Treasury Inflation-Protected Securities

• September 2016 update: Investors should know: TIPS ETFs and mutual funds are riskier than you think

Treasury Inflation-Protected Securities are a super-safe and super-conservative investment, right? That’s true if you buy and hold TIPS to maturity. I think it’s OK to say there is zero risk of default. You might not beat inflation after taxes, and you might miss out on other investing opportunities, but you will always get all your money back at maturity.

But investing in TIPS mutual funds and ETFs do carry risks, because the net asset value of those funds rises and falls in reverse correlation to the interest rate paid by the underlying securities. In 2012, with the base interest rates of TIPS issues near all-time lows, TIPS values have soared to near all-time highs. If those rates reverse, TIPS values will decline and so will the net asset value of the ETFs and mutual funds.

So there is risk, especially at a time of super low interest rates.

But how much risk?

I am going to try to draw a picture with charts. First, take a look of at the one-year performance of the iShares TIP ETF:

That is an impressive move upward – a gain of 10.5% in net asset value since last February. The all-time high for this fund is $119.38, about 34 cents above where it is trading today. This fund was up 13.4% in calendar year 2011.

That chart might lead you to think the TIP ETF is ‘volatile’ — but actually is isn’t. It has a reported ‘effective’ duration of 4.24, which is fairly low. (See the comments section below for updated information.) The performance was caused by a mighty drop in Treasury interest rates, not by volatility. For evidence, take a look at this next chart:

As you can see, long-term Treasuries were tracking close to TIPS until August 2011, just before the Federal Reserve began ‘Operation Twist’ to drive down long-term interest rates. The Fed action sent the value of long-term Treasuries soaring, and holders of the TLT ETF (Barclays 20+ Year Treasury Bond Fund) ended up with a 33.6% gain in 2011. This fund has a duration of 16.6. That is the definition of ‘volatile’ and TLT is therefore much riskier  than the tamer, shorter-duration TIP ETF.

Now I am going to add a couple of popular TIPS mutual funds to this chart, Vanguard Inflation-Protected Securities Fund (VIPIX, duration 8.5) and Fidelity Inflation-Protected Bond (FINPX, duration 6.7):

Interesting … despite some differences in duration, these three funds tracked very closely, all rising about 10% in the last year.

Finally, I am going to drop the volatile long-term Treasuries from the chart, along with the two TIPS mutual funds that track close to TIP, and add IEI (the intermediate-term Treasuries ETF, duration 4.45) and Vanguard’s Total Bond Market Fund (VBMFX, duration 5.0):

These three funds have similar durations, around 5, and yet the TIP ETF has greatly outperformed mid-range Treasuries and the overall bond market, which melds into a giant intermediate-term fund.

Why?

I think the ultra-low Treasury rates, across all maturities, are driving investors to TIPS because these investments are protected against a sudden rise in inflation. And with that flood of money into TIPS comes risk. They have outpaced the overall intermediate Treasury market, and the overall bond market. When interest rates begin to rise — when, who knows? — TIPS could suffer a deeper-than-expected drop as investors pour out of TIPS and into more conventional bonds, CDs and money markets.

That is the risk that buyers of TIPS ETFs and mutual funds face, even if the fund appears on paper low-risk and rather tame.

Here is a summary of the Associated Press report:

Consumer prices rose modestly in January on higher costs for food, gas, rent and clothing. But economists downplayed the increase, saying inflation will likely ease in the coming months as prices for raw materials level off.

The consumer price index increased 0.2 percent last month, after a flat reading in December, the Labor Department said Friday. Excluding volatile food and energy, so-called “core” prices ticked up 0.2 percent.

Here is the full press release from the Bureau of Labor Statistics.

Inflation (CPI-U, which determines the principal adjustment for TIPS) has been slowing in recent months, running at 2.9% for the last 12 months but slowing to zero in October and December 2011 and just 0.1% in November 2011.

The Treasury has posted the results of today’s auction of a new 30-year Treasury Inflation-Protected Security, with the auction generating a yield to maturity of 0.770%. This is CUSIP 912810QV3 and it will have a coupon rate of 0.750%, meaning that buyers are getting it at a slight discount, about $99.34 for each $100 purchased.

The yield to maturity of 0.77% is the lowest in the history of 30-year TIPS auctions and reissues. But it was an improvement over the expected rate, which in recent days looked like it could dip to about 0.65%. The previous low was 0.999% for a reissue in October 2011.

Commentary on the auction, from Cynthia Lin of  Dow Jones:

 … The government attracted only tepid interest at its 30-year inflation-protected bond sale. The $9 billion offering booked a bid-to-cover ratio of 2.46, the weakest level since sales of this maturity were reintroduced in 2010.

