Treasury Inflation-Protected Securities

The likely yield on the reissue of a 30-year TIPS has been creeping up this week, making this 29-year 4-month TIPS at least slightly more attractive.  If you have been on the fence about this one, you should at least take a look.

It is CUSIP 912810QV3 and carries a coupon rate of 0.75%. This TIPS, which trades on the secondary market, closed Wednesday with a yield to maturity of  0.478%. This is up fairly sharply since last Wednesday, when it closed at 0.371%. The resulting market price for $100 of value has dropped from $110.17 to $107.14. That is almost a 3% drop in a week.

(A buyer of this TIPS will pay more than the principal value because he will get a coupon interest rate of 0.75% for 30 years, on principal that rises with the rate of inflation. So when you see a yield of 0.478%, that means the buyer – after paying up – actually gets 0.478% plus the rate of inflation.)

Even if Thursday’s auction – which closes at 1 p.m. – ends up with a yield of 0.5%, that would be a record low for any 30-year TIPS issue or reissue. The current record is for this same TIPS when it was reissued on June 21 with a yield to maturity of 0.520%.

Breakeven rate? The traditional 30-year Treasury closed today at 2.98%, meaning a TIPS yield of 0.478% results in a 30-year breakeven rate of 2.502%. That is up a bit from last Friday, when it was 2.45% and it is a negative for buyers of this issue.

Oh well. Let’s see what happens Thursday.

The Old Bushmills Distillery attracts about 110,000 visitors a year. By contrast, the Guiness Storehouse in Dublin attracts more than 1 million a year – Ireland’s No. 1 international tourist attraction.

I was touring in Northern Ireland recently and visited the historic Old Bushmills Distillery plant in County Antrim. It was a so-so tour, but a few days later I toured the impressive Guinness Storehouse in Dublin, a fascinating and high-tech homage to hops, malt, yeast and water.

Both Bushmills and Guiness are brands of Diageo plc, the  multinational alcoholic beverages company based in London. It is the world’s largest distributor of premium alcoholic beverages, with an impressive list of brands: Johnnie Walker, Crown Royal, J&B, Windsor, Buchanan’s and Bushmills whiskies, Smirnoff, Ciroc and Ketel One vodkas, Baileys, Captain Morgan, Jose Cuervo, Tanqueray, Guinness … and more.

I have owned Diageo stock (ticker: DEO) in the past and sold it at a nice profit. The visit to Ireland left me with a strange thought: Would a 30-year investment in Diageo, with dividends reinvested, be a better investment than the 30-year TIPS about to be auctioned Oct. 18?

Why even think about this? The premise is an apples-and-oranges stretch, but I think it’s legitimate to  wonder whether buying a high-quality, dividend-paying stock (and reinvesting the dividends) might be a better investment today than a 30-year TIPS, which will pay just slightly over the rate of inflation over 30 years.

Although Diageo’s stock has been on quite a nice run lately, so have TIPS. Neither is ‘cheap’ at current prices. Here is a chart comparing Diageo’s 5-year stock price to the TIP ETF:

The TIP ETF, shown in blue, is up about 20% over the last five years, slightly trailing the performance of Diageo, shown in red. But Diageo has been much more volatile.

Safety. The TIPS completely wins on this measure. A buyer of a Treasury Inflation Protected Security will get his principal back, plus the inflation adjustment, if the TIPS is held to maturity. But if the buyer decides to sell within 30 years, there is a real possibility  that this TIPS will be worth sharply less (even 15-20% less) on the secondary market in coming years.

Diageo’s safety comes with its rock-solid brands of an ‘addictive’ nature and a growing market across the world. But it will be a volatile ride; the chart above shows how Diageo’s stock price plummeted 50% during the financial crisis. In 30 years, what are the chances of corporate mismanagement, accounting fraud, etc.? It is a risk.

Return. The 30-year TIPS will probably auction with a yield about 0.38% above inflation. If inflation runs 2.2% in the next year, the return will be 2.58%. Diageo currently yields 3%, so in the short term Diageo is likely to provide a greater return. The TIPS could yield substantially more in future years if inflation rises, but that is an unknown.

Taxes. Diageo’s dividend will likely be taxed at a lower rate – currently 15% – but that also could change in the future. In addition, a future sale of the stock may get preferable tax treatment. The TIPS interest and inflation adjustment is taxable as income in the year earned, which is a disadvantage. But there is no state income tax.

Reinvesting dividends. The key to my premise was to compare the two investments held over 30 years, with dividends reinvested. In the case of the TIPS, the interest earnings can’t be directly reinvested, but the inflation adjustment adds to the principal. Diageo’s dividends have been steadily increasing – from about $1.25 a share in 2000 to about $2.75 a share in 2012.

If that dividend continues to increase, DEO is likely to outperform the 30-year TIPS, by a wide margin.

But it is a much more risky investment.

At the moment, I probably won’t buy either.

Diageo is fairly pricey right now at $113.94 a share, selling at a P/E ratio of 22.95 for trailing-year profits. But it is expected to earn about $6.49 a share in in the current fiscal year, and $7.25 a share in the next, bringing the P/E down to a reasonable 15.7.

Something to think about in days of ultra-low yields.

