Treasury Inflation-Protected Securities

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.

The Federal Reserve announced June 20 that it will extend its program of selling short-term Treasuries and buying long-term Treasuries, effectively extending ‘Operation Twist’ beyond its scheduled expiration at the end of this month. From the McClatchy Newspapers report:

Because of the deteriorating conditions, the Fed said, benchmark interest rates are likely to remain near zero through at least late 2014. And a program set to expire this month, where the Fed swapped out $400 billion in short-term bonds for bonds of longer duration, will continue through the end of the year.

The Fed did not indicate the size of the swap for the rest of the year, but said it would trade out bonds with maturities of three years or less for those with maturities of six years to 30 years.

The expected result would be for Treasury values to strengthen, but the market for Treasury Inflation-Protected Securities, already at record-high prices (and low yields), has responded with a ‘ho-hum.’

Here’s a chart comparing prices over the last five days for TIP (the TIPS ETF) and TLT (the long-term Treasury ETF, shown in red in the chart):

So far, Operation Twist is doing little to support the very-lofty values for TIPS.

However, the Fed’s commitment to holding short-term interest rates very close to zero through 2014 will provide support for TIPS because yields on traditional Treasuries will remain very low. If break-even rates remain around 2.0%, TIPS will continue to provide negative yields to inflation for many more months.

The Treasury today auctioned a 29-year, 8-month reissue of CUSIP 912810QV3, resulting in a yield to maturity of 0.520%. That’s a record-low yield for an 30-year TIPS issue or reissue; the previous low was 0.77%, for this same TIPS when it was first auctioned on Feb. 16, 2012.

The record low isn’t a surprise – this TIPS was trading in the secondary market yesterday at about 0.479%, so the 0.52% was a bit of a positive move for today’s buyers. The auction continues a one-year trend of steadily lower TIPS yields, across all maturities.

The 30-year breakeven rate, which is the difference between yields on a traditional 30-year Treasury and 30-year TIPS, is about 2.17%. This rate ran as high as 2.56% in March, when the U.S. economy appeared to be gaining momentum.

‘Headline’ inflation – the measure that determines the inflation adjustment to principal for TIPS – took a dive in May, falling 0.3%, pulled down by a plunge in gas prices. It was the biggest drop since December 2008 – the dark days of the global financial crisis.

Gas prices sank 6.8 percent, also the most since December 2008. Food costs were unchanged.

But ‘core’ prices, which exclude food and energy and are closely watched by the Fed, rose 0.2 percent for the third straight month. From the Washington Post report:

Over the past 12 months ending in May, consumer prices rose 1.7 percent, much less than the pace for the 12 months that ended in April. Core prices have risen 2.3 percent in the past year, the same as for the 12 months ending in March and April. That’s close to the Fed’s 2 percent target for inflation.

In the Fed’s view, inflation is just about on target. Blogger Michael  Ashton points out that  ‘core inflation didn’t show any signs of rolling over. ‘ Although ‘deflation’ would seem to open the door to new Federal Reserve stimulus, Ashton says:

We’re unlikely to see core CPI dipping any time soon, so if the Fed wants to do QE, they’ll need to suddenly grow interested in headline inflation.

But weakening headline inflation means lower returns for holders of TIPS, which are currently carrying negative base interest rates far up the maturity ladder. When you combine a negative base rate with a weak inflation rate, TIPS holders get double dose of weak returns.