Bloomberg‘s Cordell Eddings tied the weak demand to the record-low yield, a huge factor for investors in a 30-year bond:

Demand declined at the Treasury’s auction of $9 billion in inflation-indexed bonds as investors balk at yields at record lows. … “It’s was a rough auction and there is no way around it,” said Michael Pond, co-head of interest-rate strategy in New York at Barclays plc, a primary dealer. “Investors just have a lower appetite for real yields as low as they are that far out the curve.”

The reaction of the TIP ETF demonstrates that the auction was a ‘downer,’ which is actually a good thing for buyers of this issue (defying expectations, they got a 10-basis point boost in yield over 30 years.)

The Treasury announced last week that it will auction a new 30-year Treasury Inflation-Protected Security on Thursday, Feb. 16. This will be CUSIP 912810QV3.

As always, you can buy this new issue directly from the Treasury by using TreasuryDirect, but if you are buying it for a tax-deferred account you’ll need to talk to your broker.

What to expect. A 30-year TIPS maturing in February 2041 is trading on the secondary market with a yield to maturity of 0.682%, so that gives a rough idea of the likely yield on this new issue. But new issues can be unpredictable. I’m guessing the rate will be a bit higher.

There have been only five new 30-year TIPS issues in history, because the Treasury stopped issuing them from 2001 to 2010. Here are all the new issues and their reissues:

As you can see, one year ago CUSIP 912810QPC auctioned with a yield to maturity of 2.19% (in addition to the inflation adjustment to principal over the 30-year life of the bond.) For buyers, that ended up being a very strong purchase. The market value of that TIPS has risen about 30% in a year as its yield has fallen to around 0.68%.

This happened in one year. Amazing. It demonstrates 1) the massive lack of confidence in the world’s economic recovery, and 2) the Federal Reserve’s aggressive program to buy long-term Treasuries and keep those rates very low.

If you are a trader and you want to buy this week’s issue, you should wonder: How likely am I to see a 30% increase in the value of a long-term Treasury, ever again? Not likely. It would mean TIPS buyers would be willing to take negative real returns over 30 years.

If you are buy-and-holder, and are building a TIPS ladder of varying maturities, this issue could be attractive, especially if the yield ends up being closer to 1%. At least for awhile, you won’t see positive real returns for any TIPS with 10-year maturities, or shorter.

If you are very, very worried about future inflation, then this TIPS also makes sense as a buy-and-hold investment, because you would be protected against that inflation. You can’t get that protection with a bank CD paying 1.2%.

If you decide to wait it out … This TIPS will be reissued on June 21, 2012, so you will get another shot if you suspect long-term rates could begin rising.

Charles Schwab, founder of one of the nation’s great brokerage firms, laid out his case today in the Wall Street Journal that the Federal Reserve, by holding interest rates near zero and committing to this policy for years to come, is damaging the U.S. economy and harming the nation’s savers by forcing them into riskier investments.

Thank you, thank you, thank you, Charles Schwab!

I have been seeing more and more of this sort of commentary. On the one hand, employment is gradually improving and GDP growth is holding around 2%. The stock market is rising nicely. And yet the Fed is determined to hold interest rates down, well below the rate of inflation, which Schwab rightly calls “central government manipulation of the free-market system.”

Schwab makes some excellent points:

Savers are being crushed.

“Average American savers and investors in or near retirement are being forced by the Fed’s zero-rate policy to take greater investment risks. To get even modest interest or earnings on their savings, they move out of safer assets such as money markets, short-term bonds or CDs and into riskier assets such as stocks. Either that or they tie up their assets in longer-term bonds that will backfire on them if inflation returns. They’re also dramatically scaling back their consumer spending and living more modestly, thus taking money out of the economy that would otherwise support growth. “

Fed policy sends the world into alarm.

“… the Fed’s actions, rather than helping, are having the perverse effect of destroying the confidence of businesses and individuals to invest and the willingness of banks to loan to anyone but those whose credit is so strong they don’t need loans. … To any potential borrower, the Fed’s policy is saying, in effect, the economy is still in critical condition, if not on its deathbed. You can’t keep a patient on life support and expect people to believe he’s gotten better.”

The Fed has no confidence in free markets.

“… the economy doesn’t need life support. Just the opposite. The patient needs to get up and start moving. We could get out of this mess, if only the Fed believed in the free-market system.”

What this means for TIPS. There is a new issue of a 30-year TIPS coming up this month, on Thursday, Feb. 16. That TIPS will likely auction with a base interest rate around 0.6%. While that would be a nice rate on a 5-year TIPS, it is ridiculously low for a 30-year TIPS. This is the result of the Fed’s assault on U.S. interest rates, and savers around the world.

I will just point out that one year ago, the Treasury auctioned a new 30-year TIPS, and it went off with a yield to maturity of 2.125%. And this was at a time of Federal Reserve easing! This same TIPS reissued in June at 1.744%. And now … 0.6%?

Really?

Thank you, Charles Schwab, for laying out the case that Treasury investors need to hear: The Federal Reserve is stealing from you.