Treasury Inflation-Protected Securities

If you read investment commentary (it’s hard to avoid, isn’t it?) you surely have seen the rash of stories in 2012 predicting a long-term bear market for traditional Treasuries and their mutant offshoot, Treasury Inflation-Protected Securities. Examples:

• April 27, Kiplinger: Treasury Bonds: A Lousy Deal
• April 18, CNN: Here comes the bear market for bonds
• April 8, Business Insider: Is The US Treasury Market About To Mint A Fresh Generation Of Idiots?
• March 20, Seeking Alpha: Are Bond ETFs Finally In A Bear Market?

I’m not criticizing this train of thought, in fact, I pretty much agree with it. Since the middle of 2011, with massive Federal Reserve intervention in the Treasury market and a boiling economic crisis in Europe, interest rates on traditional Treasuries and TIPS have fallen to all-time lows. Those rates can’t be sustained.

I have been saying that for several months. And I have been wrong.

Here’s the way TIPS have performed in 2012, represented by the widely held TIP ETF:

The TIP ETF closed Friday at 119.54, just pennies off the all-time high of 119.77. Yields to maturity for TIPS are now negative (before the inflation adjustment) all the way up to 2025 Jan 15, nearly 13 years into the future. And this is happening at a time when:

1. Inflation is slowing, dropping to 2.7% for the 12 months ending in March.
2. The Federal Reserve is winding down ‘Operation Twist’ to force down long-term rates and is not committing to a new round of easing.
3. The stock market has soared, slumped and then recovered, leaving the S&P 500 with a year-to-date return of 11.86%.
4. The European crisis has stabilized – at least temporarily.

TIPS, so far, have a bit of a ‘safe-haven’ status in the Treasury world. The inflation protection gives them appeal to investors even when their base rates fall into the negative. Look at how the TIP ETF has performed this year versus TLT, the long-term Treasury ETF:

While the long-term Treasury ETF has rallied, its year-to-date performance is running well behind the TIP ETF, which is up about 2% for the year.

So far, TIPS are the Energizer Bunny of bond investments, they keep going and going. It’s reasonable to expect this long-term, massive move upward will eventually break. But it isn’t happening yet.

What to expect from here? In a New York Times analysis, Jack Duff speculated that the strong run in TIPS could prove to be a loser for future investors:

“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.”

But that analysis was written in July 2011, the dawn of a huge surge in TIPS. At the time of the article, the TIP ETF closed at 109.30 and today stands at 119.54, a 9.3% gain since the New York Times article appeared.

Here are some more-recent thoughts from Jeffrey Kosnett’s Kiplinger article I cited above:

Bond markets do not turn around instantly and aren’t vulnerable to a flash crash, as the stock market has shown it is. Pessimists often spin the widespread ownership of Treasuries by people and institutions around the world as a reflection of our dependency on foreign money. But I see the global affection for Treasuries differently: I think it shows that every nation on earth has confidence in the U.S. as a place to keep reserves. But those investors, no matter where they are located, will gradually demand to be paid better by Uncle Sam.

So if you’re a Treasury investor and feel on the spot, you don’t have to rush to decide what to do next.

The Treasury just completed its auction of a new 5-year Treasury Inflation-Protected security, which resulted in a yield to maturity of -1.080%.

CUSIP 912828SQ4 has a coupon rate of 0.125%, meaning that today’s buyers had to pay up for this issue – $106.38 per $100 of value.

This is the lowest rate ever for a new or reissue of a 5-year TIPS. The previous low was -0.877% for an auction on Dec. 15, 2011.

Reaction to the auction, from Bloomberg:

“There is still significant demand for inflation protection given the accommodative Fed,” said Michael Pond, co- head of interest-rate strategy in New York at Barclays Plc, one of Fed’s 21 primary dealers that are required to bid at U.S. auctions. “For the largest-ever notional tips auction at the lowest-ever real yield, the Treasury has to be very pleased with these results.”

Bloomberg points out that the auction set a 5-year breakeven point of 1.93%, versus a 5-year Treasury trading today at 0.85%. That is …

down from a year-to-date high of 2.22 on March 14. The average during the past decade is 1.94 percentage points.

I think the breakeven rate on a 5-year is pretty distorted, since you can get a 5-year insured bank CD today at about 1.75%, pushing the breakeven point to 2.83%, higher than the current 12-month rate of inflation of 2.7%, even with gas prices soaring.

Nevertheless, I think the Treasury has to be very happy about this record-low yield, and buyers should just shrug and accept a super-safe investment that is protected against an unexpected surge in inflation.

The U.S. Labor Department reported today that the Consumer Price Index rose 0.3% in March, mostly because of higher food and gas prices. In 12 months that ended in February, prices rose 2.7 percent. That’s below last year’s peak year-over-year rate of 3.9 percent.

From the Associated Press report:

Core prices have risen 2.3 percent in the 12 months that ended in February, close to the Federal Reserve’s inflation target of 2 percent. … Fed chairman Ben Bernanke has acknowledged that rising gas prices have boosted inflation. But he has maintained that the increases are likely temporary.

From Bloomberg:

“Inflation is going to be slowly decelerating as the energy price impulse that we’ve seen starts to fade,” said Michael Carey, the chief economist for North America at Credit Agricole CIB in New York, who correctly forecast the rise in prices. “The Fed is in wait and see mode. Inflation is not driving policy. They are more concerned about economic growth and the labor market.”

Holders of TIPS get the benefit of a 0.3% increase in principal for all issues. But it does appear that inflation is slowing from the plus-3% annual rate of recent months.