Treasury Inflation-Protected Securities

As one of the world’s most boring investments, Treasury Inflation-Protected Securities generally don’t get a lot of press. But lately, TIPS are getting all sorts of play in the Wall Street Journal, both negative (mostly) and positive (somewhat).

Article No. 1 is ‘Looking for Inflation Protection? Take TIPS off Your List‘ by Brett Arends. It starts with the classic TIPS dismissal:

Would you buy an investment that was guaranteed
to lose money? That is the situation investors are embracing today in the market for Treasury inflation-protected securities, or TIPS.

Arends makes the case that TIPS, yielding negative to inflation well up the maturity ladder, are a horrible investment:

The effective interest rates on TIPS have collapsed to record lows. It is mathematically impossible now for investors to earn respectable returns from any of them, and in many cases they are a lock to lose money in real, inflation-adjusted terms.

Arends actually is making a perfectly reasonable case. TIPS are expensive, with yields
following traditional Treasuries down to pathetic lows, thanks to two years of Federal Reserve manipulation. (I have down on buying TIPS for the last 18 months.)

My criticism, though, is that Arends is singling out (and ridiculing) TIPS as an investment that is ‘guaranteed’ to produce a negative real yield. Yet Arends admits that TIPS, because of the inflation protection, are preferable to traditional Treasuries, which also yield well below current and likely future inflation. The same is true of bank CDs, short-term
bond funds and money market funds.

The only way to get a ‘real yield’ is to increase your risk level, meaning stocks or commodities or real estate. I think stocks, commodities and real estate are fine for your portfolio, but not for your ‘super safe’ allocation. TIPS might be flawed and expensive, but inflation protection still makes them today’s 2nd best super-safe investment, after I Bonds.

So that leads me to article No. 2, ‘A ‘Bucket List’ for Better Diversification‘ by Jason Zweig, who makes the case for a different sort of portfolio allocation. Zweig suggests that investors replace the traditional stock vs. bonds formula with one that puts investments in buckets tailored for economic conditions:

• Expansion, stocks and real estate (and possibly commodities)
• Inflation, TIPS and I Bonds (and possibly commodities)
• Recession, traditional bonds and bond funds
• Deflation, traditional Treasuries and insured bank CDs

Zweig ends up endorsing TIPS as an investment, despite their low yields.

How does differsification work in practice? If you own no TIPS, your inflation bucket is perilously empty, and you need to fill it. Otherwise you are gambling that the cost of living won’t rise higher or faster than most people expect—and that is an expensive bet to get wrong.

Investors are predicting an inflation rate over the next 10 years of roughly 2.5% annually, says Gemma Wright-Casparius, manager of the Vanguard Inflation-Protected Securities Fund. If inflation runs higher than that, TIPS will guard you against a loss of your purchasing power. If it doesn’t, you could lose money on your TIPS—but your other buckets should do well.

My personal style is to buy TIPS at auction and hold them to maturity, so there is no risk
of losing money. But at today’s prices TIPS aren’t attractive for that strategy. If you have TIPS maturing this year – like I do – you’re facing tough choices.

The U.S. Treasury announced today that its auction of a new 10-year Treasury Inflation-Protected Security went off with a coupon rate of 0.125% and a yield to maturity of -0.630%, well above the record-low yield of -0.750% for 9-year, 10-month reissue last year in September.

This is the second 10-year TIPS auction in a row that failed to set a record low, a good trend for TIPS buyers who have been seeing yields negative to inflation for nearly two years, well up the maturity ladder.

Read the Treasury’s announcement for CUSIP 912828UH1

Because buyers are getting a yield 0.755% below the coupon rate, they will be paying up for this issue, about $107.50 for every $100 of value.

Buyers have until noon Thursday to place an order for a new-issue, 10-year Treasury Inflation-Protected Security (CUSIP 912828UH1), so I thought I’d take another look at this issue, which I wrote about last week.

Yes or no? I’m solidly in the ‘no’ category. I predicted (guessed) last week that the yield to maturity would end up being about -0.69%, and that still looks about right. The yield on a 10-year TIPS that matures Jul 15, 2022 (the nearest thing to a 10-year on the market) closed today at -0.748%, slightly lower than last Wednesday’s close of -0.738%.

