Treasury Inflation-Protected Securities

It’s big news when the U.S. Treasury rolls out a new product, since the last new one was Treasury Inflation-Protected Securities in 1997. That one worked out well, for both the Treasury and investors.

These floating rate notes will be of interest to TIPS buyers, I think, because they similarly ease the risk that buy-and-hold investors face with traditional Treasuries. We don’t know many details yet, and the floating rate notes won’t launch for about a year.

The Wall Street Journal says:

… the payments on these new notes would periodically reset to match prevailing market rates, as measured by a market index. The private-sector advisory committee that offers guidance to the Treasury suggested that the notes initially have a maturity of as long as two years.

TIPS pay a base return (lately that is 0.125% for most maturities), plus the principal is adjusted to reflect the overall Consumer Price Index. In reality, though, many TIPS after auction currently pay a negative yield to maturity, plus inflation.

These floating rate notes would react to prevailing interest rates, not inflation. So they could serve as a hedge against rising interest rates, which could harm the value of TIPS.

If they really are issued for two years, they would look make a good buy-and-hold investment today, when interest rates are ultra low. This assumes that the Treasury won’t allow the interest rate to go negative. At the moment, a two-year Treasury is paying 0.24%. I’d guess a floating-rate note would pay less, possibly close to zero interest with the chance of rising interest rates later.

Of course, interest rates could also go down, but if the Treasury didn’t allow a negative rate, that would make a floating-rate Treasury much more attractive than a traditional two-year Treasury.

The floating-rate note would also be a great alternative for investors who continuously turn over short-term Treasuries. The three-month Treasury is now paying 0.09%, practically zero. From the Wall Street Journal:

For buyers of Treasurys looking for a haven rather than an investment, floating-rate notes also might be relatively attractive. These notes will likely pay a higher yield than fixed bills, because investors will lock their money up for a longer period. And because yields on floating-rate notes reset automatically to mirror market rates, they wouldn’t have to be continuously redeemed and repurchased like short-term bills, a process that adds costs.

We won’t be able to buy these for at least a year, and so for now we can only speculate. My thinking is that if they are indeed 2-year issues and come with a guarantee of no negative interest rates, they will be worth considering in this ultra-low rate environment.

More on negative rates from Bloomberg. This was in Bloomberg’s report on the floating-rate Treasuries, but it wasn’t specifically referring to the floating-rate notes. TIPS buyers already know all about negative rates, because after-auction yields on many TIPS have been negative for more than a year:

The Treasury also said it is “in the process of building the operational capabilities to allow for negative-rate bidding in Treasury bill auctions, should we make the determination to allow such bidding in the future.”

Investors who bid at auctions for Treasury bills at negative yields would pay more than face value for the securities, ensuring that if they hold the debt to maturity they will get back less than they paid.

Vanguard on July 24 filed paperwork with the SEC to launch the Vanguard Short-Term Inflation-Protected Securities Index Fund, and it will come in traditional Investor and Admiral mutual fund varieties – along with an ETF. This fund will track the Barclays U.S. Treasury Inflation-Protected Securities (TIPS ) 0-5 Year Index, and invest in TIPS that have a remaining maturity of less than five years.

The fund is expected to launch around Oct. 10, 2012. The mutual funds will impose a 0.25% purchase fee (which doesn’t apply to reinvested dividends and capital gains). This fee benefits current shareholders, and is designed to discourage short-term trading. ETF buyers will be exempt from this fee.

The management fee for the ETF is expected to be 0.1%, the same as for Admiral shares. So ETF buyers would get Admiral advantages without the 0.25% purchase fee.

You can read the preliminary prospectus here (Admiral shares)

Vanguard’s fund won’t be the first for short-term TIPS. Already launched are:

• iShares Barclays 0-5 Year TIPS Bond Fund (STIP), which tracks the same index, with a 0.2% expense ratio.
• The Pimco 1-5 Year US TIPS Index ETF (STPZ), linked to the BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index. It also has an expense ration of 0.2%.

So the Vanguard ETF will have the advantage in expenses, although slight. However, with the very low returns this fund will offer, that little advantage makes a difference.

Here is how the iShares fund has performed against the Pimco fund over the last year. Keep in mind that the iShares fund will use the same index as Vanguard’s:

The iShares fund has slightly outperformed the Pimco fund over the last year.

These funds are not going to pay much in dividends, in fact, buyers can expect negative returns to inflation over the short term, and possibly much longer. The current 30-day yield on STIP is -0.22%.

Vanguard notes the fund is designed for low-risk investors, but still carries risks:

Income fluctuations. The Fund’s quarterly income distributions are likely to fluctuate considerably more than the income distributions of a typical bond fund. Income fluctuations associated with changes in interest rates are expected to be low; however, income fluctuations associated with changes in inflation are expected to be high. Overall, investors can expect income fluctuations to be high for the Fund.

Interest rate risk, which is the chance that the value of a bond will fluctuate due to a change in the level of interest rates. Although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. Because the Fund’s dollar-weighted average maturity is expected to be 5 years or less, interest rate risk is expected to be low for the Fund.

The Treasury today at 1 p.m. closed out its auction of a new 10-year Treasury Inflation-Protected Security with a yield to maturity of -0.637%, a record low for any 9- to 10-year TIPS at auction.

