Treasury Inflation-Protected Securities

The U.S. Treasury just announced that its reissue of a 10-year TIPS auctioned with a record-low yield to maturity of -0.75%. This is CUSIP 912828TE0, which will mature on July 15, 2022.

The previous record low was for this same Treasury Inflation-Protected Security, when it was first auctioned in July with a yield of -0.637%.

Breakeven rate. The 10-year Treasury closed today with a yield of 1.80%, setting the inflation breakeven rate for this TIPS at 2.55%. This means that inflation will have to average 2.55% for the next 10 years for this TIPS to beat a traditional Treasury. This is a near record-high breakeven rate (I think the record is 2.64%) for a 10-year TIPS, as shown in this chart from Michael Ashton’s E-piphany blog:

The higher the breakeven rate, the more expensive the TIPS. Buyers were paying a lot at today’s auction, that is clear. (And I should point out that this same TIPS, when it first auctioned in July, had a much more modest breakeven rate of 2.17%.)

Reaction. The Wall Street Journal cited ‘lukewarm‘ support for this auction, despite the record-low yield. The article notes:

TIPS shield owner from inflation because their payouts increase as the consumer price index rises. But without inflation, buying at a negative yield means the investor will get a smaller amount of money paid back than originally lent out.

Because of newfound inflation concerns, prices on TIPS have soared recently–but perhaps so much so that it made Thursday’s auction a bit too expensive, analysts say.

As expected, U.S. inflation ticked up sharply in August, rising 0.6% because of higher energy prices. This was the first increase of any kind since March. Higher gas prices accounted for 80 percent of the increase. Food prices rose 0.2 percent.

Read the full August report on inflation

The 0.6% increase in August is the ‘headline’ number (CPI-U) that holders of TIPS and I Bonds care about, because it adjusts the principal balance of TIPS upward and eventually sets the inflation-adjustment interest rate on I Bonds. So, in the crooked logic of TIPS investors, a 0.6% increase is a good thing, given the 0.3% decline in infation from April to July.

In the past 12 months, headline inflation has increased 1.7%. That’s down from a peak of 3.9% in September 2011 and below the Fed’s inflation target of 2%.

The Federal Reserve cares about ‘core inflation’ – which strips out the more-volatile energy and food. Core inflation in August was a very muted 0.1%, which should keep the Fed happy. Core consumer prices rose 1.9 percent in the past 12 months, the smallest annual increase in a year.

An Associated Press report notes that food prices have not yet figured into rising inflation:

The modest increase in food prices indicates the drought in the Midwest is not yet pushing up grocery prices. Some economists say that will happen in the comings months.

The U.S. Treasury announced today that it will auction a reissue of CUSIP 912828TE0 on Sept. 20, resulting in a 9-year, 10-month Treasury Inflation-Protected Security investment for buyers.

Read the auction announcement.

This TIPS was originally auctioned July  19, 2012, with a coupon rate of 0.125% and a record-low yield to maturity of -0.637%. Because the principal of a  TIPS investment also grows at the rate of inflation, TIPS buyers back in July were accepting -0.637% less than the rate of inflation over the next 10 years.

What about it? So now, two months later, what can buyers expect? More of the same. This TIPS trades on the open market, and today it closed with a yield to maturity of -0.730%, meaning next Thursday’s auction could set another record low.

You can check the daily yields here. The line you care about looks like this:

Notice that the accrued principal on this issue stands at 997, when it should be 1000 or more. Why? Because we have seen slight deflation in the last two months, instead of inflation. So July’s buyers got two slaps in the face: 1) negative yield and 2) negative inflation.

But deflation isn’t likely to continue. The August inflation report, due out Friday, could show a monthly rise of as much as 0.6%, which you could speculate indicates an annual rate of 7% or more. Don’t speculate. It won’t be that high. But headline inflation – the number that matters for TIPS buyers – could easily rise back to the 3% to 4% range we saw last year. Reasons? 1) The Fed today again launched a stimulus program with a plan to buy mortgage-backed securities, 2) turmoil in the Mideast threatens a spike in oil prices and 3) drought conditions in much of the country are forcing food prices up.

