Treasury Inflation-Protected Securities

The Treasury on April 19 will auction a new issue 5-year Treasury Inflation-Protected Security, and it is likely to have a deeply negative base interest rate. I am going to try my best to explain why anyone would buy this issue — skeptics are going to tell you it is a disastrous investment. Negative rates!

Yes, the base rate is negative, but the principal on TIPS continues to grow at the rate of inflation until maturity, at least partly balancing off that negative base rate. So if inflation runs high enough, a 5-year TIPS works out well for the buyer. Otherwise, it can be a loser. But how much of a loser?

Right now, a 5-year TIPS maturing July 15, 2017, is selling on the secondary market with a yield to maturity of -1.148%. The new issue should come in around that rate. (But I suspect the rate will be more favorable, possibly around -1.0%; that has been the trend at recent auctions).

But let’s assume the auction goes off at -1.148%. That looks like a very bad rate, I admit. How does it stack up against similar super-safe investments?

I Bond, zero base rate, plus rate of inflation
5-year TIPS -1.148%, plus rate of inflation
5-year Treasury 1.03% fixed rate
5-year insured CD 1.75% fixed rate

Let’s look at the returns these investments would generate under varying rates of inflation:

Assumption No. 1: Inflation averages 1% over the next five years

• 5-year insured CD 1.75%
• 5-year Treasury 1.03%
• I Bond, 1%
• 5-year TIPS, -0.148%

The TIPS is the big loser, the bank CD is the winner.

Assumption No. 2: Inflation averages 2% over the next five years

• I Bond, 2%
• 5-year insured CD 1.75%
• 5-year Treasury 1.03%
• 5-year TIPS, 0.852%

The I Bond edges out the bank CD, the TIPS is the least favorable investment.

Assumption No. 3: Inflation averages 3% over the next five years

• I Bond, 3%
• 5-year TIPS, 1.852%
• 5-year insured CD 1.75%
• 5-year Treasury 1.03%

The I Bond again leads the way, but now the TIPS has surpassed the bank CD.

Assumption No. 4: Inflation averages 4% over the next five years

• I Bond, 4%
• 5-year TIPS, 2.852%
• 5-year insured CD 1.75%
• 5-year Treasury 1.03%

Assumption No. 5: Inflation averages 5% over the next five years

• I Bond, 5%
• 5-year TIPS, 3.852%
• 5-year insured CD 1.75%
• 5-year Treasury 1.03%

The lesson of this exercise: Buy I Bonds, up to the limit ($10,000 per individual and $20,000 for a couple.)

But after you reach that limit, you should weigh a bank CD against a 5-year TIPS. If you can get a rate of 1.75% on a bank CD, you push the TIPS breakeven rate all the way up to 2.898%. The bank CD is a winner unless inflation averages more than 2.9% a year for five years. And with a bank CD, you might be able to get an attractive early withdrawal penalty, making it a more flexible investment.

If you really, really fear inflation in the next five years, this TIPS makes sense for you. If you think inflation will remain under 3%, then a bank CD might be the better option.

Otherwise, it looks like demand for this 5-year TIPS new issue will come from the high-roller investment firms and foreign banks. It isn’t very appealing for the small investor.

Are Treasury Inflation-Protected Securities now an unsafe or unwise investment? Is the Treasury market at the start of a long bear market? Will stocks greatly outperform bonds over the next 10 years?

Burton Malkiel

Burton Malkiel, author of ‘A Random Walk Down Wall Street,’ wrote an intriguing piece for the Wall Street Journal on March 22, titled ‘What Does the Prudent Investor Do Now?‘

Malkiel makes the case that as the economy continues to improve, investments in bonds – especially Treasuries – are going to make investors weep. One of his key points:

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.

While Malkiel doesn’t specifically mention TIPS, he does point out that super-low rates on today’s Treasuries mean that investors will get negative real returns (less than the inflation rate). In the case of TIPS, most buyers today are guaranteeing themselves rates  less than inflation, since the base rate is currently negative all the way up to 10-year issues.

As an alternative, Malkiel suggests investments in low-cost stock mutual funds (he feels that stocks are still a bit undervalued) and real estate (which could be nearing the end of a massive bear market).

