Treasury Inflation-Protected Securities

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.”

Federal Reserve Chairman Ben Bernanke today told the world what we already knew: The U.S. economy is gradually improving, and if this improvement continues, the Fed will begin tapering off its bond-buying stimulus program, possibly this year.

Bernanke set this all up on May 22, giving the markets just enough of a peek at the policy to send investors into shivers. Today he embellished on the path we knew was coming: The gradual end of ‘eternal QE.’ He said:

• The economy. “Based on its review of recent economic and financial developments, the committee sees the economy continuing to grow at a moderate pace, notwithstanding the strong headwinds created by current federal fiscal policies.”
•  Inflation.  “Inflation has been running below the committee’s longer run objective of 2% for some time and has been a bit softer recently. … The committee expects inflation to move back to the 2% longer-term objective.”
• Interest rates. “The committee reaffirmed its expectation that the current exceptionally low range for the funds rate will be appropriate at least as long as the unemployment rate remains above 6.5% so long as inflation and inflation expectations remain well behaved.:
• Asset purchases. ” The committee has been purchasing $40 billion per month in agency-backed securities and $45 billion per month in Treasury securities. …  Although the committee left the pace of purchases unchanged at today’s meeting it’s stated that it may vary the pace of purchases as economic conditions evolve.”
• Tapering and then ending the asset purchases. “The committee currently anticipates that it will be appropriate to moderate the monthly pace of purchases later this year, and that the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year ending purchases around mid-year.”

My reaction: About time.

This is s pretty cautious approach by the Fed, keeping short-term interest rates extremely low into probably 2016 and continuing its bond purchases for the time being, gradually tapering them down later this year and ending them in 2014. In other words, the Fed will lock short-term rates down, but will allow mid- to longer-term interest rates to begin rising to a ‘more normal’ level, which would mean positive to expected inflation.

If that happens, TIPS yields will need to also rise, probably to the ‘more normal’ yields (plus inflation) of maybe 0.5% for a 5-year, 1.5% for a 10-year, and 2.5% for a 30-year. That would be a painful transition for holders of TIPS mutual funds and TIPS traders, but it would be fantastic for net buyers of TIPS, the buy-and-hold investors looking to preserve capital into retirement.

The market’s reaction: Horror.

Bernanke began speaking at 2:30 p.m. and he had an immediate negative effect on stocks, bonds and even gold. This chart shows exactly what happened, comparing the one-day returns for the S&P 500 (SPY), TIPS ETF (TIP) and gold ETF (GLD):

I keep repeating, ‘None of this was a surprise.’ But the stock, bond and gold markets seem to be living in that Fed-fantasy world of eternal QE. It’s time to get off the bond-buying methadone and bring yields back to reality.

Thursday’s 30-year TIPS reissue. Things are shaping up very well for buyers, with the likely yield rising to about 1.25%, plus inflation. Remember that this TIPS, CUSIP 912810RA8, first auctioned four months ago with a yield of 0.639% and a coupon rate of 0.625%. That means Thursday’s buyers will snag this TIPS at a massive discount, paying about $84.20 for $100 of value.

Of course, yields may be rising in the future and that discount could get even more extreme. But this is the most attractive TIPS auction in about 18 months.

I’ll probably pass on the 30-year (maturity is too long) and hope this trend continues for the new issue 10-year TIPS coming in July.

Over the last couple of years, Treasury Inflation-Protected Securities were the toughest prizefighter in the investment world: You could knock them around a little, but they always came roaring back.

Then … Ben Bernanke spoke.

It was May 22, and the Federal Reserve chairman was speaking to the Congress’ Joint Economic Committee. Although the Fed chairman said a lot of middle-of-the-road mumblings about economic stimulus, jobs and interest rates, the markets seized on this comment about the Fed’s monthly purchases of $45 billion of Treasuries and $40 billion of mortgage bonds:

“At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.”

Later, in response to a question, Bernanke suggested – but only suggested – that the bond buying could be trimmed back in the next few months, if the economy continues improving.