Here is the Treasury’s summary of the auction.

For the record, this is CUSIP 912828TE0 and it has a coupon rate of 0.125%, the lowest allowed by the Treasury. But today’s buyers had to pay up – dramatically – for this issue, about $107.78 for every $100 of value.

The previous low for any 9- or 10-year TIPS was -0.391% for a reissue on May 17,  2012.  This is the fourth consecutive auction for a TIPS in this range that resulted in a negative yield. From the Wall Street Journal report:

The $15 billion auction of 10-year Treasury Inflation Protected Securities, or TIPS, garnered mediocre interest given the negative-0.637% yield that was offered in a time of little inflationary threat. That’s the lowest yield the government has had to deliver in its sales of 10-year TIPS. It drew a bid-to-cover ratio of 2.62, the lowest measure of overall demand since September.

It might have been mediocre demand, but the government still got the highest price in history for this type of TIPS. The Treasury wins out on this one.

Breakeven rate. Since a traditional 10-year Treasury closed today at 1.54%, buyers of this TIPS will need inflation to average 2.17% over the next 10 years to beat a traditional Treasury. There lies the logic in buying this TIPS over a traditional Treasury: In a time of massive monetary stimulation and ‘financial repression,’ who wouldn’t take the bet that inflation will average more than 2.17%? That makes TIPS an attractive option.

On the other hand, inflation is currently muted. It’s likely that June’s CPI number will come in at zero, as did May’s. That is two months in a row without inflation, and that trend will drag down the overall 2012 inflation number, possibly well below 2.17%.

Read the Treasury announcement

The U.S. Treasury today announced details of the upcoming 10-year auction of a new issue Treasury Inflation-Protected Security. It will be forever known as CUSIP 912828TE0.

View the Treasury announcement.

Details: The coupon, or base rate, of this TIPS will be set at auction, but we can say with certainty it will be 0.125%, the lowest rate possible. In addition, buyers will see their principal grow at the rate of inflation until maturity on July 15, 2022.

The actual yield to maturity will be set at the end of the auction, 1 p.m. on Thursday, July 19. As of today, a similar TIPS that matures 2022 Jan 15 is trading on the secondary market with a yield to maturity of -0.627%.

If this new TIPS auctions next Thursday anywhere near this yield, it will be the lowest yield ever for a 10-year TIPS issue or reissue. The previous low was -0.391% for a reissue auctioned on May 17, 2012.

(It’s important to note for buyers of this TIPS that you will be paying up, dramatically up, to get that base rate of 0.125%.)

Want more historical perspective? Read this.

At this point, this auction is shaping up to be spectacularly undesirable for the small-scale investor. Who wants to accept 0.6% less than the rate of inflation over the next 10 years?

On the other hand, investors can choose similarly spectacular disasters, such as a 10-year traditional Treasury yielding 1.50% today. If you buy that, you are pretty much betting on economic Armageddon. At least with the TIPS you get the side benefit of gaining from whopping unexpected inflation, as undesirable as that would be.

For me? Observe it in awe. But don’t buy.

The Treasury will announce Thursday that it will be auctioning a new 10-year Treasury Inflation-Protected Security on July 19, 2012.

What can we expect? The coupon rate is likely to be set by auction at 0.125%, the lowest rate possible, and the yield to maturity looks like it will be somewhere around -0.55%, judging from this similar TIPS currently trading in the secondary market:

So that means buyers will be paying up for that coupon rate of 0.125%, and will accept a yield a half percentage point below inflation for 10 years. If the rate comes in around -0.55%, it will be the record-low yield for any 10-year TIPS issue or reissue.

Here is a chart of recent 10-year auctions, and you can see how dramatically the yield to maturity has fallen – it was 1.920% just three years ago and still-positive in November 2011:

It’s hard to get excited about this 10-year issue, with a yield driven down by worldwide economic turmoil, plus anticipation of further Federal Reserve action to stimulate the economy. The Fed has committed to keeping rates very low through the end of 2014, so we aren’t likely to see dramatic rate changes in the near term. Still, a 10-year yield zero above inflation seems more reasonable.

Breakeven point? The 10-year traditional Treasury as of Friday was yielding 1.57% (inching toward the 2012 low of 1.47%). That means a TIPS yielding -0.55% would need to have inflation average 2.12% over 10 years to win out over a traditional Treasury. That is in the lower-end of the breakeven range over the last year:

Source: Reuters

Given the super low rate on a 10-year Treasury, the breakeven rate is tolerable and I’d say it makes the TIPS preferable to 10-year Treasury. If you are looking to park cash for 10 years with supreme safety and can accept very little or zero real growth in your investment, this TIPS will work.

Alternatives?

• I Bonds purchased up the the yearly maximum ($10,000 per person at Treasury Direct) remain the best option. They pay the rate of inflation and can be sold after one year with only a minimal penalty, and after five years with no penalty, plus taxes are deferred.
• A 5-year bank CD can pay around 1.75%, creating a breakeven rate over 5 years of 2.3% compared with a 10-year TIPS paying -0.55%. Plus, it will mature in 5 years, or you can unload it early with a penalty. Because of the recent economic slowdown, inflation is muted (it turned to deflation in May and may be negative again in June). I’d say a bank CD competes pretty favorably.