Treasury Inflation-Protected Securities

I’ve raised this issue before, and I hope this is actually the last time I need to raise it, since yields on TIPS have risen dramatically since February 2013.

But here is the problem: If you bid on CUSIP 912810RA8 at Thursday’s auction, in a taxable account (such as TreasuryDirect), you will very likely be cash-flow negative until the TIPS matures 29 years, 4 months from now.

Here are the facts:

• CUSIP 912810RA8 was originally auctioned on Feb. 21, 2013, with a coupon rate of 0.625%. That coupon rate, the actual interest you receive each year, will never change over the next 29 years.
• On Thursday, you can buy CUSIP 912810RA8 at a substantial discount, because the yield to maturity is now running about 1.30%. That means you can buy this TIPS at about $83.10 for $100 of value.
• However, buying at a discount means you are more or less buying a zero-coupon TIPS, so you pay $83 today and get $100 in February 2043.
• So, let’s say you buy $100,000 of this TIPS at auction Thursday, in a taxable account. You’ll pay maybe $83,000 for that $100,000 value. (I am ignoring any adjustment for accrued principal since February.)
• For the next 29 years, you will be getting about $625 of income from the TIPS coupon rate of  0.625%. The yearly payout will grow with inflation, as the TIPS principal rises.
• Also, the TIPS principal balance will climb with the rate of inflation. So if inflation averages 2.5%, your principal will increase about $2,500 a year, rising with inflation.

And there is the problem …

• The IRS views the inflation adjustment to principal a taxable event for the current year. So you’ll owe income taxes on $3,125 a year ($625 + $2,500) in 2014. If you are in a 38% federal tax bracket you would owe $1,187.50.
• But your coupon rate gives you only $625 a year.
• You are cash-flow negative $562.50. If inflation averages higher than 2.5%, then you’d be even more cash-flow negative.
• That will continue for 29 years until the TIPS matures and you get your zero-coupon payout of $100,000 plus inflation.
• At that point, all the money comes to you tax-free, except for the small final interest payment. But it was a long time to wait to go cash-flow positive.

The solution

• Don’t buy this TIPS in a taxable account.
• Wait until February 2014, when a new 30-year TIPS will be issued with a coupon rate (hopefully) at 1.54% or higher. That would push your return to tax-flow positive, even in a taxable account, assuming inflation of 2.5%.
• At 1.54%, you’d get $1,540 in income each year, rising with inflation. At 2.5% inflation you’d get $2,500 in principal adjustment. You’d owe taxes on $4,040. At at 38% tax bracket you would owe $1,535.
• You are cash flow positive.

Well, it’s actually a reopening of CUSIP 912810RA8, so buyers will be getting a 29-year, 4-month TIPS with a coupon rate of 0.625%. It will be going off at a huge discount, showing how volatile 30-year Treasurys can be.

Right now, it’s looking like the yield will come in at 1.38%, plus inflation. That’s where this TIPS was trading on the secondary market Monday. Today’s rather weak jobs report – read the Reuters report – could give TIPS and Treasurys a boost, pushing the yield lower.

That 1.38% yield means this TIPS will be priced around $81.25 for $100 of value. That’s a fall of 18.7% since the original issue in February.

Does it make this issue attractive? Somewhat. Getting a TIPS with a yield above 1% has been very rare in the last three years. I think I counted 26 of the last 27 TIPS auctions with a yield below 1% – the only exception was when this same TIPS was reopened in June at 1.42%.

But the June (1.42%) to October (1.38%) trend shows that TIPS yields have stalled after the strong move upward beginning in May 2013. So the price buyers pay might actually be higher Thursday than it was in June.

With a 30-year nominal Treasury trading at 3.68%, the inflation breakeven rate for this TIPS stands at 2.3%, not particularly cheap. That means if inflation averages more than 2.3% over the next 30 years, this TIPS will outperform the traditional Treasury.

I do think inflation is likely to be higher than 2.3%, and I’d definitely buy this TIPS over a 30-year Treasury, just to get the inflation protection.

The key issue is: Will rates be rising by mid-2014? I suspect they will be, and so I’m going to be patient. The Federal Reserve can’t continue bond-buying forever, can it? (Ummm …) But the bigger problem is a dysfunctional U.S. government that can’t make even short-term budget decisions, let alone addressing giant spending issues arising in the next 25 years.

Inflation is a definite threat for the future.

Edvard Munch painted four versions of The Scream, plus the lithograph shown above.

One of the side effects of the U.S. government fiscal circus of the last few weeks is that  Federal Reserve officials must be sitting on the sidelines, mouths open in horror. Sort of like Edvard Munch’s famous paintings and lithographs. What are they doing?

So, today, the Wall Street Journal’s ‘Heard of the Street’ column (‘Shutting the Fed’s Taper Plans‘) confidently predicted a complete shutdown of taper talk until the federal government comes up with some sort of consensus on the budget and debt limit.

