Treasury Inflation-Protected Securities

A New York Times article with the headline ‘An Inflation Hedge Carries Its Own Risks‘ spells out why TIPS mutual funds appear to be overpriced, and possibly risky, after substantial gains. Some of its major points:

Investors who placed bets on mutual funds specializing in inflation-protected Treasury securities were among the bond market’s biggest winners over the last two years, even as other Treasury funds struggled. … “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.”

The surprise is that this article was written July 11, 2011, practically to the day that TIPS base yields began moving into negative and TIPS mutual funds started a strong move higher. Here is the chart for the TIP ETF, which has risen about 8.9% since July 11, 2011:

Obviously, you can’t trust the experts. But …

I will admit that back in July 2011, I agreed with this New York Times article. TIPS seemed pretty expensive. Looking back, boy, were we wrong. Yes, TIPS were expensive relative to history, but not expensive at a time of massive Federal Reserve manipulation in the Treasury market.

Since July 2011, yields have literally turned upside down to what I would call the ‘Real World.’ Now we are living in the ‘Fed World.’

Real World. On July 21, 2011, a 10-year TIPS auctioned with a yield of 0.639%, meaning that buyers would receive 0.639% above inflation over 10 years. That looked expensive at the time, but in retrospect …

Fed World. This week the Treasury reissued a 10-year TIPS with a yield of -0.75%, meaning that buyers were accepting 0.75% less than inflation for the next 10 years. They  were betting big on higher-than-expected inflation.

A yield of -0.75% is expensive, right? Can we finally settle on that? But it was another in a string of record-low yields for TIPS. Until we see that trend turn around, I think we can say the Fed World is still going strong.

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.