Back to being ‘prudent’ … Malkiel makes a sensible, conservative investing argument: Stocks will outperform Treasuries in the next 10 years. Yes, that could very likely happen, as Treasuries are probably ending an amazing 30-year run of lower rates.

But the argument should never be stocks vs. bonds. The argument should be risk investments vs. super-safe investments. I have never argued that anyone hold 100% of their portfolio in TIPS or Treasuries. That would not make sense.

Every investor should decide, how much risk do I want to take? … and allocate assets to match that risk. An investor interested in capital preservation – nearing retirement with a sizable nest egg – could come up with something like:

• 10% Highest risk: International, small cap stocks
• 40% Higher risk: Large-cap dividend paying stocks
• 25% Lower risk: Broadly diversified bond funds, municipal bonds
• 25% No risk: TIPS, I Bonds, insured bank CDs, Treasuries held to maturity

My contention is that you can change the asset allocations, but you can’t change what’s in them. No matter how safe you think stocks are, you can’t put them into your ‘No Risk’ category. There are only a few ‘No Risk’ investments (money market funds, by the way, don’t qualify).

With the No Risk category, the investor is looking to preserve capital, no matter what happens. Stocks and bond mutual funds (including TIPS funds) can’t fill that role. In recent years, buying and holding TIPS to maturity has been an excellent way to fill this need. Today’s low rates make TIPS less attractive. I Bonds remain the best choice for this category, up to your purchase limit.

The Treasury ‘bear’ market. There are lots of news articles out this weekend pointing out that the Treasury market has taken a hit in 2012, for example: ‘Bonds limp to end worst quarter since 2010.’ And of course, stocks have done very well in the last three months.

So I want to close today with this chart, which compares the performance of the SPY ETF (S&P 500), the TIP ETF (overall TIPS market) and the TLT ETF (long-term Treasuries):

Amazingly, the TIP ETF split the difference between the stock market gains and the long-term Treasury losses, and was actually up slightly in the first quarter. That is not a bear market.

TIPS are a different animal, because of the inflation adjustment to principal. It appears that investors are fleeing longer-term Treasuries, but not TIPS.

And that also means that TIPS remain ‘unattractive’ for near-term buy-and-hold purchases.

The Treasury just posted the results for CUSIP 912828SA9, a 9-year, 10-month reissue.

The previous low for any 10-year TIPS issue or reissue was this same CUSIP 912828SA9, first issued on Jan. 19. It went off two months ago at -0.046%, the first 10-year TIPS in history to auction at a negative yield.

Since this TIPS carries a coupon rate of 0.125%, buyers at today’s auction had to ‘pay up’ for the purchase, about $102.22 for every $100 of value, and that’s up from the $101.66 buyers paid two months ago.

About that negative yield …  it’s not really negative. The principal balance of a TIPS issue continues to grow with inflation until maturity. In effect, buyers of today’s new issue were accepting the rate of inflation minus 0.089% for 10 years. If inflation averaged 2.5% over the next 10 years, TIPS buyers would be getting 2.411% on their investment. The 10-year traditional Treasury was paying 2.29% today. Pick your poison.

Reaction to the auction, from Bloomberg:

“We are continuing to see inflation expectations gather steam,” said Aaron Kohli, an interest-rate strategist at BNP Paribas SA in New York, one of 21 primary dealers that are required to bid at the sale. “With energy prices running hot the market has priced in inflation over the next 10 years.”

As I have said in previous posts, you should ignore the talk that TIPS are moving into a bear market, along with traditional Treasuries. TIPS are showing surprising strength, too much strength in my opinion. But that is what the fear of inflation does to TIPS investments.

(Bear market = buyers market. We aren’t in one.)

If … if … if … rates on traditional Treasuries continue to climb (no sign of that this week), TIPS yields will be dragged higher. As the 10-year Treasury climbs, the 10-year TIPS rate cannot continue below zero. That won’t happen, because buyers … at the least … will move to traditional Treasuries.

So right now, we are in this limbo, with TIPS setting an all-time low today. There it is.

It’s been an interesting month for Treasuries – just read the reports, all over the Web, about the end of the Treasury bull market, the coming Treasury bear market, steeply rising interest rates, and on and on. But if you were an investor in TIPS, you would have seen maybe a blip in your holdings. The fact is, very little has changed.

