Treasury Inflation-Protected Securities

The U.S. Treasury will announce tomorrow that it will be auctioning a new-issue 10-year Treasury Inflation-Protected Security on July 18. This will be CUSIP 912828VM9. The coupon rate and yield to maturity will be set at auction.

Update: Here is the Treasury’s auction announcement.

Yield = positive, a rare thing. Right now, it looks like this 10-year TIPS will auction with a yield to maturity of 0.59% (but a lot can change in a week). This will be the first positive yield for a 10-year TIPS since November 2011 and the highest yield in two years. Here’s a chart showing the steep decline in yields after mid-2011; and how the trend began reserving after March 2013:

Here is another chart that shows just how quickly TIPS yields have risen from their ultra-low levels of the last two years:

This chart also shows there’s plenty of room for TIPS yields to continue rising to reach more ‘normal’ levels, say about 1.5% on a 10-year TIPS. My prediction is that 10-year TIPS yields will climb (or fall) at about the pace of a 10-year nominal Treasury.  The bond market is pricing in future ‘tapering’ of bond-buying by the Federal Reserve. The Fed hasn’t started tapering and we don’t know if it will, or when.

If the economy slumps, the Fed won’t taper and the bond-buying will continue, and TIPS yields will head back to zero or below. If the economy improves, yields are going to rise.

Inflation breakeven rate. The 10-year nominal Treasury closed Tuesday at 2.65% and the 10-year TIPS was yielding 0.59%, creating an inflation breakeven rate of 2.06%. This means if inflation averages more than 2.06% in the next 10 years, the TIPS will be a better investment than a 10-year Treasury. Although the breakeven rate has risen from the 1.95% range a few days ago, this is still an attractive rate. (I usually say that TIPS are ‘cheap’  when the breakeven rate hits 2%, and this is very close.)

Here is a chart showing the breakeven rate over the last 10 years; while the rate can fluctuate wildly at times of deflation, it usually remains above 2%:

TIPS vs. I Bonds. Ten-year TIPS traditionally have paid a 1% yield premium to I Bonds, because of the tax advantages and flexibility of US Savings I Bonds. TIPS  still haven’t reached that level, mainly because I Bonds cannot earn a negative yield. So I think I Bonds are still a better investment in mid-2013. That means: First, buy I Bonds up to the limit ($10,000 per person per year), then buy TIPS.

Strategy? I probably will be a buyer at the July 18 auction, because I have a 10-year TIPS maturing this month. This will be buy-and-hold-to-maturity investment, so even if yields rise in the future, the investment is ultra-low risk. This will be a rollover, not a bet-the-house investment.

I suspect the trend has turned on TIPS and we will see gradually increasing yields. If you want to gamble on that, this TIPS will be reissued in September (when the Fed in theory could begin tapering). You could sit on the sidelines and see what happens.

Soon after I woke up Friday morning, I heard on the radio that the U.S. economy had created 195,000 jobs in June and many more in April and May than was previously thought. My immediate thought was: “Ooops, that won’t be good for TIPS.”

Here is the reason, summed up nicely in the Associated Press jobs report:

The job growth suggests a stronger economy and makes it more likely the Federal Reserve will slow its bond purchases as early as September.

And here is what a 5-day, holiday-week chart looked like for the TIP ETF, which holds a wide range of Treasury Inflation-Protected Securities, and SPY, the ETF that tracks the Standard & Poors 500:

The stock market greeted Friday’s positive jobs report with a buying surge, but the overall bond market – and especially Treasuries – suffered.

In more-normal times, TIPS investors are OK with positive economic news, because it brings the possibility of higher inflation, which is the reason investors buy TIPS. And in the reverse, negative economic news brings the fear of deflation, which is not good for TIPS.

At the moment, we are in non-normal times, and the situation is reversed. TIPS will be helped by negative economic news and hurt by positive economic news. This is because of the overhanging fear of Federal Reserve ‘tapering’ (or outright halting) of bond purchases. Any positive economic news is going to be negative for TIPS.

TIPS in mid-2013 face the worst-possible conditions: Rising interest rates combined with very low inflation. As long as overall interest rates are rising, and annual U.S. inflation remains below 2.0%, TIPS will have little appeal to investors.

The result will be higher yields and lower prices for TIPS on the secondary market.

Positive economic news will mean higher interest rates. This is almost guaranteed by the Fed, and the market has started pricing this in.

Inflation is the X Factor. TIPS will suffer until we see some evidence of igniting  inflation. Until then, TIPS will be getting more and more attractive as a buy-and-hold-to-maturity investment.

In other words: Buying opportunity.

The market for Treasury Inflation-Protected Securities rebounded nicely last week after several days of panic selling in the wake of Federal Reserve Chairman’s Ben Bernanke’s comments on ‘tapering’ of the Fed’s bond-buying stimulus program. The TIP ETF rose 2.8% on the week.

But the needle has definitely moved, with 10-year TIPS returning solidly to yields positive to inflation. As of Friday, the 10-year nominal Treasury had settled in at 2.52%, up 66 basis points this year. If it holds at that level for the near term, TIPS yields should be holding steady around Friday’s numbers:

• 5-year TIPS, with a yield of -0.35%, up 101 basis points this year.
• 10-year TIPS, with a yield of 0.53%, up 115 basis points this year.
• 30-year TIPS, with a yield of 1.31%, up 84 basis points this year.

