Treasury Inflation-Protected Securities

Yes, I knew there was a TIPS auction today, and actually thought about it around noon. But then I pretty much erased it from my mind. I mean, who really cares? Who is actually buying this thing?

Well, today’s auction for CUSIP 912828SQ4, effectively a 4-year, 4-month Treasury Inflation-Protected Security, resulted in a yield to maturity of -1.496%, meaning that today’s buyers are accepting a return 1.496% below the rate of inflation for the next five years.

Need I point out that inflation for the last 12 months is currently running at 1.8%? Indicating a current return for this TIPS of about 0.304%?

How … exciting … Well we did set another record low yield for any 4- to 5-year TIPS at auction. The previous low was -1.286% for this same TIPS when it was reissued in August.

But really, this was a very unattractive issue, because even if inflation perks up in the future, it will probably miss most of this 4-year, 4-month term. The current breakeven rate for a 5-year TIPS is 1.91%, with the 5-year nominal Treasury yielding 0.77%.

Yes, inflation will probably average more than 1.91% over the next five years, so this TIPS beats a nominal Treasury. But if you look at a super-safe insured 5-year bank CD, you can get 1.8% right now, pushing the breakeven inflation rate up to a much-more-iffy 3.3%.

Why would anyone buy this TIPS?

The U.S. Labor Department reported today that the ‘headline’ consumer price index fell 0.3% in November, primarily because of a big drop in gasoline prices. In the past year, consumer prices have risen 1.8 percent.

You can read the full report here

This headline number – technically called the Consumer Price Index for All Urban Consumers (CPI-U) –  is the one watched by holders of inflation-adjusted TIPS and I Bonds. The decline in November means a 0.3% decrease in the principal balance of a TIPS, and will cause a lower future interest rate for I Bonds.

The Federal Reserve watches the ‘core’ inflation rate, minus food and energy. This index rose 0.1% in November, which continues a trend of mild inflation.

This fall’s decline in gas prices has offset a late-summer bump in inflation, as shown in this chart generated by the Labor Department:

From the Associated Press report:

“In simplest terms, inflation is not a problem,” Jim Baird, chief investment strategist at Plante Moran Financial Advisors, said. Lower inflation “is a real positive that should provide modest relief for households dealing with limited income growth.”

High unemployment and slow wage growth have made businesses reluctant to raise prices. Many worry higher prices could drive away customers. That’s helped keep inflation tame.

Somehow I own a fractional share of the Fidelity Inflation-Protected Bond Fund (FINPX) and so I get its annual and semi-annual reports. As I’ve noted before, the managers of this fund – William Irving and Franco Castagliuolo – are unusually frank in their ‘managers overview’ in each report. So their opinions perk my interest.

You can read the Sept. 30, 2012, report here.

TIPS have been an incredible investment over the last two years, combining safety with decent capital returns. This Fidelity fund, FINPX, has seen a year-to-date increase of 7.15% in net asset value. That nicely tops Vanguard’s Total Bond Market gain of 4.26% in net asset value. (Uh … I own the Total Bond Market, not FINPX, a decision I made at the perfectly wrong time of spring 2011.)

Below are some excerpts from their report, which I think lays out pretty well the positives and potential negatives of TIPS (fund) investing. On the one hand, we know that the Federal Reserve is committed to keeping interest rates very low in the near- and even mid-term future. And then there is the impending fiscal cliff, which in a worst-case scenario could cause deflationary pressures. Although the Fidelity managers don’t mention this, serious deflation would boost traditional Treasuries, but could ravage TIPS, which are an inflation-protection investment.

The one thing TIPS investors – especially those investing in funds like FINPX – might lose sleep over is a ‘miracle’ resolution of these problems, causing a stock market boom, employment growth, economic expansion. In those conditions, almost certainly, TIPS yields will rise, along with the overall Treasury market.

TIPS yields are sensationally low. Wildly low. Bubbly low. On the other hand the Federal Reserve presents a nice bodyguard for TIPS investors: Keeping rates ultra low by manipulating the Treasury market, while at the same time prompting inflationary fears, which in turn increases the attractiveness of TIPS.

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Reader Joe pointed out that current pricing on the TIPS maturing April 15, 2013, has moved to a positive yield, while almost the entire TIPS ladder is negative. At this point, it is substantially positive:

Tempting, isn’t it? This TIPS has a coupon rate of 0.625% and is selling at a discount, resulting in a yield of 0.739%. That’s attractive, but the TIPS will mature in 4 1/2 months, so it’s definitely a short-term investment.

There’s a thread discussing this issue in the Bogleheads forums, dating back to June but with posts continuing through this week. Experts there agree it is an intriguing investment in theory, but it reality will generate very little income in the short remaining time period, less than 0.2% on the money invested. Still, that is better than a six-month Treasury (0.13%) and even better than a one-year (0.18%).

Why the pricing anomaly? With oil and gas prices declining, we are currently in an inflation downswing, and the ‘fiscal cliff’ raises a specter of deflation. TIPS are inflation protection, and there is little chance of much inflation at all before April 2013. So there is no ‘inflation premium’ on this issue. In fact, a couple months of deflation could nearly wipe out its positive return.

There is little risk in this investment, though, so it could be interesting for someone parking short-term cash, which is going to earn near-zero anyway.