Treasury Inflation-Protected Securities

The announcement will come next Thursday  (Aug. 16), but we know the Treasury will be auctioning a reissue of a 5-year TIPS on Aug. 23.

I am guessing that this will be a reissue of CUSIP 912828SQ4, which was first auctioned on April 19 with a coupon rate of 0.125% and an auction-determined yield to maturity of -1.080%. That was an all-time low for a new or reissue of a 5-year TIPS.

Update: Here is the Treasury announcement, confirming it is a reissue of CUSIP 912828SQ4.

This one matures on April 15, 2017, and it currently trades on the secondary market at -1.227%, meaning that investors would get the rate of inflation minus 1.227% for the next five years.

Breakeven rate? The yield to maturity on TIPS is being held down, way down, by the ultra-low rates on traditional Treasuries. As of today, a 5-year Treasury is paying 0.74%, meaning a buyer of this TIPS at -1.227% will be a winner versus the traditional Treasury if inflation averages 1.967% over the next five years. I’d say there is very little risk in buying this TIPS, at least versus a traditional Treasury, which carries a rate priced for economic Armageddon.

But with a five-year TIPS, it’s better to look at other alternatives, such as:

• I Bonds, which pay the inflation rate and can be sold after five years with no penalty. I Bonds are clearly the winner, bought up to your purchase limit – $10,000 per person per calendar year.
• A 5-year bank CD, especially one with a minimal penalty for early withdrawal. You can find 5-year bank CDs paying around 1.75%, which pushes the breakeven rate on that five-year TIPS all the way up to 2.977%. Bank CDs are at rates we saw months ago, while Treasury rates have continued falling. Worth considering.

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%.