Treasury Inflation-Protected Securities

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.

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.