Treasury Inflation-Protected Securities

There’s a new issue of a 10-year Treasury Inflation-Protected Security coming up July 21, so prospective buyers will want to keep up with the likely yield (which is the base interest rate of a TIPS; in addition, the owner’s principal keeps rising with inflation until maturity.)

Boring info, but necessary … A lot of people don’t know what a TIPS is, or how it auctions. So I will try to explain. You can find lots of information at TreasuryDirect.gov, but I admit that government site is a bit hard to navigate. So I will try …

That base yield is set at auction. The TIPS also has a ‘coupon rate’ — the actual amount of interest it will pay over the next 10 years. If the coupon rate is 1% and the TIPS auctions at 0.9%, buyers will have to pay more than $100 for each $100 of this issue. If it auctions at 1.1%, buyers will pay less than $100 to get that 1% coupon rate.

As of Tuesday, the market yield for a 10-year TIPS was 0.676%. I get that by going to this Barron’s chart and looking at the yield for the TIPS maturing 2021 Jan 15. Since July 21 is a few weeks away, this number is going to change. But keep it in mind.

Here are the auction yields for every 10-year TIPS ever issued or reissued:

I highlighted the record low yield, 0.409% in November 2010, and the record high yield, 4.25% in January 2000. (I was a buyer of that one, but unfortunately it has matured. That is a fond memory.)

I also highlighted an unusual low point in April 2008 (1.25%), which is bracketed by higher numbers in July 2007 (2.749%) and October 2008 (2.85%). I think this is important because it shows that the 10-year TIPS yield can move fairly dramatically in a year or less.

This chart from the St. Louis Fed shows the eight-year pattern for 10-year TIPS yield:

The trend is definitely down. The recessionary period, shaded in gray, is interesting. It initially dipped, then rose as the Fed and U.S. government poured money into stimulating the economy. The peak in late 2008 may be an aberration, because financial institutions were selling off everything, including TIPS, to raise cash.

So, is a record low likely? TIPS yields are very hard to predict, and institutional geniuses out there are often wrong. But I doubt the 10-year TIPS auctioned July 21 will go below 0.409%.

I don’t know a lot about what charts can tell you, but the one above indicates to me that the 10-year yield is unusually low, but not insanely low. We could very well hang around in this sub 1.0% range unless 1) the economy severely worsens, creating a fear of deflation, or 2) the U.S. launches into yet another giant stimulus program. I am ruling out 3) the U.S. government defaults — hope we don’t get drawn into that mess.

What does that mean to you? If you are going to buy this TIPS at auction and hold it to maturity … well, you are going to get a subpar base rate. However, on all other counts you have a buy-it-and-forget-it investment, and you are protected against future inflation.

If you are holding a lot of money in TIPS mutual funds, your money could be at risk if the 10-year TIPS yield returns to a 1.5% to 2.0% range. As I showed in the chart above, that can happen pretty quickly.

Mihir Worah, PIMCO portfolio manager, is discussing inflation and TIPS in a new economic outlook titled, ‘Higher Commodity Prices and the End of Economic Growth Without Inflation‘.

Worah is manager of the $19.8 billion Pimco Real Return Fund (PRRIX),  which has about 78% of its investment in Treasury Inflation-Protected Securities.

Here are some excerpts:

Commodity prices are rising. Given the global supply/demand imbalances that we see, we expect commodity prices to be generally rising going forward, noting, of course, that commodity prices are volatile and that there will be differentiation among commodities. Much of this is related to the dynamics in and between developed and emerging economies. …

Inflationary pressure from commodities will be even higher within emerging markets. The reason: commodities are such a large part of their consumption basket – for example, nearly 60% in India, compared to about 25% in the U.S. …

Currency issues. Currencies may become another strong driver of inflation, especially among developed economies. We anticipate policymakers in the developed world will attempt to make their economies more competitive via a cheaper currency, which likely will, for net importers like the U.S., lead to higher inflation. …

Finally, in our view, the biggest implication for the global economy of these dynamics is that the goldilocks days of the ’90s where nations could have strong growth and low inflation simultaneously are gone.

Worah goes on to endorse Treasury Inflation-Protected Securities as a hedge against rising inflation. (Remember, however, that he manages a fund that specializes in TIPS, so he has an interest in promoting them.)

To be sure, there is currently a valuation issue with inflation-linked bonds as real rates on such bonds are low. But we believe those rates are likely to stay low – one way for developed markets to escape from their debt overhang is by artificially keeping real rates low, either through regulation or through higher inflation via inflationary/low-rate policies. So in our view, inflation-linked bonds have the potential to hold their value while serving as a cornerstone of an inflation-hedging strategy. …

Investors should seek out prudently managed active strategies that provide the benefits of inflation-linked bonds while attempting to enhance the offered yields.

Update: Yes or no on this 10-year TIPS auction?

Buyers of Treasury Inflation-Protected Securities used have have to wait months for new auctions, but now they seem to come every month. And in fact … they do … you will have a TIPS buying opportunity every month for the rest of this year.

Next up  is a new-issue 10-year TIPS. The announcement will come July 14, and the auction is July 21, 2011. It will settle July 29. This is the last new issue of the year, the rest are reissues. Here is a 2011 schedule presented on ExploreBonds.com:

N = a new issue that hasn’t been on the market before
R = a reopening of a bond sold in a previous auction

10-year TIPS, what to expect? Not much in the way of yield, unfortunately. Right now, a 10-year TIPS sold on the open market would net a yield-to-maturity of about 0.620%, plus the inflation adjustment to principal. That’s near historic lows, and … not very exciting.

The last 10-year reissue, issued on May 31, 2011, auctioned at a base yield of 0.887%. I was a buyer of that one, and I will probably hold my nose and buy the July new issue, in a small amount.

10 years, the sweet spot? Not sweet in yield, that is certain. Ten-year TIPS traditionally yield about 2% above inflation.

But if you are laddering TIPS, 10 years is a great number. Possibly you will be retired in 10 years? Then, when this TIPS pays out, you will have the option to keep the proceeds and spend it, or reinvest it however you wish. If you have a lineup of 10-year TIPS, you will have this option every year in retirement.

I want to keep a supply of TIPS paying out into the future.