Negative yield? That’s right, buyers of this 10-year TIPS will be accepting about 0.7% less than the rate of inflation over 10 years. Headline inflation ran at 1.7% in 2012. So take your pick of possible yields for buyers of this issue, compared with competing products:

This 10-year TIPS cannot – ever – be better than a US Savings I Bond, which pays the rate of inflation, minus nothing. Plus, an I Bond has tax advantages, better deflation protection and can be sold after one year with little penalty and after 5 years with no penalty. Even a 5-year bank CD is more attractive, I say, because it can also be cashed in with some penalty (shop around for the best deal on that), or reinvested in 5 years when interest rates are likely to be higher.

Breakeven rate? OK,  forget bank CDs and I Bonds, how does this TIPS compare with a 10-year traditional Treasury? The 10-year Treasury closed today at 1.86%, meaning that the inflation breakeven rate for this TIPS will be about 2.56%. That’s rather high. As I pointed out a few weeks ago, a breakeven rate above 2.5% is relatively rare, and indicates that TIPS are getting expensive versus traditional Treasurys.

For the small investor, this TIPS is a loser. Leave it to the hedge funds, big money banks, national banks and even the Federal Reserve, which will be buying this, to be sure, lowering your yield at the same time.

The Treasury will announce this tomorrow, but I can give you the scoop on next week’s auction: A new-issue 10-year Treasury Inflation-Protected Security. This will be CUSIP 912828UH1. (Update: Here is the Treasury’s announcement.)

The coupon rate? That will be set at auction, but … come on … it will end up being 0.125%, the lowest coupon rate the Treasury will set on a 10-year TIPS.

Yield to maturity? This is much harder to predict with super accuracy. The closest existing issue now trading on the secondary market matures 2022 Jul 15 and it has a yield to maturity of -0.738%, meaning buyers are accepting a rate of return 0.738% below inflation for 10 years. In theory, this TIPS with a maturity six months longer, ought to have a slightly better rate. So maybe around -0.69%?  Just a guess.

Will it set a record low for yield? Good question. It is going to be close. The record low yield for any 9- to 10-year TIPS at auction is -0.750%, for a reissue last year in September. Unless we see a lot of turmoil in the stock market in the next seven days, that record looks pretty safe. In fact, this new issue will probably rise above the -0.720% for a 9-year, 8-month reissue in November 2012.

TIPS failing to set record lows is a nice trend, in my opinion.

Here are the recent auction results for 9- to 10-year TIPS:

Please note …. Just two years ago, on Jan. 20, 2011, a 10-year TIPS auctioned with a yield to maturity of 1.17%. That is 1.17% above inflation, instead of today’s 0.7% below inflation. Two years ago, the Treasury market was ‘normal.’ Today it is ‘abnormal.’ And that means this 10-year TIPS should probably be ignored.

Unless … you really, really believe massive inflation is coming around the corner.

Uh .. about that lurking inflation. Today the Bureau of Labor Statistics announced that headline inflation (CPI-U – the one that matters to TIPS buyers) was unchanged in December. For the year, consumer prices rose only 1.7%, down from 3% in 2011.

That sort of presents a double whammy for recent TIPS buyers, who are seeing very low inflation, but earning a yield well below inflation. Ouch. (When you take a yield below inflation, you tend to cheer for higher inflation, as morbid as that sounds.)

Core inflation, which the Fed wants to keep under 2.5%, rose only 0.1% in December and 1.9% for year year. Here are the monthly increases for headline inflation:

I stumbled upon this fact yesterday as I was looking at historical TIPS prices: TIPS have outperformed stocks in the last five years, despite four consecutive positive years for the stock market.

Over the last five years, the TIP ETF has seen its net asset value rise 11.7%, climbing from 108.5 in January 2008 to 121.26 in January 2013. That beats the S&P 500, which had a much wilder ride to gain 11.1% over five years, rising from 1325.19 to 1472.05.

Here’s the chart, comparing the slow-moving TIP ETF with the more-volatile S&P 500:

TIPS took a hit at the beginning of the financial crisis, a combination of fear of inflation and wholesale selling of financial instruments by cash-hungry banks. The decline of about 13% by late 2008 made TIPS an especially attractive buy.

The stock market at the same time was heading to a nearly 50% decline (also creating a great buying opportunity for the brave investor). It has climbed, unsteadily, to surpass the highs of 2008.

How about the future? TIPS are expensive and have been propped up by an aggressive Federal Reserve. Stocks aren’t cheap, but don’t seem expensive either. If the economy keeps improving, it’s highly unlikely that TIPS will outperform the stock market over the next five years. But any move back to recession would probably bolster Treasuries and slam the stock market.

Wise investors continue holding stocks and bonds in up and down markets. TIPS fill the super-safe niche in your portfolio, and carry few risks for a buy-and-hold-to-maturity investor.