Treasury Inflation-Protected Securities

The U.S. Treasury announced today that it auctioned a new 30-year Treasury Inflation-Protected Security, with a coupon rate of 0.625%, and a yield to maturity of 0.639%.  This is CUSIP 912810RA8.

Buyers are getting a yield well above the record low for a 30-year TIPS, 0.479% for a reissue in October 2012. Today’s auction broke a string of five consecutive 30-year TIPS auctions (issues and reissues) that set records lows. I think that is significant.

Here’s the Treasury announcement.

Bill Gross

Are bonds, especially Treasurys, in a bubble, driven up by by a mob of wild-eyed coupon clippers, fighting to get 0.87% on a five-year traditional Treasury?

I ran across these comments from Bill Gross, co-founder of Pacific Investment Management who is also known as ‘The Bond King,’ while reading a week-old Barron’s. (I get behind, sorry). This is from the annual Barron’s Roundtable, part 3:

The Fed is buying 80% of the Treasury market today. It is remarkable to think that when the Treasury issues debt in the trillion-dollar-plus category, the Fed ends up buying most of it. The Treasury sells it to the banks and primary dealers, who sell it back to the Fed at a higher bid. This is a very different financial system from the free-market capitalism we’ve come to know. And it will continue until inflation exceeds the upper end of the central bank’s target of 2.5% or, by some miracle, we get real economic growth. …

With yields so minimal, an investor is obliged to ask whether investing is worth the risk, given the possibility that the central bank misjudges the situation. … The public doesn’t realize that when yields come down, prices go up, and when yields go up, prices go down. ….

Let me be clear. Bonds are artificially priced, but aside from long-term bonds, there don’t appear to be the elements necessary to pop the bubble. That’s because central banks are buying the majority of bonds, and the cash flow from the existing stock of bonds, when reinvested, as most is, is more than the supply of bonds.

My question is: If one buyer – a buyer than can magically create dollars – is buying 80% of U.S. Treasurys, can you call that a ‘bubble,’ or is it outright market manipulation? Are there great hordes of Americans buying Treasurys? Obviously not, if the Federal Reserve is buying up 80% of the new supply.

TIPS buyers, though, are bidding against both the Federal Reserve and a large contingent of investors who truly fear future inflation. And that is pushing TIPS up. Here is a 2-year chart of the TIP ETF versus Vanguard’s Total Bond Market ETF:

These two funds have similar durations, but the Total Bond Market has greatly lagged the returns of the TIP ETF over the last two years. By the way, the Federal Reserve began its market manipulation in mid 2011, and at that point the TIP ETF sharply changed course.

It is not a coincidence. It is market manipulation. Can that continue forever? No.

Are bonds overpriced? Yes. It there a bond bubble? My answer is no. Not at least in the total bond market.

The Treasury will announce this tomorrow, but as usual it let some details slip out. On Feb. 21, it will auction a new 30-year Treasury Inflation-Protected Security, CUSIP 912810RA8. Update: Here is the announcement.

The coupon rate and yield to maturity will be determined at auction, but we can guess that the coupon rate will come in around 0.50% or  0.625% and the yield to maturity might be somewhere around 0.59%, based on today’s market.

The longest-maturing TIPS currently on the market, maturing Feb. 15 2042, is trading at a yield of 0.576%. This new issue, which adds a year and increases supply, should get a better rate.

(Some definitions: ‘Coupon rate’ is the actual interest rate the TIPS pays each year, based on a growing principal balance. ‘Yield to maturity’ is the true interest rate a buyer gets. This is set at the auction. Buyers ‘pay up’ when the yield is lower than the coupon rate, or ‘pay down’ when the yield is higher than the coupon rate. In addition to that yield, buyers of TIPS see their principal balance rise with inflation until maturity.)

Deal or no deal? My strategy with TIPS is to buy them and hold them to maturity. I don’t ever look at their prices on the secondary market, I don’t care. Viewed this way, TIPS are a very conservative, very predictable, and very boring investment. The problem with a 30-year TIPS is: Will I live long enough to see it mature? I am 59. I could live to 89.

Or … somewhere in my 80s, I might need to sell this TIPS. If that is the case, I am likely – I’d say extremely likely – to receive a secondary market price well below my original investment. I am going to lose money on a very boring investment. Not nice.

Why will I lose money? The Federal Reserve for the last two years has aggressively bought Treasuries to force down interest rates. At the same time, that Fed action has raised the fear of inflation. Both of those factors have driven TIPS yields down to record lows (although TIPS are now trading a bit above those lows).

I can only point to history, and here is the history of every TIPS 30-year issue and reissue (make special note of the yield column):

The history of 30-year TIPS is short because the Treasury halted 30-year auctions from October 2001 to February 2010.

Maybe we live in a ‘new world,’ but when I look at this chart, I see 30-year TIPS issued at 3% to 4% above inflation. OK, that was the ‘old days’ of the Internet boom. Today’s rate is 0.59%. Even in this new world, I would expect 30-year TIPS to be paying at least 1.5% to 2% above inflation — the historical return of all U.S. Treasuries.

Someday – maybe soon, or maybe not – 30-year TIPS will again be yielding 1.5%, or 2%, or more. When that day comes, the secondary-market value of a long-term TIPS yielding 0.6% is going to be crushed.

Example: The October 2012 reissue of CUSIP 912810QV3, a TIPS maturing in February 2042, auctioned with a record-low yield of 0.479%. Because its coupon rate was 0.75%, buyers paid more than $109 per $100 of value for this issue. At one time, the yield on the secondary market dipped to 0.335%, but today, it is selling on the secondary market at $104.20 and yielding 0.576%.

So my advice is, traders beware. TIPS yields have already risen above record lows. This could be the beginning of a long-term trend. (Or not, who knows?)

Buy and holder? I can’t deny the attraction of a positive yield on a TIPS, and it might be a nice addition to your TIPS ladder. If you are sure you can buy and hold, and you are sure you will ignore the secondary market, and you truly fear future inflation … have at it.

Another strategy would be to park your money, or buy a 5-year TIPS, and suffer through a yield that lags inflation. Eventually, you could roll over into higher interest rates.

Why do people buy 5-year TIPS paying -1.34% less than inflation? Because it’s for five years. And then they can reinvest. Thirty years is a mighty long commitment.

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.