If  … and it is a HUGE if … inflation were to rise quickly in the next year, this TIPS reissue would end up being a very wise investment. If … on the other hand … the economy continues slogging along (and high oil prices could cause that), and inflation remains muted over the long term, this will be a fairly lousy investment.

I contend that TIPS bought and held to maturity will never be a horrible investment. You will get your money back. You may get a miserable return, but you will get your money back.

Look at the breakeven rate. The Wall Street Journal had an article this week titled ‘Uncle Sam Has an Inflation Deal for You‘ with the very odd premise that because the breakeven rate – comparing a TIPS versus a comparable Treasury – has been rising, TIPS are a good buy.

… the amount that investors have been willing to pay has risen noticeably. Ever since talk heated up that the Federal Reserve will engage in a third round of bond buying, implied bets on inflation have, too. The 10-year break-even rate has risen to 2.376% currently from 2% in late July.

But the article continued:

Perhaps the oddest thing about TIPS, though, is that they aren’t even pricier, whatever the Fed’s immediate plans. Today’s 2.39% break-even rate over 30 years not only is well below the actual average inflation rate of 3.8% since 1950.

OK, but I would still contend that TIPS are most attractive (‘cheap’) when the breakeven rate is around 2%. Where are we today? The 10-year Treasury closed today at 1.75%, well above the rate of 1.54% when this TIPS was auctioned on July 19. So the yield to maturity has declined at the same time traditional Treasuries are paying more.

The result: A breakeven rate, today, of 2.48%. Folks, that is a high breakeven rate. (It was 2.17% back in July, just saying …) When the breakeven rate rises, it means inflation fear is rising. And when inflation fear is rising, TIPS are expensive.

Update: On Friday, the breakeven rate rose even higher. The 10-year Treasury closed the day at 1.88%, while the July 15 2022 TIPS closed at -0.811%, pushing the breakeven rate out to 2.69%. If this trend continues a 10-year Treasury may actually look attractive.

I’d say keep an eye on the market yield of CUSIP 912828TE0 over the next week. Perhaps the breakeven rate will slip. If not, this auction is risky.

The U.S. Treasury has announced results of today’s reissue of CUSIP 912828SQ4, resulting in a yield to maturity of -1.286%, meaning that today’s buyers are accepting 1.286% less than the rate of inflation over the next four years, 8 months.

Read the Treasury’s auction summary.

This is a record low for any 5-year Treasury Inflation-Protected Security, issue or reissue. The previous low was for this same TIPS, when it was first issued in April at a yield to maturity of -1.080%.

Since this TIPS has a coupon rate of 0.125% – the lowest the Treasury allows – today’s buyers had to pay more than 6.5% above actual value to get the resulting negative yield.

Although TIPS yields had been falling in recent days, demand for today’s auction was considered strong. The open-market yield for this issue had dropped to about -1.1% in recent days. The TIP ETF got quite a bounce this week:

TIPS yields had been rising a bit in recent days, but this trend turned around with the midweek release of Fed minutes hinting at further economic easing. When TIPS yields fall, values rise, as show in this chart.

From a Bloomberg report:

“It was strong any way you slice it,” Michael Pond, co- head of interest-rate strategy at Barclays, said. … “Clearly, yesterday’s Fed minutes have increased investors’ appetite for TIPS, particularly at the short end of the curve.”

Short-term TIPS are attractive to investors who fear unexpected inflation. Although inflation in 2012 is muted, fears are rising because of possible Fed action to stimulate the economy. Past Fed moves have boosted the prices of stocks, commodities and energy.

TIPS buyers are willing  to accept a meager yield in the short term because TIPS protect against a spike in inflation, which could be devastating to the value of traditional fixed investments like regular Treasuries and bank CDs.

Breakeven rate. The rate on a 5-year traditional Treasury dropped today to 0.71%, 12 basis points below the rate of 0.83% on Aug. 16. Today’s rate results in a 5-year breakeven rate of 1.996%. This means today’s buyers will win against a traditional Treasury if inflation averages 2.0% or more over the next 5 years.

While this isn’t a bad bet, keep in mind that inflation has been running 1.4% over the last 12 months.

Still, TIPS buyers aren’t worried about sacrificing a small amount of yield today, when weighed against a spike in inflation in the future. TIPS buyers ‘gain’ from inflation.

And that is why you get a strong TIPS auction at a record-low yield.