Treasury Inflation-Protected Securities

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.

I try to check, at least occasionally, the TIPS inflation breakeven rate – determined by subtracting the current TIPS yield from the current nominal Treasury rate for the same term. A high 10-year breakeven rate (generally above 2.5%) indicates that inflation fear is running high and TIPS are expensive. A low breakeven rate (generally under 2%) indicates that TIPS are inexpensive, at least relative to nominal Treasuries.

In my opinion, a breakeven rate between 1.5% and 2.0% indicates TIPS are an attractive buy, but also may indicate fear of deflation. For TIPS owners, deflation is not a good thing. TIPS protect against inflation. Traditional Treasuries are better to protect against deflation.

5-year breakeven rate

A TIPS maturing Jan 15 2018 is currently trading on the secondary market at -1.446% and the 5-year nominal Treasury closed Monday at 0.72%. That pegs the 5-year inflation breakeven rate at 2.166% – not excessively high, but higher than the current rate of U.S. inflation of 1.8% over the last 12 months.

10-year breakeven rate

There is no TIPS maturing in January 2023, so I am using the TIPS maturing on July 15 2022, which currently trades at -0.751%. The 10-year nominal Treasury closed Monday at 1.78%, setting the 10-year inflation breakeven rate at 2.531%.

While this is not near an all-time high, it is high and indicates that the 10-year TIPS is expensive relative to a 10-year Treasury. Here is a chart of the historical 10-year breakeven rate:

It’s interesting to note how little time the breakeven rate has spent above 2.5% and below 2.0%. The sharp plunge in the breakeven rate in late 2008 made TIPS a screaming buy, for those willing to gamble that deflation would not be severe over a long period. (Very good gamble, even though today’s inflation remains muted.)

But today’s breakeven rate just above 2.5% indicates that TIPS are historically expensive.

The better alternative.   The breakeven rate is the perfect illustration of why US Savings I Bonds are superior to TIPS at almost all maturities. Reader Ed sent along this chart that compares ‘real’ yields of TIPS and I Bonds of various maturities:

Since I Bonds currently pay the inflation rate – not below the inflation rate – the breakeven rate for an I Bond is the same ultra-low rate as a traditional Treasury: 0.72% for 5 years or 1.78% for 10 years. Plus, I Bonds earn tax-deferred interest that compounds over time.

I Bonds are the last great deal in super-safe investing. The new year opens up your chance to buy another $10,000 per person at Treasury Direct. That’s a no-brainer.

It’s been a sorry year for buy-and-hold investors in Treasury Inflation-Protected Securities, with yields plummeting to ever-lower all-time records. That means TIPS – like all Treasuries – are very expensive and produce little income. There are currently 35 TIPS issues trading on the secondary market, and 32 of those have negative-to-inflation yields. You have to go all the way out to an issue maturing in February 2040 to get a positive yield, 0.256% plus inflation.

The TIP ETF saw some volatility in prices but still had a 4.7% gain for the year. Click on image for larger view

On the other hand, TIPS traders and mutual fund holders have had a decent year. Even though the TIP ETF took a dip after the Federal Reserve announced QE4 this month, its net asset value is up about 4.7% for the year.

Just like last year, TIPS buyers found their best purchases early in the year, as TIPS yields declined steadily. Here’s a recap of the year’s auctions:

10 year TIPS, CUSIP 912828SA9

First auctioned: Jan. 19, 2012, with a yield-to-maturity of -0.046%. This was the first 10-year TIPS in history to auction with a negative yield, but the rate was expected to be lower just before the auction. So this one ended up being the best buy of the year.

Reissued: March 22, 2012, with a yield to maturity of -0.089%. Today, this still looks attractive.

Reissued: May 17, 2012, with a yield to maturity of -0.391%.

Hard to believe this issue currently trades at -0.841%, meaning the January buyers are sitting on a gain of more than 8%.

3o-year TIPS, CUSIP 912810QV3

First auctioned: Feb. 16, 2012, with a yield to maturity of 0.770%. I viewed this issue positively back in February, despite the long-term commitment. It actually went off at a discount to its 0.75% coupon rate (that’s a rarity in TIPS auctions these days).

Reissued: June 21, 2012, with a yield to maturity of 0.520%.

Reissued: October 18, 2012, with a yield to maturity of 0.479%. Each of these auctions set a record low for a 30-year TIPS.

Today this issue trades on a secondary market at 0.335%, meaning the original buyers are sitting on a capital gain of more than 10% for an issue they bought at a discount.

5-year TIPS, CUSIP 912828SQ4

First auctioned: April 14, 2012, with a yield to maturity of -1.080%. Although I have tried to warm up to short-term TIPS, I just can’t accept a yield more than 1% below inflation. Back in April, I issued a call to buy I Bonds instead, which was probably my wisest advice of the year.

Reissued: Aug. 23, 2012, with a yield to maturity of -1.286%.

Reissued: Dec. 20, 2012, with a yield to maturity of -1.496%. Each of these auctions set a record low for a 5-year TIPS.

This issue currently trades on the secondary market at -1.485%, about where it auctioned 10 days ago.

10-year TIPS, CUSIP 912828TE0

First auctioned: July 31, 2012, with a yield to maturity of -0.637%. By mid-year, TIPS yields were nearly hitting rock bottom. It’s significant that they have been pretty much holding at these very low levels for six months — despite the ‘fiscal cliff’ scare and the Fed’s commitment to QE4.

Reissued: Sept, 20, 2012, with a yield to maturity of -0.750%.

Reissued: Nov. 21, 2012, with a yield to maturity of -0.720%. This auction was a milestone because the TIPS yield didn’t set a record low — it’s been many months since that happened.

This issue currently trades on the secondary market at -0.787%, a bit lower but still pretty close to the original auction price.