Treasury Inflation-Protected Securities

Minutes from the Federal Reserve Open Market Committee always get a lot of attention, but the minutes from December’s meeting are especially important, because at that meeting the Fed finally launched a slowdown of its bond-buying economic stimulus program.

Embedded in those minutes was intriguing discussion on whether the Fed’s near-eternal quantitative easing was causing a bubble in the stock and housing markets. After all, the S&P 500 was up about 28% in 2013, and U.S. housing prices rose about 13.5%.

The Wall Street Journal jumped on this with a story headlined: ‘Fed Minutes: Bubble Risks Drawing Attention‘. The story quoted Dan Greenhaus, chief global strategist at brokerage firm BTIG LLC, as saying, “The Fed is looking for evidence that they may be creating asset bubbles. That’s better than not looking.”

Read the full text of the Federal Reserve minutes and you can decide for yourself. Here is my summary of the core topics from the minutes, released Wednesday:

• At least a little risk of a bubble? The Fed committee considered its aggressive bond-buying program, which lowers long-term interest rates and propels values of stocks, and said:

Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector.

• Do we really know what we are doing? Um … not sure.

It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.

• How do we get out of this? Ah yes. How do you yank away this economic stimulus, which has boosted the housing and stock markets for years?

(P)articipants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came. Many participants, however, expressed confidence in the tools at the Federal Reserve’s disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.

• OK, but is this even working? Another great question.

A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment. A couple of participants thought that the marginal efficacy of the program was not declining,

• The economy is doing fine.

The information reviewed for the December 17-18 meeting indicated that economic activity was expanding at a moderate pace. … The unemployment rate declined, on net, from 7.2 percent in September to 7.0 percent in November. … (T)he forecast for growth in real gross domestic product (GDP) in the second half of this year was revised up a little.

• Inflation isn’t high enough. The Fed isn’t happy with the 1.2% rise in CPI over the last 12 months. It wants 2% or higher.

Inflation continued to run noticeably below the Committee’s longer-run objective of 2 percent, but participants anticipated that it would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady. … (I)nflation was projected to be subdued through 2016.

• Housing is slowing down. This is what happens when prices rise and long-term interest rates increase.

The pace of activity in the housing sector appeared to continue to slow somewhat, likely reflecting the higher level of mortgage rates since the spring. … Sales of existing homes and pending home sales decreased further in October, although new home sales rose in October after falling markedly in the third quarter.

• Interest rates are rising, even when you try to hold them down. It works that way sometimes.

Mortgage rates rose over the intermeeting period to levels about 100 basis points above their early-May lows.

• American consumers are getting their mojo back, thanks to higher stock and housing prices.

Consumer spending appeared to be strengthening, with solid gains in retail sales in recent months and a rebound in motor vehicle sales in November. … (S)pending was being supported by gains in household wealth associated with rising house prices and equity values, the still-low level of interest rates, and the progress that households have made in reducing debt and strengthening their balance sheets.

• Congress and the White House are behaving.

(A) number of participants observed that the prospect that the Congress would shortly reach an accord on the budget seemed to be reducing uncertainty and lowering the risks that might be associated with a disruptive political impasse.

• Let the tapering begin, with qualms. The Federal Reserve actually set a plan to lower its bond-buying stimulus, and the world did not end.

(M)ost participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee’s previous policy communications. … However, several participants stressed that the unemployment rate remained elevated … and that the projected pickup in economic growth was not assured. Some participants also questioned whether slowing the pace of purchases at a time when inflation was running well below the Committee’s longer-run objective was appropriate.

• Can we please have a plan?

A few proposed that the Committee lay out, either at this meeting or subsequently, a more deterministic path for winding down the program or that it announce a fixed amount of additional purchases and an expected completion date, thereby reducing uncertainty about the trajectory of the purchase program.

• Finally, a decision. The tapering door opens, a crack, but it is now open.

(T)he Committee agreed that, beginning in January, it would add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month.

This blog is focused on Treasury Inflation-Protected Securities and I Bonds, both inflation-protected investments. So you might wonder why I’ve been ‘all excited’ about a 3% 5-year CD being offered by the Pentagon Federal Credit Union through Jan. 31, 2014.

One word answer: Math.

The bigger picture is that my wife and I try to keep an asset allocation of 40% stocks and 60% bonds, with a heavy allocation of bonds in tax-deferred accounts. But that is just the ‘asset type’ allocation. In addition, I monitor our ‘inflation-protected allocation‘, which I’d like to be about 15% to 20%.

