Treasury Inflation-Protected Securities

Update: This 5-year TIPS reissue auctioned at negative 0.825%.

Stocks looking punk. The Dow Jones Industrial Average is down 430+ points this morning, on the day that the Treasury is auctioning a reissue of a 5-year TIPS, CUSIP 912828QD5. That reissue was already likely to generate a record low for a 4- or 5-year TIPS. This TIPS, which matures in April 2016, was going for a yield to maturity of negative 0.856% yesterday. (The record low was negative 0.555% in October 2010.)

A decline in the stock market doesn’t necessarily mean lower TIPS yields, but in recent days of volatility, a lower stock stock market has triggered lower TIPS yields as investors move to safe havens.

Mixed news on inflation. Also out today is a bump in overall consumer inflation, but a dip in core inflation:

The Labor Department says the Consumer Price Index rose 0.5 percent in July, following a drop of 0.2 percent in June. Gas prices accounted for much of the swing. They increased by a seasonally adjusted 4.7 percent after dropping sharply in June. The core index, which excludes volatile food and energy, rose 0.2 percent. That’s below the 0.3 percent rise in each of the previous two months.

Thursday’s report showed that on an annual basis, consumer prices were up by 3.6% in July, above the Fed’s target. But stripping out energy and food, inflation was only 1.8% higher over a 12-month span.

Could this TIPS go for negative 1%? One thing I know: I can’t predict a TIPS auction. But I would guess against negative 1%. Let’s see how bad things get today.

Inflation Trader blogger Michael Ashton weighed in on the auction last night:

With the Fed pinning the 5-year nominal Treasury at 0.90% at the moment, consider that even with the real yield of the 5y TIPS bond at -0.85%, all you need to be indifferent is for inflation to average about 1.75% over the next 5 years. … You would be hard-pressed to underperform 5-year nominal Treasuries over the next five years.

The auction results will come at 1 p.m.

Min Zeng wrote a good analysis last week on the rising asset values of Treasury Inflation-Protected Securities — at the same time inflation risk seems to be lessening. As Zeng points out, economic turmoil often leads to higher base yields on TIPS (and lower asset prices), because economic distress usually means lower inflation in the short term and also raises the specter of deflation.

Normally, when fears about the economy flare up, investors flee Treasury inflation-protected securities because their need to hedge inflation risk lessens. That was reflected in the selloff in TIPS that occurred in 2008, when the collapse of the Lehman Brothers Holdings Inc. fueled a deflation scare.

Yet prices of TIPS have surged in recent days, pushing down the 10-year benchmark TIPS yield below zero for the first time since the Department of the Treasury started selling this type of bond in 1997.

The price swings for TIPS have been rather amazing in the last 10 days, given that this is one of the world’s most ‘boring’ investments. For most investors, TIPS are the super-safe ballast in their portfolio. This chart shows that the TIP ETF (in blue) has been outperforming the AGG (aggregate bond market, red) since Aug. 1, and also shows that TIPS prices soared about 3.6% in about 8 days before coming back down a bit:

This is the opposite of what happened in the 2008 financial crisis, set off by Lehman Brothers’ collapse, as this chart shows:

The TIP ETF was down almost 10% during the fall of 2008, while the overall bond market stayed close to zero. When people ask me about the risks of TIPS mutual funds, I speculate: The downside risk is probably about 10% — bad, but not a portfolio crusher.

TIPS are at very lofty levels right now, with negative real yields climbing way up the maturity chart, to right about 10 years. Next week’s reissue of a 5-year TIPS could draw a real yield of as low as negative 0.9%. That is shocking because this same TIPS was first auctioned in April 2011 with a real yield of negative 0.18%. That is a huge swing in four months.

Zeng points to the underlying risk of inflation, even amid this turmoil.

