Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities are almost entirely risk free when bought and held to maturity. Default risk? As close to zero as you can get. Inflation risk? Covered. Duration risk? Hold to maturity and forget it. Downgrade risk? We’ve been through this and it actually caused TIPS values to rise. Liquidity risk? Hold to maturity and forget it.

But there is this one nagging thing: Reinvestment risk.

The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. – Investorwords.com

One way to minimize reinvestment risk is to build a ladder of bonds with maturities stretching out many years. Each year, as a bond matures, you buy another of a set maturity. My preference is to build the ladder with 10-year TIPS purchased at auction, because the 10-year maturity seems to be the ‘sweet spot’ for yield and term. I worry about the negative cash flow of taxable 30-year TIPS.

Reinvestment risk is something that longtime TIPS holders are facing right now. Each year, we have TIPS maturing with real yields of 1.5% to 2.5%. For most of the last two years, we faced replacing these with TIPS paying yields negative to inflation. That is a 200 to 300 basis point drop in return.

Depressing. My reaction was to stop buying TIPS from July 2011 to May 2013, but I continued buying I Bonds, which have an open-ended maturity date, up to 30 years. So here is what my TIPS ladder looks like right now:

My ladder actually remains pretty intact, with TIPS maturing in 2014, 2016, 2017, 2019, 2020, 2021, 2023, and then jumping out to 2029 and 2041.

But notice that I have ladder rungs missing in 2015 and 2018. I can’t do anything about 2015, but I can fill the 2018 spot with August’s reissue of a 5-year TIPS. Normally, I wouldn’t get too excited about a 5-year TIPS with a yield of about -0.47%, but I think this would a good investment to fill the gap.

It won’t return much, but it will set aside money for me to reinvest in 2018, probably into a TIPS maturing in 2028. When that matures, I will be 75 years old. I will have punted money forward to my 75-year-old self.

I had a 10-year TIPS mature in July and I thought it would be interesting to look at how that Treasury Inflation-Protected Security performed against a traditional 10-year Treasury. Did it outperform? By how much?

So here are the basic details: The TIPS was CUSIP 912828BD1 and it was auctioned on July 9, 2003, with a coupon rate of 1.875% and a yield to maturity of 1.999%. That means this TIPS was sold at a discount to par, $98.881 for each $100 of value.

On the same day – July, 9, 2003 – the 10-year Treasury closed at 3.73%. This established an inflation breakeven rate of 1.731%. (3.73 minus 1.999 = 1.731%). I didn’t know it in 2003, but this was an excellent breakeven rate. It meant that if inflation averaged more than 1.731% over the next 10 years, this TIPS would outperform the nominal Treasury.

So, what happened? It turned out that the next 10 years were a period of extremely low inflation, averaging 2.4%, the lowest of any 10-year period in 50 years. There was a two-year period, from 2009 to 2010, when inflation was actually negative, falling -0.2%. (You can find detailed inflation data on eyebonds.info, a site that is loaded with data about TIPS and I Bonds.)

And yet, despite that weak inflation, this TIPS greatly outperformed the Treasury.

The lesson? The inflation breakeven rate does matter. When it falls below 2%, TIPS are cheap relative to Treasurys. When it rises above 2.5%, TIPS are expensive. (This assumes long-term inflation trends continue, we can never be sure.)

In September 2012, the 10-year breakeven rate rose above 2.6% and earlier this year  above 2.5%, a rate that’s higher than the last 10 years of inflation. After weeks of turmoil in the bond markets, it has settled in about 2.21% after recently dipping below 2%.

Back in 2003, when the economy was still in shock from the Internet crash, investors were pricing in very low inflation (1.731%). That was fortunate for buyers of CUSIP 912828BD1.

And here are the numbers:

Note: The 10-year Treasury in this example is theoretical, since there wasn’t a 10-year Treasury auction on July 9, 2003. The TIPS numbers are the actual interest payments from a $10,000 investment in CUSIP 912828BD1, reconstructed with data from eyebonds.info.

Here’s a 1969 menu from a restaurant in my hometown, Rockford IL. It’s a reminder about why we need protection from inflation. Click on the image to see it larger.

I was updating my TIPS Q&A page today and I realized that I never really answered this question: Who should buy TIPS? So here we go …

First off, I want to state loudly that TIPS are for preserving wealth, not building wealth. If you are in the early stages of investing and far from your long-term needs for buying a house or for paying for college or especially for retirement, TIPS aren’t going to be a great investment. That’s especially true when yields are less than 1% over inflation. You probably won’t build enough wealth to meet your goals.

(There was a time, in the late 1990s when the stock market was bubbling, that TIPS paid nearly 4% above inflation. That was a screaming buy, no matter your situation, as a long-term buy-and-hold investment, or even as a speculation. Those days are long past.)

So who should buy TIPS?

If you are nearing retirement, or in retirement, and have an adequate nest egg, then TIPS make sense as part of your investment portfolio – especially if you buy and hold them to maturity. That strategy is risk-free, and you can protect a part of your savings from the dangers of unexpected inflation.

I think of TIPS as a way of punting money into the future. You will need it then. With TIPS paying a positive yield, you can preserve the current value against the threat of inflation. If you buy and hold to maturity, you have a lot of certainty – X dollars coming on X date.