View the announcement

The U.S. Treasury on Thursday released its formal announcement of a reissue of CUSIP 912810QV3, which will mature on February 15, 2042, making this a 29-year 4-month TIPS. It has a coupon rate of 0.75%, but will likely auction on Oct. 18 with a yield to maturity of about 0.38%.

That means buyers will have to pay money upfront to get this issue, since they will be getting interest payments about 0.37% higher than the auctioned yield. When you project that across 30 years, the cost will end up being about $110 to $111 per $100 of value.

Let’s say a buyer wanted $10,000 of this TIPS. It would cost that buyer about $11,100. In return, the buyer will receive taxable interest payments of 0.75% a year on a principal balance that will rise with the inflation rate for 30 years (and also be taxed each year for the increase, unless the TIPS is in a tax-deferred account).

Simple? Right. The only questions the buyer should ask are: 1) Will I be alive in 30 years? 2) Or if I sell before maturity, what will this TIPS be worth? While it may gain value in the short term, it is highly likely to lose value over the long term … my opinion. 3) Or, if I am committed to holding to maturity, can I live with a record-low interest rate and probable decline over time of this TIPS’ market value, even though I am holding to maturity?

The one appeal of this issue is that it does actually carry a positive yield over the inflation rate. Only TIPS maturing in 2040 and beyond still carry a positive yield, a remarkable plunge in rates that began in mid-2011 as the Fed began manipulating the Treasury market to force interest rates down. You can see that trend in the history of CUSIP 912810QV3.

First auction, Feb, 16, 2012: Yield to maturity of 0.770%

First reissue, June 21, 2012: Yield to maturity of 0.520%

Upcoming reissue, Oct. 18, 2012: Likely yield of about 0.38%

Who would buy this? Getting a yield above the inflation rate would look especially appealing to someone worried about very high future inflation and trying to protect against that inflation in coming years. This TIPS also could be appealing to big money managers (pension funds, international banks, etc.) that need the inflation protection.

But this issue will be very expensive (meaning the yield will be very low and the upfront cost very high). Here is the history of all 30-year TIPS auctions and reissues. Note that in June 2011 – 16 months ago – a 30-year TIPS reissue had a yield of 1.744%:

30-year breakeven rate. We look at the breakeven rate with each TIPS issue to see how it compares with a traditional Treasury. On Friday, the 30-year Treasury yield closed at 2.83%. Since this TIPS reissue will likely carry a yield of about 0.38%, the 30-year breakeven rate is currently 2.45%. So, if inflation runs more than 2.45% on average, the buyer of this TIPS will beat an investment in a 30-year Treasury.

That is a high breakeven rate, but I think a lot of people believe inflation is likely to run higher than 2.45% over the next 30 years. Blogger Michael Ashton produced this chart to show rolling 10-year inflation rates, compared with the then-current 10-year TIPS breakeven rate of 2.48%:

Ashton notes:

With the exception of the Great Depression, when the Fed tightened policy as money velocity declined in a manifest error, inflation has almost never been below the current level on a compounded 10-year basis. And it has never, with that singular exception, been very far below the current level. Ergo, inflation insurance is very cheap, even though 10-year breakevens are not far from all-time highs (since TIPS began, in 1997).

I advise reading this blog, which ends with a very funny (and brilliant) graphic on inflation-protection decisions. But keep in mind that Ashton is advising big money managers, not small investors. Inflation protection is ‘cheap’ for the big money group, but still rather expensive for the small investor looking for a super-safe investment.

A New York Times article with the headline ‘An Inflation Hedge Carries Its Own Risks‘ spells out why TIPS mutual funds appear to be overpriced, and possibly risky, after substantial gains. Some of its major points:

Investors who placed bets on mutual funds specializing in inflation-protected Treasury securities were among the bond market’s biggest winners over the last two years, even as other Treasury funds struggled. … “TIPS have gone through a period where just about everything has gone right for them,” said Robert Johnson, director of economic analysis at Morningstar. “Now the situation has changed, and they are looking quite expensive.”

The surprise is that this article was written July 11, 2011, practically to the day that TIPS base yields began moving into negative and TIPS mutual funds started a strong move higher. Here is the chart for the TIP ETF, which has risen about 8.9% since July 11, 2011:

Obviously, you can’t trust the experts. But …

I will admit that back in July 2011, I agreed with this New York Times article. TIPS seemed pretty expensive. Looking back, boy, were we wrong. Yes, TIPS were expensive relative to history, but not expensive at a time of massive Federal Reserve manipulation in the Treasury market.

Since July 2011, yields have literally turned upside down to what I would call the ‘Real World.’ Now we are living in the ‘Fed World.’

Real World. On July 21, 2011, a 10-year TIPS auctioned with a yield of 0.639%, meaning that buyers would receive 0.639% above inflation over 10 years. That looked expensive at the time, but in retrospect …

Fed World. This week the Treasury reissued a 10-year TIPS with a yield of -0.75%, meaning that buyers were accepting 0.75% less than inflation for the next 10 years. They  were betting big on higher-than-expected inflation.

A yield of -0.75% is expensive, right? Can we finally settle on that? But it was another in a string of record-low yields for TIPS. Until we see that trend turn around, I think we can say the Fed World is still going strong.