Up until Sept. 19, the markets had been betting the Federal Reserve would begin a gradual tapering of its bond-buying economic stimulus program. But on that day, the Fed decided to put taper on hold. That was probably a wise move, given the huge disruptions this month caused by the government shutdown and debt-ceiling brinksmanship.

Now, with only a short-term agreement in place, Congress has effectively given the Fed a free pass to continue the bond buying into 2014. The Wall Street Journal notes:

If the numbers look good, Fed policy makers at their December meeting might feel justified in scaling back the central bank’s bond-buying program. But that would ignore one crucial consideration: With the budget deal funding federal agencies only through Jan. 15, and raising the debt ceiling only through Feb. 7, another battle could be brewing.

The Fed will probably want to avoid doing anything to discomfit markets until the risk of another showdown has passed. That pushes the likely timing for starting the tapering process to the Fed’s March meeting …

What does this mean for holders and buyers of Treasury Inflation-Protected Securities? I think we can see yields lingering in this current range, around 0.40% for a 10-year TIPS and 1.35% for a 30-year TIPS, well into next year. Yields have fallen more than 50 basis points since an early-September peak. We probably won’t get that 50 back in the near term, and I don’t think we’ll see much of a fall from here, if the economy remains stable.

We don’t know the answer to this question because of the partial U.S. government shutdown. The Bureau of Labor Statistics was due to release its September inflation report today at 8:30 a.m., but it is has not been gathering data since Sept. 30. So … no report. Instead we get this notice on the BLS site:

This website is currently not being updated due to the suspension of Federal government services. The last update to the site was Monday, September 30. During the shutdown period BLS will not collect data, issue reports, or respond to public inquiries. Updates to the site will start again when the Federal government resumes operations. Revised schedules will be issued as they become available.

Update: The BLS now says it will release the CPI report on Wednesday, Oct. 30. Here is the update – 0.2% inflation in September.

This inflation number, known as the Consumer Price Index, is important. For example, the September inflation rate is the final piece used by the Social Security Administration to determine its annual cost-of-living adjustment for beneficiaries. Of course, CPI-U is also used to set the daily principal adjustment for Treasury Inflation-Protected Securities, and goes into the data determining the future interest rate paid by US Savings I Bonds.

So now what? The Wall Street Journal reports today that the Treasury will now be forced to generate its own data. The figure will be based on the last available 12-month change in CPI, which was a meager 1.5% (one of the lowest of recent years). From a Treasury document:

(iv) If the CPI for a particular month is not reported by the last day of the following month, we will announce an index number based on the last available twelve-month change in the CPI. We will base our calculations of our payment obligations that rely on that month’s CPI on the index number we announce.

(The principal adjustment for TIPS has already been established through Oct. 31, so there is no immediate effect from the delayed data. For example, here are the data for the 30-year TIPS being reissued on Oct. 24.)

The Journal also notes that the BLS has already gathered the September data, so once the shutdown ends, it can issue the report very quickly. But the October report is in jeopardy because the agency has not been gathering data for more than half a month.

The U.S. Treasury will formally announce this Thursday, but it has already indicated it will reopen CUSIP 912810RA8 at auction on Oct. 24, creating a 29-year, 4-month Treasury Inflation-Protected Security.

Update: Here is the Treasury announcement

This will be an especially interesting auction because the announcement comes on the very day the Treasury predicts it will hit its debt ceiling. If this political crisis continues on for days or even a week beyond Oct. 17, it could roil Treasury, stock and bond markets. But I doubt that will happen.

This auction will also be interesting because buyers will be getting this TIPS at a huge discount from its original price on Feb. 21, when it auctioned with a coupon rate of 0.625%, and a yield to maturity of 0.639%. CUSIP 912810RA8 is now trading with a yield of about 1.4% and a price of about $81 for $100 of value. (The price buyers pay will also reflect about $1.70 in inflation adjustment since the February auction.)

A TIPS with a yield well above 1% (plus inflation) has been a rare thing recently. The only other auction with a yield above 1% was for this same TIPS in a June reissue, which netted a nice yield of 1.42%.

TIPS were under attack in June. On that auction date, the 30-year traditional Treasury was yielding 3.49% and it has since risen 25 basis points to 3.74%. The 30-year TIPS yield has actually declined a couple of basis points. That puts a pinch on the 30-year inflation breakeven rate, which currently stands at about 2.34%.

My theory is that a 30-year TIPS should pay at least 2% above inflation, which approximates the historical return for U.S. Treasurys. Looking back at historical data supports this, but there’s a big gap in the history because the Treasury halted 30-year TIPS auctions from 2002 to 2009, when TIPS yields were in a fairly stable pattern.

At this point, this auction will be very interesting to watch, maybe the most interesting of the year. If you are looking to give your TIPS ladder an interest-rate boost, and you can tolerate the ups and downs of a volatile 30-year issue, this will be one to consider.