Treasury Inflation-Protected Securities

The U.S. Treasury on Thursday issued its formal announcement for the April 18, 2013, auction of a new 5-year Treasury Inflation-Protected Security.

This will be CUSIP 912828UX6, and although the coupon rate will be set at auction, we can say with 100% certainty that it will be 0.125%, the lowest rate the Treasury allows on TIPS. The yield to maturity is likely to be somewhere near -1.69%, maybe a bit higher.

Although several consecutive 10-year TIPS auctions have failed to set record low yields, this 5-year TIPS will probably blow out the record low for any 4- to 5-year TIPS, -1.496% for an auction last December. Here is a history of 5-year TIPS auctions running back to 2005:

I’ve highlighted the last three auctions to show the trend of a sharply declining yield, and that trend appears likely to continue in Thursday’s auction. Compare that with the reverse trend in 10-year TIPS:

So 5-year TIPS must have some sort of magical appeal? Why are they so desirable? I can think of only one reason: There has been a surge of money pouring into shorter-term TIPS funds and this has expanded demand for TIPS of 5-year maturities or less.

For the small investor, maybe those short-term TIPS funds make sense, although they offer very little, if any, return. But buying this new 5-year TIPS will have you fighting a trend – one that’s working against you. To demonstrate this, I will compare this year’s TIPS auction versus last year’s (April 2012) and other similar investments:

The key here is that the yield to maturity on a 5-year TIPS has dropped 61 basis points, double, triple or quadruple the decline for nominal Treasuries. An insured 5-year bank CD has barely budged. I Bonds, of course, still pay inflation minus nothing. And this has happened at a time of declining inflation, creating a double whammy for TIPS buyers.

But what about the ‘real’ return, after inflation? Isn’t that where a TIPS should shine? This chart shows the real return buyers could expect at the time of purchase, 2012 vs. 2013:

Because inflation has declined and the TIPS yield has also dropped, the current TIPS yield of -1.69% is dramatically more expensive than similar investments, all of which are yielding a better return against current inflation, compared with last year. Except for I Bonds, of course, which pay inflation no matter what.

OK, let’s say you believe the current rate of inflation can’t continue, and you believe it is going much higher. (The current trend in housing prices supports that theory, but the weak job market counters it.) Let’s say inflation doubles, to 4%. How would this 5-year TIPS perform, versus 2012 and similar investments?

Here’s a manta for TIPS buyers: The yield to maturity is the real return. When you buy a TIPS with a yield of -1.69%, you are getting an after-inflation return of -1.69%, no matter how high inflation goes. However, this chart shows that in 2013, a 5-year TIPS provides a better real return at 4% inflation than similar investments, except the stalwart I Bond, which is clearly superior.

It also shows that a 5-year TIPS has gotten much more costly than similar investments in the last year.

That is the trend buyers at next week’s auction are fighting.

The TIP ETF was down about a half percentage-point today, closing at $121.24 but still not far off  the all-time high of $123.44. The chart for the last five days is looking a bit sickly:

The TIP ETF rebounded nicely after dipping to near $120 in mid-March. So much for warnings of a ‘bond bubble.’ But in the last five trading days it has again dipped, under-performing the AGG EFT (aggregate bond index.)

Today the Federal Reserve pulled a shocker by accidentally releasing minutes of its latest policy meeting 19 hours before the expected time. The Wall Street Journal reports:

The Fed said Wednesday that a staff member in its congressional liaison office accidentally released minutes of a March 19-20 policy meeting Tuesday afternoon to many of his contacts, including Washington representatives at Goldman Sachs Group Inc., Barclays Capital, Wells Fargo & Co., Citigroup Inc. and UBS AG. …

Officials at the Fed didn’t notice the mistake until about 6:30 a.m. Wednesday, after which they scrambled to release the information to the wider public, which was done at 9 a.m. A Fed spokesman said: “Every indication is that [the release] was entirely accidental.”