I also try to monitor our ‘asset safety allocation‘, which I have written about before, and it looks something like this:

• 10% Highest risk: International stock funds, smaller-cap stock funds
• 30% Higher risk: Total stock market funds, S&P 500 funds, etc.
• 35% Lower risk: Broadly diversified bond funds, TIPS funds, municipal bonds
• 25% No risk: TIPS, I Bonds, insured bank CDs, Treasurys held to maturity

Those numbers might vary, and in fact it has been hard to keep the no-risk category up to the desired level with yields so low. I Bonds are especially helpful, because they are tax-deferred but not in a tax-deferred account. The only problem with I Bonds is the yearly purchase cap ($10,000 per person per year, plus $5,000 possible as a tax refund.).

Everywhere you turn today you see articles warning about the dangers of bond investments. And my answer to that is: Find safety. By buying TIPS, I Bonds and insured CDs – and holding to maturity (whatever you choose for I Bonds) – you completely eliminate risk. Your principal balance is not going down.

So along comes the PenFed CD, federally insured for 5 years paying 3%. It fits into the ‘no risk’ category,  it’s in the fixed-income category, it can be purchased in a tax-deferred account, and the insured limit is a lofty $250,000. But it does not offer inflation protection.

So how does it compare with a 5-year TIPS, an I Bond or a traditional Treasury? Here’s the math, with the winning investment highlighted for each inflation rate:

Conclusion: This 5-year CD, especially in a tax-deferred account, can be a nice supplement to your I Bond investment this year. And since the I Bond fixed rate of 0.2% is intact through April 30, there is no rush to buy I Bonds. The PenFed offer lasts through Jan. 31, though, so time is limited on that investment.

I’ve been watching to see if the Pentagon Federal Credit Union would extend its 3% five-year CD into 2014, and indeed, it has extended it until Jan. 31. I opened a $5 savings account there in December, hoping to put my entire 2014 IRA contribution in this account.

I’ll be reporting more on this later this week. For now, check it out on http://www.penfed.org.

Update, Jan. 2:  Last month, I created a PenFed savings account with $5 in it and my application was approved. My father served in the Navy and later worked in the Defense Department as an auditor, so that was my military connection. But even if you have no military connection, you can get a PenFed account by joining (for a small one-time fee) the National Military Family Association or Voices for America’s Troops. Here are details.

Once you are member, you can open an IRA account with a $25 investment (or you can fully fund it with one investment). The IRA application process is just a little daunting. You need to download the IRA information package, which includes the forms you’ll need.

I am going to fully fund my 2104 IRA with one investment in the 5-year CD, so I will send in a check with the completed form. If all goes well, the account should be created in a few days, and I will update again.

If you are considering transferring IRA assets into PenFed, the information packet also includes those forms.

Update Jan. 6: My IRA account at PenFed is open and my 2014 IRA contribution is earning 3%, tax-deferred, for the next 5 years. Very easy process, after all.

It hasn’t been a pretty year for the TIPS ETF. Click on the image for a larger version.

Holders of mutual funds investing in Treasury Inflation-Protected Securities won’t be sad to see 2013 fade away: It’s been the worst year for TIPS values since the Treasury instrument was launched in 1997. The TIP ETF – which holds a wide range of maturities – started the year at $120.03 and closed Dec. 24 at $109.86, a decline of 8.5%.

And so you are probably seeing a lot of negative press about Treasurys and TIPS in particular, with headlines like these:

• TIPS Poised for Worst Year Ever
• Is Your Inflation Protection Really Protecting You?
• Low Inflationary Pressures Left TIPS ETFs Feeling the Pinch
• The Sad Story of TIPS and Why There’s No Silver Bullet to Fight Inflation

But here’s the thing: If you are a buy-and-hold-to-maturity investor in TIPS and I Bonds, both these investments are a lot more attractive in December 2013 than they were in December 2012. And that is why I would say that 2013 was a good year – a much needed year – in TIPS history. Yields are creeping up, back to more-normal levels. At the same time, the once-inflated value of the TIPS you are holding to maturity is declining, but so what? You are holding to maturity.

And 2014 is going to offer some buying opportunities for those of us who have been sitting on the sidelines since mid-2011. Here’s a recap of the year’s TIPS auctions:

10-year TIPS, CUSIP 912828UH1

First auctioned: Jan. 24, with a yield to maturity of -0.630% (plus inflation), well above the record-low yield of -0.750% for any 9- to 10-year TIPS. This was an early indication of yields creeping higher. I took a negative view of this auction.

Reopened: March 21, with a yield to maturity of -0.602%, very close to the original auction. At the time, the 10-year inflation breakeven point was 2.54%, pretty expensive.

Reopened: May 23, with a yield of -0.225%. I took a positive view of this auction, and in fact, this is one of three TIPS I bought at auction in 2013. At this point the 10-year breakeven rate had dropped to a more reasonable 2.255%.