The recent selloff in TIPS was much more frenzied than the overall Treasury market (115 versus 66 basis points) and that pushed the 10-year inflation breakeven point down sharply, settling in at 1.99% on Friday. I don’t think the breakeven rate is going much lower, so future rises in TIPS yields should follow nominal Treasurys more closely.

Here’s a chart showing the 10-year TIPS breakeven rate over the last 10 years. Although the rate can decline sharply at times of panic, it traditionally runs above 2.0%:

Michael Ashton, an inflation watcher who writes the E-piphany blog, makes the case that TIPS won’t continue under-performing Treasurys:

As the bond selloff extends, I don’t think TIPS will continue to underperform nominal bonds. I believe breakevens, already at low levels (the 10-year breakeven, at 1.97%, is lower than any actual 10-year inflation experience since 1958-1968), will be hard to push much lower, especially in a rising-yield environment.

TIPS may be a much-hated investment at the moment, but I suggest looking beyond that noise for opportunities to invest, in a laddered approach or dollar-cost averaging. TIPS are a lot more attractive in July 2013 than they were six months ago.

After about six weeks of turmoil in the markets for Treasury Inflation-Protected Securities, we have seen yields on TIPS rise dramatically and a resulting free-fall in market prices on TIPS and and TIPS mutual funds. A recap:

• The 5-year TIPS is trading today with a yield of -0.24%. On May 1 it was -1.50%. That’s a gain of 126 basis points.
• The 10-year TIPS is trading today with a yield of 0.59%. Yes, that is positive 0.59%. On May 1 it was -0.66%. That’s a gain of 125 basis points.
• The 30-year TIPS is trading today with a yield of 1.45%. On May 1 it was 0.440%. That’s a gain of 101 basis points.
• The TIP ETF is trading today at $110.44. On May 1 it was $121.50. That’s a decline of 9.2%. Since this fund has a duration of about 8, that is what you get when interest rates rise 125 basis points.
• Because the 10-year Treasury is currently trading at 2.52%, this creates a 10-year inflation breakeven point of 1.93% for a 10-year TIPS. My ‘cheap’ marker for TIPS is a breakeven point of 2%. We are there.
• Likewise, the breakeven rate for a 5-year TIPS is a very attractive 1.66%.

What this means. In less than two months, TIPS have gone from extremely expensive with paltry yields to reasonably priced with more acceptable yields. In other words, TIPS are again an attractive investment.

Strategy? I have said for two years that I am not a fan of TIPS mutual funds, which is the way most people hold TIPS in retirement accounts. Today, I am changing my view. My view is that it’s time dip gently into TIPS mutual funds and set up automatic investments for the future. In other words, dollar-cost average in.

The overall bond market has taken a shock in mid-2013, and it could very well over-correct. On the other hand, I can’t see interest rates really soaring until the economy drastically improves. And Fed is continuing is bond purchases for the time being.

The risk? The TIP ETF is down 11.1% from its all-time high. If yields on TIPS rise another 100 basis points, which could happen in the longer (or even shorter) term, you’re going to see another 8% drop. By starting with a small investment and dollar-cost averaging in, you can minimize that risk.

My overall strategy is not changing however. My main holdings in TIPS will remain purchases at TreasuryDirect and holding to maturity, along with I Bonds. (My two-year ‘buying strike’ ended with last month’s 10-year auction.) If these current yields hold, future auctions are going to be a lot more attractive.

That’s what I am doing, but I can’t say it’s the best advice for everyone. Just something to think about.

The U.S. Treasury just announced that its 29-year, 8-month reissue of a Treasury Inflation-Protected Security auctioned with a yield of 1.42%, capping a spectacular run-up in yield in recent days. Read the announcement.

This TIPS, CUSIP 912810RA8, was trading at 1.236% yesterday and 0.750% one month ago, on May 20. That’s a powerful increase of 67 basis points in four weeks.

The yield of 1.42% is the highest on any TIPS of any maturity in the last two years – since June 2011 – just before TIPS yields began a long, steady decline because of the Fed’s bond-buying and fears of resulting inflation.

Because this TIPS was first auctioned in February with a coupon rate of 0.625%, buyers at today’s auction are getting a giant discount, paying about $81.75 for $100 of value. It’s almost like a zero-coupon bond, with a lot of the interest being discounted up-front. The market value of this TIPS has fallen 17.9% since it was first auctioned four months ago.

The overall TIPS market is having another miserable day, with the TIP ETF currently trading at $111.61, down more than 1% today. This auction certainly won’t help.

I have been predicting that the TIP ETF could fall to about $111 as overall interest rates increased. But this decline has been dramatic, and probably indicates rough times ahead.

Reaction to the auction, from Carolyn Cui of the Wall Street Journal:

Though the TIPS were offered at 1.420%, the highest yield for similar bonds in two years, the auction didn’t draw much interest from investors. The interest rate was higher than the 1.390% for similar bonds already in circulation before the auction, another sign of poor reception. …

The poor auction results reflected the plummeting inflation expectations so far this year, driving the 30-year inflation-adjusted yield up from 0.404% to 1.400%.

Also, this from Cordell Eddings & Susanne Walker of Bloomberg:

“The TIPS auction was pretty awful given the concession that we had,” said Aaron Kohli, an interest-rate strategist at BNP Paribas SA in New York, one of 21 primary dealers that are obligated to bid at U.S. debt auctions. “There just isn’t any inflation pressure, and the markets aren’t buying that there will be any inflation.”