So the slip-up overshadowed the actual news in the minutes, which is that the Federal Reserve seems to be considering a halt to its bond-buying stimulus program, possibly this year.  Here is another Wall Street Journal report:

The minutes of the March 19-20 meeting showed that “all but a few” Fed officials agreed the central bank would likely want to keep the program going “at least through midyear.” After that, officials had a wide range of views about how they might proceed. …

For now, Fed officials agreed, “additional purchases would be necessary to achieve a substantial improvement in the outlook for the labor market,” the minutes showed

I don’t think anyone seriously believed the Fed was considering an immediate end to the bond-buying, which has forced Treasury interest rates to extreme lows. So the news here was more that the stimulus could end earlier than the ‘sometime in 2014’ that was once planned, or at least hinted.

The stock market liked the news, with both the Dow and the S&P 500 closing today at all-time highs. Bonds took a hit, though, with the 10-year Treasury yield climbing to 1.84% from yesterday’s 1.78%.

An end to stimulus will mark a major change for nominal Treasurys and TIPS. Their extremely low yields have been supported by lavish Federal Reserve purchases, and when that ends – even if the Fed doesn’t begin selling its stockpile – interest rates will rise.

So I think the Fed’s message was read two very different ways: 1) The stock market saw easy money continuing through at least midyear, and 2) the Treasury market saw bond-buying possibly ending after midyear.

The result was that – finally – stocks and bonds diverted. It’s been amazing to see the stock market hitting all-time highs while at the same time the Treasury market was returning toward all-time low yields.

Something was wrong with that picture.

Investors get another chance to demonstrate insanity on Thursday, April 18, 2013, when the U.S. Treasury will auction a new 5-year Treasury Inflation-Protected Security.

This thing will be expensive. CUSIP 912828UX6 will have a coupon rate of 0.125% and will probably auction with a yield of about -1.7%. That means buyers will be paying up for a 1.825% boost to yearly income, probably about $109 for every $100 of value. (The last new issue of a 5-year TIPS went off in April 2012 with a yield to maturity of -1.080% and a cost of $106.38 per $100 of value.)

I get a lot of feedback from readers who dismiss buying short-term TIPS because of the negative yield, and I understand that. And paying up for a TIPS is a poor strategy because it undercuts the deflation protection TIPS provide. When you pay $100 for $100 of a TIPS (as in the good old days), at maturity you get back $100 plus inflation. When you pay up, your premium is at risk because at maturity you get back $100 plus inflation. If there was no inflation, you get back $100.  Bad deal.

But is buying this 5-year TIPS an act of insanity? No, it is not. Actually, it makes some sense for the big-money folks: Hedge funds, foreign banks, foreign governments. They are looking to stash money in a super-safe, inflation-protected investment and can afford to make little or no income.

And … it matures in five years. That makes it easy to buy and hold-your-nose.

For the small investor, though, this 5-year TIPS looks like a loser. The 5-year time-frame opens up competing investments, such as bank CDs and especially U.S. I Bonds, that aren’t practical for the super-big-money investors. When comparing these investments, you need to look at how they will perform under varying inflation rates.

This chart of actual returns shows that a bank CD paying 1.7% (you might find better) will outperform a 5-year TIPS and I Bonds up to an inflation rate of 1.7%. Once inflation reaches 1.8% – the current rate is 2.0% – or higher, I Bonds outperform. A 5-year TIPS won’t outperform a bank CD until inflation reaches 3.5% or higher.

But what if you look at after-inflation return?

The bank CD outperforms up to an inflation rate of 1.7%. The I Bond outperforms at inflation rates of 1.8% and higher. The TIPS outperforms the bank CD only when inflation reaches 3.5% or higher.

Conclusion: When there’s actual inflation, I Bonds are clearly superior, and you should buy them to the max ($10,000 per person per year at TreasuryDirect). Purchases through April will pay the inflation-adjustment rate of 1.76% for six months. Earnings are tax-free until you sell the bonds.

After the I Bonds, where do you go with money you want in a super-safe investment, a 5-year TIPS or a 5-year bank CD?

• If you think we are heading toward deflation and economic Armageddon, buy insured bank CDs or traditional U.S. Treasurys.
• If you think inflation will remain tame over the next five years, buy bank CDs.
• If you believe inflation will average 3.5% or higher over the next five years, feel free to buy the new 5-year TIPS being auctioned April 18.