Tomorrow (March 22) the Treasury will auction a reissue of a 10-year Treasury Inflation-Protected Security, CUSIP 912828SA9, that was first issued on Jan. 19, with a coupon rate of of 0.125%, but it auctioned at -0.046%, the lowest rate ever for a 10-year TIPS.

Tomorrow’s auction is going to threaten that lowest-ever record. Here is the current value of CUSIP 912828SA9, at the close of today’s market:

So, to recap … Treasuries are in a bear market. However, this TIPS, which was issued three months ago, has gone up in value about 2% and pays a yield of -0.109%, lower than the issued yield of -0.046% three months ago.

Some bear market.

TIPS are not yet in a bear market. As Treasuries slumped last week, TIPS did take a hit, but it appeared some investors were leaping from traditional Treasuries into TIPS to take advantage of the inflation protection. That explains the rise in breakeven rate, which today settled in at 2.41%. (Here’s why that is important.)

I consider Thursday’s auction to be unattractive, especially if it goes off at a record-low base yield. Right now, that looks very likely. I should mention that predicting TIPS yields is very difficult, and I am lousy at it. I’d expect this auction to be a bit better than the current yield, maybe something along the lines of -0.08%? My guess is based on the fact that recent auctions have been coming in with better-than-market rates.

I have to ask: Who is buying this? Treasuries are under fire, and yet buyers want to take a TIPS issue at an all-time low yield?

For the record, here are all the 10-year TIPS issues and reissues from recent years. Check out that yield column. The time to buy is not yet here, just my opinion.

• Jan. 8, 2015, update: TIPS investors: Why the inflation breakeven rate is your friend

A curious thing happened last week. The Treasury market took a hit, with the yield on a traditional 10-year Treasury rising to 2.31%, its highest level since Oct. 28, 2011. With that increase in yield came a decline in the value of all Treasuries, including Treasury Inflation-Protected Securities.

But at the same time, the ‘breakeven rate’ for 10-year TIPS issues went up, meaning that even as TIPS values went down, they were becoming more expensive.

What is the breakeven rate? If you are interested in buying the 10-year TIPS being auctioned this Thursday (March 22), you should be looking at the breakeven rate, which reached a very high level at the end of last week. Here is the formula:

10-year Treasury yield – 10-year TIPS yield = 10-year breakeven rate

As of Friday, this equation was 2.31 – (-0.118) = 2.428.

Is this important? Very. Here’s why: On Friday, you could get a 10-year Treasury with a yield of 2.31% or a 10-year TIPS with a yield of negative 0.118%. If you buy that TIPS, inflation must average 2.428% over the next 10 years for you to ‘breakeven’ over a traditional Treasury.

It is as simple as this: When the breakeven rate rises, TIPS are more expensive, at least compared with traditional Treasuries. Here is a breakeven chart for 10-year TIPS auctions over the last five years, with Friday’s rates at the top for comparison:

As you can see, Friday’s breakeven rate popped well above the rate of recent auction dates. It’s also interesting to see the extraordinarily low breakeven rate of 0.265% in January 2009, when the world feared deflation and economic meltdown. That was the single greatest day to buy TIPS at auction in the last five years.

This chart shows the one-year and one-month trends in the breakeven rate:

What happened last week? I have been speculating that the soaring stock market, relative calm in Europe and waning Federal Reserve stimulation might result in higher interest rates, especially for Treasuries. The market took a step in that direction last week. Will this continue? Who knows.

If you invest in the TIP ETF (or any TIPS mutual fund), you took a hit, as this 5-day chart shows, but the damage was not severe:

I included IEI (red line) in this chart because it is an ETF of traditional Treasuries, with a similar duration to TIP. The damage was worse for IEI, and note that on Friday, the TIP ETF recovered more of its losses than IEI. That is the breakeven rate rising.

This week’s auction. My feeling is that the breakeven rate needs to come down and the TIPS base yield must rise for Thursday’s 10-year TIPS auction to be attractive. If Treasuries continue their decline next week, and Treasury yields rise, how much appetite will there be for TIPS with negative real yields?