Treasury Inflation-Protected Securities

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.”

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.