But even then, I think TIPS, I Bonds and bank CDs should make up no more than 30% of your portfolio. Put the rest in stock and bond index funds, whatever matches your risk tolerance. In the past, I have suggested something like:

• 10% Highest risk: International, small cap stock index funds
• 30% Higher risk: U.S. stock index funds
• 35% Lower risk: Broadly diversified bond funds, municipal bonds
• 25% No risk: TIPS, I Bonds, insured bank CDs, Treasuries held to maturity

I Bonds are a special case, since there is a limit on purchases of $10,000 per person per year. If you want to build a large stake, you need to start early. I think I Bonds could work well for almost any investor. They are flexible enough to be a 1-year savings account, or a 30-year investment, with taxes deferred.

The U.S. Treasury just announced that its auction of a new 10-year Treasury Inflation-Protected Security resulted in a yield to maturity of 0.384%, the highest in two years for any 9- to 10-year TIPS.

This is CUSIP 912828VM9 and it will have a coupon rate of 0.375%.  That means buyers will pay very slightly less than par, but when accrued interest is added in the price will be nearly exactly $100 for $100 par. Here is the announcement.

This is the highest auction yield for any 9- to 10-year TIPS since July 2011, when a new issue 10-year TIPS went off with a yield of 0.639%. It is also the first positive yield for this term of TIPS since November 2011. (TIPS pay a base coupon rate, plus the principal grows at the rate of inflation until maturity.)

Although 10-year TIPS yields have backed off a recent high of about 0.64% on July 10, they’ve still seen a remarkable surge in 2013. Remember, a 10-year TIPS auctioned in January at -0.630% and was reissued in March at -0.602%. This is a gain of about 97 basis points in four months.

Inflation breakeven rate. The 10-year Treasury closed yesterday at 2.52%, so this TIPS has a breakeven rate of 2.136%. That means it will outperform a nominal Treasury if inflation averages more than 2.136% over the next 10 years. (As recently as March the breakeven rate was 2.54%.) Today’s number, while still relatively good, has been creeping up in the last two weeks. after dipping below 2.0%. This indicates stronger recent demand for TIPS than traditional Treasurys.

(And by the way, did you ever wonder how often inflation has averaged less than 2.2% over 10-year periods in the last 50 years? Check out this chart, looking at the columns on the right. Since 1961, the lowest-ever 10-year inflation average was 2.4%.)

Did I buy it? Yes. While I was disappointed with the recent swoon in yield, I wanted to lock in a 10-year TIPS with a positive yield. This was only my second TIPS purchase in two years.

Reaction to the auction. Bloomberg’s report says the yield was expected to be 0.399%, based on its survey of primary dealers. It quotes this negative viewpoint on TIPS from Aaron Kohli, an interest-rate strategist in New York at BNP Paribas SA:

“The TIPS market got ahead of itself and is still too rich and has overpriced demand. … “The economy hasn’t seen inflation pressure to justify TIPS strength.”

The article also quotes Michael Pond, head of global inflation-linked research at Barclays Plc, as saying today’s positive yield helped draw investors:

“TIPS got to very cheap levels relative to fundamentals and are now starting to offer some value. … The Fed has brought the dual back to the dual mandate by increasing communication around inflation which should bolster the idea that the Fed is serious about pushing inflation up.”

The Wall Street Journal‘s report notes the auction drew “robust demand from end-investors, with indirect bidders purchasing 57.7% of the notes, compared with an average of 49.6% for the past six sales.”

The TIPS market overall appeared pleased by the auction, which closed at 1 p.m. Here is the one-day chart for the TIP ETF, showing a sharp move upward after the auction:

I have pretty much lost my appetite for Thursday’s auction of a new issue 10-year Treasury Inflation-Protected Security. Why? It’s hard to swallow a jawbone.

The jawboning has been coming from Federal Reserve Chairman Ben Bernanke, who last Wednesday afternoon tried to scale back fears of future Fed ‘tapering’ of its aggressive bond buying. Again today, speaking to Congress, Bernanke went dovish on quantitative easing. From the Wall Street Journal report:

Federal Reserve Chairman Ben Bernanke amplified his efforts to calm markets about the end of the Fed’s easy-money policies, pointing to a variety of economic risks that could persuade the central bank to keep its large bond-buying program going in the months ahead. …

“Because our asset purchases depend on economic and financial developments, they are by no means on a preset course,” he said. … In fact, if necessary, the Fed “would be prepared to employ all of its tools, including an increase [in] the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”

The result. Last Wednesday, by Treasury estimates, a 10-year TIPS was drawing a yield to maturity of 0.64%. Today, according to Bloomberg’s real-time estimates, that yield has fallen to 0.30%. That’s a fall of 34 basis points in 5 market days. Here is how jawboning looks in a 5-day chart for the TIP ETF (its price rises when its yield falls):

I am not a fan of buying something while the price is soaring. I haven’t ruled out participating in this 10-year TIPS auction, but my enthusiasm definitely has waned. I think I will wait until Thursday morning to decide.

I am convinced that higher interest rates (and TIPS yields) are ahead. That means the best strategy is being patient for buying opportunities.