Treasury Inflation-Protected Securities

The Treasury today is reopening CUSIP 912828VM9, creating a 9-year 8-month Treasury Inflation-Protected Security. This TIPS trades on the secondary market, so we can get a pretty good idea of the likely yield, which was 0.587% (plus inflation) at the market close on Wednesday.

It’s trading around 0.62% right now, so the race is on to a higher yield when the auction closes at 1 p.m.

There’s been a big bump in yield in the last week, a good thing for buyers. Last week, when I previewed this auction, the TIPS was trading at 0.481%. The TIPS ETF has seen a fairly sharp two-day decline leading up to this auction:

I’m speculating, but a well-publicized negative opinion on TIPS from the investment firm BlackRock might have something to do with this jump in yields. Barrons picked this up in an article titled: ‘TIPS Are Still Expensive, Keep Avoiding Them‘. I can’t argue with the main points: That Treasurys are still overbought and TIPS are hurt by the current rate of inflation, which is extremely low. This was double-confirmed in Wednesday’s inflation report.

From the BlackRock report:

(W)e don’t believe investors need to increase holdings that are designed to protect against inflation, especially if those asset classes are expensive. In particular, we have a negative view toward Treasury Inflation-Protected Securities (TIPS). The absence of inflation is a key reason why TIPS have underperformed so much in 2013.

An update on inflation

Inflation in October fell 0.1 percent on a seasonally adjusted basis, and was just 1.0% over the last 12 months, the U.S. Bureau of Labor Statistics reported Wednesday.

The non-seasonally-adjusted CPI-U, which is used to adjust the principal balance of TIPS and set future inflation-adjusted interest rates on I Bonds, was even worse, falling 0.3% in October and rising only 1.0% over the last year.

For TIPS buyers, this is a double whammy. Buyers have been accepting yields near or below inflation over the last two years, and now inflation has turned into deflation. This stark reality ought to cast a pall over today’s auction.

On the other hand, the weak inflation report leaves the door open for continued economic stimulus from the Federal Reserve, a fact that in normal times would heighten inflation fears and boost the desirability of TIPS. That’s not likely to happen, today at least.

Conclusion. While buyers are getting a better-than-expected yield, this TIPS auction ought to have all the appeal of a moldy coffee mug. With inflation this low, TIPS buyers should be demanding a yield at least approaching 1.0% over inflation. Let’s see how it goes.

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The U.S. Treasury formally announced yesterday that on Nov. 21 it will reopen CUSIP 912828VM9, creating a 9-year 8-month Treasury Inflation-Protected Security.

View the Treasury announcement.

This TIPS has an interesting history, because it was reissued on Sept. 19, the day after Ben Bernanke and the Federal Reserve backed off on any tapering the Fed’s bond-buying economic stimulus program. This ‘extension’ of QE3 gave the TIPS market a double boost, because 1) it meant the Fed would continue manipulating the Treasury markets, driving down yields and 2) it raised fears of future inflation based on runaway currency creation. I said at the time that TIPS buyers had been ‘Bernanked.’

So here is CUSIP 912828VM9’s history:

• First auctioned on July 18, 2013 with a coupon rate of of 0.375% and a yield to maturity of 0.384%, the highest in two years for any 9- to 10-year TIPS.
• Reissued on September 19, 2013 with a yield to maturity of 0.5%. But this yield was down substantially from the prevailing yield of 0.8% this TIPS was trading at before Bernanke blinked.
• It is now trading on the secondary market with a yield of 0.481%.

I consider the 10-year maturity the ‘sweet spot’ for TIPS purchases, because buyers benefit from the higher yield while also retaining a manageable maturity. By manageable I mean: I’ll be alive when this thing matures.

So looking at the big picture, this reissue is attractive. Buyers will get the TIPS at a discount, around $99 for $100.05 of value, calculating in the meager 0.5% inflation we’ve seen since July.

But I still hear a voice calling out: ‘This yield should be higher.’ The Fed’s efforts to keep longer-term interest rates low has had an effect: Just look at stock prices soaring while Treasury yields are holding at relatively low levels. Something has to give.

With the 10-year Treasury trading at 2.69% and this TIPS yielding around 0.48%, you are looking at an inflation breakeven rate of 2.21%, in the moderate zone but definitely not cheap. Back in July this number was 2.136%, indicating that TIPS have gotten more expensive relative to nominal Treasurys.

It has been a wild year for TIPS yields and I suspect we will see more of the same in 2014. The 10-year yield started 2013 at -0.62% and rose to 0.92% on  Sept. 5. That is an amazing swing of 154 basis points. Since September, though, yields have fallen more than 40 basis points.

So the best deals for TIPS buyers happened to be in the late summer and early fall. But the boost in yields gave us a hint of what may be coming: ‘Normalized’ yields, returning to possibly 1.5% or even 2.0% on a 10-year TIPS.

Confession: I purchased 912828VM9 back in July in the heady days of positive yield! Waiting would have turned out better. But one thing is always true: Buying TIPS and holding them to maturity is never a bad investment.

A year ago, on Oct. 28, 2012, I wrote a post titled ‘Vanguard’s new short-term TIPS funds: Better than cash?‘ and asked if funds investing in short-term Treasury Inflation-Protected Securities could be an alternative to a money-market fund.

Back then, short-term bond funds were the rage, and short-term TIPS funds were even more popular (which might have ended up skewing their returns.) I noted then that these funds are conservative:

• Since they hold only Treasurys, there is no credit risk.
• Since they hold only short-term maturities, there is lessened interest-rate risk.
• Their return will be bolstered if we see a period of unexpected inflation.

On the other hand, there are negatives:

• The return is miniscule.
• We have seen extremely low inflation.
• Although interest-rate risk is minimized, there is still a real risk that these funds will decline in value.

As an alternative, an investor could simply buy 5-year TIPS each year at auction  and hold them to maturity, building a ladder of 1- to 5-year TIPS and eliminating all risks. But that would eliminate liquidity, and that is a key part of the appeal of short-term TIPS funds.

But can they really substitute for a cash account? Here is how the Short-Term Inflation-Protected Securities ETF (VTIP) performed against cash (0.0% return) in the year since I wrote that article:

VTIP has lost 0.82% in value since Oct. 31, 2013, and according to Morningstar data, it has had a trailing 12-month total return (including dividends) of -0.88%. So it has not outperformed cash paying zero interest.

So, answering my question of a year ago: No, VTIP was not better than cash.

The fund showed unusual volatility in the summer of 2013 as the bond market grew worried about the potential end of Federal Reserve bond-buying. VTIP has since recovered, but you don’t expect to see this kind of volatility in a fund you are holding as a cash alternative.

Take a look at how VTIP has performed against another ETF, the Vanguard Short-Term Corporate Bond ETF (VCSH), a fund that would be considered slightly more risky than a short-term Treasury ETF:

While VTIP initially outperformed short-term corporates, the performance of the two funds ends up being nearly identical over the last year, with both losing about 0.8% of value in NAV.

However, VSCH with its better yield had a much better total return over the last 12 months: 1.44%.

This chart sums up the year for VTIP and other bond funds, adding in Vanguard Prime Money Market (VMMXX) and Vanguard Total Bond ETF (BND).

In conclusion:

• VTIP underperformed cash as its net-asset value fell through 2013.
• VTIP underperformed short-term corporates, because in a time over very low inflation it couldn’t match the yield of corporate bonds.
• VTIP outperformed the total bond market, which yields more but faces higher interest-rate risk.