Treasury Inflation-Protected Securities

A new 5-year Treasury Inflation Protected Security auctioned today with a coupon rate of 0.125% and a yield to maturity of -1.311%, plus inflation. The resulting yield for CUSIP 912828UX6 was  higher than expected, indicating weak demand. Experts had been predicting -1.384% just before the auction, and a similar TIPS that matures in July 2018 closed yesterday on the secondary market with a yield of -1.582%.

Today’s TIPS auction broke a two-year string of 4- or 5-year TIPS issues that set record low yields. Today’s yield of -1.311% is above the record low of -1.496% set in December 2012.

What it cost buyers. The Treasury’s announcement says buyers paid $107.82 per $100 of value for this TIPS, the cost of getting a coupon rate of 0.125% when the actual yield is -1.31%, a boost of 1.435% a year to ‘income.’ That’s still pretty pricey, especially in a time of softening inflation.

Reaction to the auction

On April 5 I posted a blog titled ‘Is buying a 5-year TIPS the most insane move ever?‘ and I guess a lot of people must have agreed. Here are some quotes from the Wall Street Journal report on the auction:

The U.S. Treasury’s sale of $18 billion in five-year inflation-index notes went poorly, drawing the smallest investor interest since October 2008, as inflationary fears faded away. …

The yield was almost seven basis points above the negative 1.380% yield right before the auction results were released, an indication of weak demand.

TIPS are often used by investors to hedge their exposure to commodity prices. “Given the falling commodity prices recently, I think there might be less hedging needs,” said Gennadiy Goldberg, a U.S. strategist with TD Securities. “I have never seen that much struggle for a 5-year TIPS auction.”

From the Bloomberg report:

“TIPS have had a rough time recently with the commodities selloff and renewed fears of deflation,” said Jason Rogan, director of U.S. government trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. “People are again more concerned about deflation than they are about inflation. When that occurs, it will affect this market.”

Michael Ashton offers an interesting counter view in his E-pihany blog:

But the main reasons the auction failed were far simpler. Prime among these is that the 5-year TIPS have always had more problems being sold, because people who want inflation protection tend to primarily want long inflation protection. … (T)he 5y TIPS are mainly of interest to (a) indexers and (b) foreign central banks. As such, they are prone to occasional disasters …

Today’s auction might be a signal of a changing trend for TIPS, which have seen steadily declining yields since the Federal Reserve began its aggressive bond-buying programs in mid 2011.

But today certainly wasn’t an Armageddon for TIPS, with the TIP ETF closing at $120.98, down only 0.7% and well above its 52-week low of $118.43. If TIPS are heading into a time of rising yields (which I would love, since I want to be a net buyer of TIPS) there’s still a lot of room to run.

The breakeven rate

Today’s buyers could have purchased a 5-year nominal Treasury paying 0.71%, and so they need to see inflation average 2.02% over the next five years. Not a bad bet, but who is really buying 5-year Treasurys these days? I think a 5-year TIPS compares better with a 5-year insured bank CD, where you can get 1.7% at at least one bank, pushing the breakeven rate up to a more daunting 3.01%.

The U.S. Treasury on Thursday issued its formal announcement for the April 18, 2013, auction of a new 5-year Treasury Inflation-Protected Security.

This will be CUSIP 912828UX6, and although the coupon rate will be set at auction, we can say with 100% certainty that it will be 0.125%, the lowest rate the Treasury allows on TIPS. The yield to maturity is likely to be somewhere near -1.69%, maybe a bit higher.

Although several consecutive 10-year TIPS auctions have failed to set record low yields, this 5-year TIPS will probably blow out the record low for any 4- to 5-year TIPS, -1.496% for an auction last December. Here is a history of 5-year TIPS auctions running back to 2005:

I’ve highlighted the last three auctions to show the trend of a sharply declining yield, and that trend appears likely to continue in Thursday’s auction. Compare that with the reverse trend in 10-year TIPS:

So 5-year TIPS must have some sort of magical appeal? Why are they so desirable? I can think of only one reason: There has been a surge of money pouring into shorter-term TIPS funds and this has expanded demand for TIPS of 5-year maturities or less.