30-year TIPS, CUSIP 912810RA8

First auctioned: Feb. 21, with a coupon rate of 0.625%, and a yield to maturity of 0.639%. Although the yield was above the record low, TIPS traders who bought this issue were going to see a massive decline in market value over the course of 2013.

Reopened: June 20, with a yield to maturity of 1.42%, capping a spectacular run-up in yield as the Federal Reserve began raising the possibility of tapering its bond-buying economic stimulus. This TIPS had been trading at 0.750% one month earlier. The market value of this TIPS had fallen 17.9% since it was first auctioned.

Reopened: Oct. 24, with a yield to maturity of 1.33%. This auction came after the Fed backed off tapering, and yields had backed off from early-September highs.

5-year TIPS, CUSIP 912828UX6

First auctioned: April 18, with a yield to maturity of -1.311%, which broke a string of record lows for 5-year TIPS. Before the auction I had asked: Is buying a 5-year TIPS the most insane move ever?, suggesting that I Bonds were clearly a superior investment.

Reopened: Aug. 22, with a yield to maturity of  -0.127%, the highest yield for any 4- or 5-year TIPS issued in more than three years. I was a buyer at this auction, mainly because I needed a 5-year maturity to fill a hole in my TIPS ladder. The Federal Reserve gave the yield a boost by hinting at tapering in a statement one day before the auction.

Reopened: Dec. 19, with a yield to maturity of -0.375%. This auction came after the Federal Reserve officially announced it would slow down its bond-buying, but the yield still didn’t reach the Aug. 22 high.

10-year TIPS, CUSIP 912828VM9

The master manipulator

First auctioned: July 18, with a yield to maturity of 0.384%, the highest in two years for any 9- to 10-year TIPS. This auction looked very promising until Fed Chairman Ben Bernanke – on the eve of the auction – tried to scale back fears of future Fed ‘tapering’ of its aggressive bond buying. The result was that the yield dropped in a few days from an expected 0.64% to the resulting 0.384%. I was a buyer at this auction.

Reopened: Sept. 19, with a yield to maturity of 0.5%, the highest yield for any 9- or 10-year TIPS auction since July 2011. I was on vacation in remote Nova Scotia during early September when the Treasury market was roiled by fears of tapering. TIPS yields hit their high point for the year on Sept. 5, 0.92% for a 10-year TIPS. And then … Ben Bernanke – again on the eve of the TIPS auction – stepped in to rule out tapering in the near term. The result was a drop of 30+ basis points in the yield for this TIPS.

Reopened: Nov. 21, with a yield to maturity of 0.560%, slightly higher than the September auction’s 0.5%.

Where we stand now

A lot has happened this month, with the Federal Reserve announcing on Dec. 18 that it will indeed launch tapering – in a minimal form – in January. Yields for both TIPS and Treasurys have been inching up over the last week.

• The 5-year TIPS is yielding 0.05%, according to the Treasury’s Daily Treasury Real Yield Curve Rates, below its high for the year of 0.14%.
• The 10-year TIPS is yielding 0.80%, still off its high of 0.92% for the year.
• The 30-year TIPS is yielding 1.61%, just below its high of 1.64%.

The Treasury just announced the results of today’s reopening of CUSIP 912828UX6, a 4-year, 4-month TIPS that auctioned with a yield to maturity of -0.375%, plus inflation.

Because this TIPS carries a coupon rate of 0.125% – the lowest the Treasury allows on TIPS – buyers today will be paying up, about $103.22 for $101 of value, after accounting for about $1 of inflation-boosted principal since April.

The yield was slightly higher than the recent market on this TIPS on the secondary market, but yesterday’s tapering announcement from the Federal Reserve probably helped boost the number, at least a bit.

Today’s yield fell between the very low -1.311% of the original auction on April 18 and the more attractive -0.127% for the first reissue on Aug. 22. It’s interesting to note that the high-point of yield came during fears of tapering; now that tapering is official, the yield remains lower. Fear affects markets.

Inflation breakeven rate. With the 5-year nominal Treasury trading today at about 1.65%, this sets up an inflation breakeven rate of 2.025% for this TIPS, meaning that it will outperform a traditional Treasury if inflation averages more than 2.025% over the next five years. Inflation is currently running a very low 1.2% over the last 12 months.

Reaction to the auction. The TIP ETF is trading down very slightly today at $110.19, down 0.25%, and the market barely budged with the auction announcement.

From the Wall Street Journal report:

One positive reflection of the auction, however, was that end-investors bought nearly 60% of the total offering. That included 44.5% taken by indirect bidders and 14.3% taken by direct bidders, who often represent domestic fund interest.

Still, the market’s overall appetite for the new government debt was weighed down by the Fed’s decision to start trimming its asset purchases. In addition, overnight selling by money managers in Asia and Europe “started us on a negative tone to begin the trading session,” said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC.