drawing a yield to maturity of 0.64%. Today, according to Bloomberg’s real-time estimates, that yield has fallen to 0.30%. That’s a fall of 34 basis points in 5 market days. Here is how jawboning looks in a 5-day chart for the TIP ETF (its price rises when its yield falls):

I am not a fan of buying something while the price is soaring. I haven’t ruled out participating in this 10-year TIPS auction, but my enthusiasm definitely has waned. I think I will wait until Thursday morning to decide.

I am convinced that higher interest rates (and TIPS yields) are ahead. That means the best strategy is being patient for buying opportunities.

U.S. inflation took a sharp tick upward in June, rising 0.5% on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Analysts were expecting an increase of 0.3%.

This is ‘headline’ inflation, technically called the Consumer Price Index for All Urban Consumers (CPI-U). It has risen 1.8% over the last 12 months, indicating that overall inflation remains mild.

For holders of TIPS and I Bonds, the important monthly number is the non-seasonally adjusted rise in inflation, which was 0.2% in June and 1.8% over the last 12 months. This number is used to determine increases in TIPS principal and future interest rates of I Bonds.

Energy costs were the driving force behind June’s increase in inflation.

• The cost of gasoline rose 5.7%
• The cost of fuel oil rose 6.3%
• Overall energy rose 3.4%

Apparel was up a sharp 0.9% in June and medical care services was up 0.4%, breaking a string over very low monthly increases.

Core inflation. The Federal Reserve tends to watch core inflation, which it says it wants to contain under an annual rate of 2% and a danger level of 2.5%. Core inflation increased 0.2% in June, but only 1.6% over the last 12 months, well under the Fed’s goal.

For TIPS buyers? Higher inflation increases the attractiveness of TIPS as a shelter, but it also raises the fear of tightening by the Federal Reserve. TIPS have been in a bit of a rally since last Thursday, and that looks likely to continue today. Tomorrow, Federal Reserve Chairman Ben Bernanke will be speaking before Congress, and we can expect another news jolt leading up to Thursday’s auction of a 10-year TIPS.

Right now, it’s hard to see the long-term trend in headline inflation, which seems to jump in some months and plummet in others, usually along with energy prices.

Federal Reserve Chairman Ben Bernanke might have been feeling a little guilty about being so honest about the Fed’s  future ‘tapering’ of purchases of Treasury bonds. Bernanke’s heads-up (once in May and again in June) resulted in a dramatic increase in Treasury yields, pushing the yield on a 10-year TIPS from -0.65% on May 1 to a peak of 0.66% on July 5, a 131 basis point swing.

So last Wednesday, Bernanke tried to slam the lid on this Pandora’s Box, hoping to also put a lid on rising interest rates. From the Christian Science Monitor report:

Speaking at a National Bureau of Economic Research conference in Cambridge, Mass., Bernanke seemed to allay investors’ concerns about early tapering. Unemployment is too high and inflation is too low to do away with easy-money policies just yet, he said. …

Overall, Bernanke said the Fed’s outlook of the economy is a mixed bag — “somewhat optimistic,” but warily eyeing “significant risks.”

It worked. The yield on a nominal 10-year Treasury dropped from 2.7% on Wednesday to 2.61% on Friday, down 9 basis points. The yield on a 10-year TIPS dropped from 0.64% on Wednesday to 0.55% on Friday, also down 9 basis points. This chart of the TIP ETF shows that Bernanke’s words late Wednesday had an immediate effect on the market, stopping a months-long slide in TIPS prices:

And now … The immediate effect might be to somewhat dim the attractiveness of Thursday’s 10-year TIPS auction. At mid-week, it looked like buyers could get a 0.625% coupon rate, now a 0.5% coupon rate looks likely.

This will be an interesting week, because in fact I think we all know tapering is coming, possibly this year. Bernanke’s boost to bonds could already be over.