It’s not insanity. It’s math.

If you buy and hold Treasury Inflation-Protected Securities at TreasuryDirect, as I do, you’re violating a conventional wisdom rule of investing: Don’t hold TIPS in a taxable account.

I disagree with that conventional wisdom, more or less, but mainly because holding TIPS in a tax-deferred account generally means buying TIPS mutual funds instead of the actual issues. Or, a brokerage like Vanguard or Fidelity will allow you to buy TIPS at auction and  hold them in an IRA account. But then you end up trying to find ways to invest and/or reinvest cash distributions and maturities.

So while holding TIPS in a tax-deferred account is preferable, I say holding them as a taxable investment at TreasuryDirect is also acceptable as part of your overall fixed-income asset allocation.

But, TIPS are different. TreasuryDirect, I have to say, is absolutely not user friendly. While every brokerage and investment firm on Earth mails you tax forms (or at least notifies you they are ready to download), TreasuryDirect does nothing. You will get nothing in the mail, you will not receive an e-mail alert. You are expected to remember to log in to TreasuryDirect.gov and retrieve your tax forms:

• Form 1099-INT shows the sum of the semiannual interest payments made in a given year. This income is generated by the TIPS’ coupon rate, and is taxable at the federal level but tax-fee at the state.
• Form 1099-OID shows the amount by which the principal of your TIPS increased due to inflation or decreased due to deflation. Increases in principal are taxable for the year in which they occur, even if your TIPS hasn’t matured, so you haven’t yet received a payment of principal.

So 1) you find your own tax forms, and 2) you print them and 3) these Treasury forms are like no other you’ll see from Vanguard or Merrill Lynch. They just list the amounts paid for each TIPS and give you a total. At the bottom are some definitions for IRS box numbers that are never specified on the form itself. Very weird. The Treasury could do better.

Form 1099-OID is the one behind the conventional wisdom to invest in TIPS in tax-deferred accounts. You are paying tax on money you have not yet received. This is often called ‘phantom income.’ However, if you have a Total Bond Fund or GNMA Fund in a taxable account and reinvest the dividends, or have a 5-year CD at a bank and are reinvesting interest, you are doing exactly the same thing. You are paying tax on money you have not yet received.

(Read this for a scholarly treatise, including incomprehensible formulas, debunking the conventional wisdom about holding TIPS in a taxable account.)

When the TIPS matures, here’s the good thing: You don’t owe any tax on the accumulated inflation-adjusted principal, because you’ve prepaid it. So if you bought a $10,000 10-year TIPS in 2010 and it matures in 2020 with a 23% inflation boost to principal, you get $12,300 and you owe no tax. This could work in your favor for allocating spending money in retirement.

But the dreaded 1099-OID is the big reason I Bonds are preferable to TIPS, especially when they offer a favorable return, as they do now well up the maturity ladder. With I Bonds, your principal keeps increasing by the rate of inflation plus the base interest rate (which is currently zero for new I Bonds). You owe no tax on I Bonds until you redeem them, and you can hold them for 5 to 30 years before redeeming without any penalty.

I Bonds also offer a strategic advantage for retirement spending money because you could redeem them gradually to space out the tax owed. They are the ultimately flexible super-safe investment: 1) inflation protected, 2) deflation protected, 3) tax protected and 4) you choose the maturity date.

Big question mark over 30-year TIPS. If you buy a 30-year TIPS at auction – your next chance is a reissue on June 20, 2013 – you will get a coupon rate of about 0.625%. That means if you bought $10,000 in June, you’d get about $62.50 in annual interest, but that would grow as the principal grows with inflation.

However … let’s say inflation averages 3% in coming years. Your taxable adjustment to principal would be $300 a year, and it would also grow as your principal rises.

In this example, you’d owe federal taxes on $362.50, resulting in a tax of $100 or more. But you got only $62.50 in actual interest payments. So this TIPS will have a negative cash flow for 30 years.

The big question is: Will you be alive in 30 years? If not, you will never see the money that you are paying tax on. That makes no sense.

If you buy a 30-year TIPS and plan to hold to maturity, make sure you live 30 years.