Even before May 22, yields on TIPS had been rising, because of recent reports showing very weak inflation – running just 1.1% over the last 12 months. Now, with the suggestion that Federal bond-buying might slow down or even halt, the trend was locked. Here’s what has happened in those 23 days:

What’s interesting here?  Yields on TIPS are rising much faster than the overall bond market, hitting 2-year highs. Yields on nominal Treasuries, however, are increasing at a slower pace and really haven’t hit unusual levels. For example, on March 19, 2012, the 10-year Treasury hit 2.39%, 20 basis points higher than the current level. On that same day, a 10-year TIPS was yielding -0.03%, 18 basis points lower than today’s level. That’s a 38 basis-point swing.

And so … the ugly truth. TIPS are being battered because investors have lost their lust for this one particular product. That’s a hard trend to reverse. And when overall interest rates do begin climbing, TIPS will be battered even more. When you see a 10-year Treasury at 2.75%, you can expect to see a 10-year TIPS yielding around 0.6%.

For TIPS traders and mutual fund holders, if overall rates really do rise, that’s going to mean more bad news, possibly a decline of another 5%, especially if inflation remains muted.

The bright spot. This trend also means that TIPS are getting cheaper against nominal Treasurys, and more attractive to the buy-and-hold investor. If you are a buying small amounts with each auction, the outlook is good. Higher yields are a good thing.

The Treasury will announce tomorrow that it will reopen CUSIP 912810RA8, creating a 29-year, 8-month Treasury Inflation-Protected Security that will auction Thursday, June 20. Update: Here is the announcement.

This TIPS will have something going for it that’s been extremely rare: a discount. It originally auctioned Feb. 21 with a coupon rate of 0.625%, and a yield to maturity of 0.639%. It is currently selling on the secondary market for about $87 for $100 of value and a yield of 1.132%.

Yields on TIPS have been rising sharply since May 1. According to the Treasury Resource Center, the yield on a 30-year TIPS rose from 0.44% on May 1 to 1.14% on June 11. That’s an increase of 70 basis points, and it makes this 30-year offering a lot more interesting.

Buyers will get around 1.14%, plus inflation, over 30 years. Sound appealing?

The negatives. There are a couple of caveats, though.

Number 1 is: Will you be holding this issue to maturity? If so, you need to be ready to ride out — and ignore — some wild price swings. This TIPS originally auctioned for $99.61 and has fallen to $87. That’s a drop of 12.7% in four months.

If you are holding to maturity, no problem. You’ll get your 1.14%, plus inflation, and you can ignore the market noise. But this brings up negative Number 2: Will you be alive in 30 years? This is especially important if you are buying this TIPS in a taxable account. Here’s why:

Let’s say you put $10,000 into this TIPS, which will pay that coupon rate of 0.625% on a principal balance that will rise with inflation. And let’s say inflation averages 2.5% over the next 30 years. You will owe current-year taxes on $313 a year, and that number will rise. If you are in a high tax bracket your bill will be maybe $140 a year. But the coupon on this TIPS will provide you with only $62.50 a year, not enough to pay the taxes owed.

So this TIPS will be cash-flow negative until maturity. If inflation escalates, it will be even more negative.

So you will want to live to maturity, to see that money you’ve been paying taxes on for 30 years. If you die, you lose.

This is why I prefer buying 10-year TIPS and having them mature at a set date in the future, when I can decide to spend the money or reinvest.

The appeal. A yield to maturity of 1.14% (or possibly higher) will be the best yield on any TIPS auctioned in more than two years. I can see the appeal of adding that to a TIPS portfolio, just to get a boost in income. It is still below the ‘more normal’ yield of 2% to 2.5% that long-term TIPS buyers expected in the past, as this chart shows:

Another positive is the inflation breakeven rate versus a nominal 30-year Treasury, which closed Wednesday with a yield of 3.33%, up 50 basis points since May 1. That sets the probable breakeven rate for this TIPS at 2.19%, and that number could drop a bit before the auction.

It’s not much of a gamble to expect inflation higher than 2.19% over the next 30 years.

One more thing to consider. If the Treasury follows its usual pattern – and I expect it will – this 30-year TIPS will be reopened one more time in October. So you’ll need to ask yourself: Where are rates headed over the next four months? Buy in June, or wait for October?

Also, a new 10-year TIPS is coming in July.