Michael Pond, head of inflation bonds strategy at Barclays Capital Inc. in New York, the world’s biggest dealer on TIPS, said the U.S. consumer price index, stripping out of food and energy, has been running at an annualized rate of 2.5% over the past six months and 2.9% over the past three. Some analysts and economists predict they could tick up further in coming months. …

I think another factor is the Fed’s recent guarantee of ultra-low interest rates for the next two years. TIPS investors know they will have almost no super-safe, higher-yielding options in the next two years (except for I Bonds, which are limited to $10,000 per Social Security number this year, $5,000 next year.) As we face across-the-board low rates, TIPS at least have the advantage of inflation protection, a plus in these uncertain times.

One highly discussed factor is completely missing from this equation: The downgrade of U.S. debt by Standard & Poors. Treasury markets have soared since the downgrade, with the 5-year Treasury falling from 1.32% on Aug. 1 to 0.96% on Aug. 12.

Can a TIPS investment go wrong in this environment? Definitely. Zeng also adds this, quoting Mihir Worah of PIMCO:

TIPs may suffer a selloff should the debt-crisis deteriorate continues, feeding into fears about recession, he said, adding that deflation worries could re-emerge.

Great question from reader Drew:

Tipswatch — I hear you on “buy and forget it”. I’ve been doing that for years to build out a 30-year ladder which anchors the ‘safe’ allocation within my portfolio.

But I have a bit of a wrinkle I’d like to ask you about —

I recently noticed that the longer-duration 30yr notes that I bought at auction just over the last two years have appreciated considerably. For example, a 30-year TIPS note with a 2.13% coupon maturing in 2/14/2040 is currently trading at almost 30% above what I paid for it. In other words, if I sold, I’d achieve 12+ years of coupon payments in one fell swoop.

Even the recent 10-yr that clocked in at 0.639%. I bought, spending $10,008 on a note that is now trading at 10,436. If I were to sell it, just a month latter, I’d net $429, or almost 7 years of coupon payments at once. I figure I could just double up the next time 10-years go to auction.

I’m tempted to do this. . . am I missing something? Obviously if I sell I’m left with some gaps in my ladder.

Drew, I am not a financial adviser – I don’t even play one on TV – but my initial reaction is this:

I can see the quandary. I also have some older Treasury Inflation-Protected Securities that pay a real yield of more than 2% and even 3%. I consider those prized assets, but they are aging. I have one issue that pays a coupon of 3.875% and matures in April 2029. No way would I sell that one. I need those higher-yielding issues to balance off some of these more recent lower yields.

But there is logic to what you are saying, since you can sell and reap a large amount of future interest payments in the form of instant capital gains (and a lower tax rate, too). My cautions would be: 1) make sure you get the price you want since TIPS in the open market are thinly traded, and 2) understand that you may never – at least for several years – be able to replace those higher-yielding issues. The real yield on TIPS has been declining for years and that decline has even escalated recently. Eventually, we will hit bottom and start back up.

But you are right that this is a great selling opportunity.

On the 10-year paying 0.639%, that is a yield you could easily see again in a few months. So selling it, if you can get a good price, is a non-issue.

(But then this sort of reminds me of the time when I bought Apple at $80, and then sold it a couple of months later at $11o. Hmm … that worked.)

As of today, I wouldn’t be a buyer of new TIPS issues, or TIPS mutual funds. The rates are ridiculously low for all Treasuries. Treasuries are priced for a deep recession. The Fed’s announcement today of continued near-zero interest rates for two years is a slap at savers. We have few places to turn, and this could last for many more months. The lousy TIPS yields of a few months ago – like your 0.639% on a 10-year – now look very attractive.

Could the entire TIPS yield curve eventually go negative? Whoa, I don’t want to even think about that.

One of my favorite bloggers, Michael Ashton (The Inflation Trader) posted this chart today on the trend in the 10-year Treasury yield:

If this really is a bubble, selling and getting your profit now does make sense, especially for a 10-year yielding 0.639%!

One nagging question: Where will you put that money that was earning the rate of inflation plus 0.639%, until you can reinvest it in a super-safe asset?

I won’t waver from my buy and hold strategy, though. But sometimes, I say: Don’t buy. This is one of those times.