For the small investor, maybe those short-term TIPS funds make sense, although they offer very little, if any, return. But buying this new 5-year TIPS will have you fighting a trend – one that’s working against you. To demonstrate this, I will compare this year’s TIPS auction versus last year’s (April 2012) and other similar investments:

The key here is that the yield to maturity on a 5-year TIPS has dropped 61 basis points, double, triple or quadruple the decline for nominal Treasuries. An insured 5-year bank CD has barely budged. I Bonds, of course, still pay inflation minus nothing. And this has happened at a time of declining inflation, creating a double whammy for TIPS buyers.

But what about the ‘real’ return, after inflation? Isn’t that where a TIPS should shine? This chart shows the real return buyers could expect at the time of purchase, 2012 vs. 2013:

Because inflation has declined and the TIPS yield has also dropped, the current TIPS yield of -1.69% is dramatically more expensive than similar investments, all of which are yielding a better return against current inflation, compared with last year. Except for I Bonds, of course, which pay inflation no matter what.

OK, let’s say you believe the current rate of inflation can’t continue, and you believe it is going much higher. (The current trend in housing prices supports that theory, but the weak job market counters it.) Let’s say inflation doubles, to 4%. How would this 5-year TIPS perform, versus 2012 and similar investments?

Here’s a manta for TIPS buyers: The yield to maturity is the real return. When you buy a TIPS with a yield of -1.69%, you are getting an after-inflation return of -1.69%, no matter how high inflation goes. However, this chart shows that in 2013, a 5-year TIPS provides a better real return at 4% inflation than similar investments, except the stalwart I Bond, which is clearly superior.

It also shows that a 5-year TIPS has gotten much more costly than similar investments in the last year.

That is the trend buyers at next week’s auction are fighting.

The TIP ETF was down about a half percentage-point today, closing at $121.24 but still not far off  the all-time high of $123.44. The chart for the last five days is looking a bit sickly:

The TIP ETF rebounded nicely after dipping to near $120 in mid-March. So much for warnings of a ‘bond bubble.’ But in the last five trading days it has again dipped, under-performing the AGG EFT (aggregate bond index.)

Today the Federal Reserve pulled a shocker by accidentally releasing minutes of its latest policy meeting 19 hours before the expected time. The Wall Street Journal reports:

The Fed said Wednesday that a staff member in its congressional liaison office accidentally released minutes of a March 19-20 policy meeting Tuesday afternoon to many of his contacts, including Washington representatives at Goldman Sachs Group Inc., Barclays Capital, Wells Fargo & Co., Citigroup Inc. and UBS AG. …

Officials at the Fed didn’t notice the mistake until about 6:30 a.m. Wednesday, after which they scrambled to release the information to the wider public, which was done at 9 a.m. A Fed spokesman said: “Every indication is that [the release] was entirely accidental.”

So the slip-up overshadowed the actual news in the minutes, which is that the Federal Reserve seems to be considering a halt to its bond-buying stimulus program, possibly this year.  Here is another Wall Street Journal report:

The minutes of the March 19-20 meeting showed that “all but a few” Fed officials agreed the central bank would likely want to keep the program going “at least through midyear.” After that, officials had a wide range of views about how they might proceed. …

For now, Fed officials agreed, “additional purchases would be necessary to achieve a substantial improvement in the outlook for the labor market,” the minutes showed

I don’t think anyone seriously believed the Fed was considering an immediate end to the bond-buying, which has forced Treasury interest rates to extreme lows. So the news here was more that the stimulus could end earlier than the ‘sometime in 2014’ that was once planned, or at least hinted.

The stock market liked the news, with both the Dow and the S&P 500 closing today at all-time highs. Bonds took a hit, though, with the 10-year Treasury yield climbing to 1.84% from yesterday’s 1.78%.

An end to stimulus will mark a major change for nominal Treasurys and TIPS. Their extremely low yields have been supported by lavish Federal Reserve purchases, and when that ends – even if the Fed doesn’t begin selling its stockpile – interest rates will rise.

So I think the Fed’s message was read two very different ways: 1) The stock market saw easy money continuing through at least midyear, and 2) the Treasury market saw bond-buying possibly ending after midyear.

The result was that – finally – stocks and bonds diverted. It’s been amazing to see the stock market hitting all-time highs while at the same time the Treasury market was returning toward all-time low yields.

Something was wrong with that picture.