Treasury Inflation-Protected Securities

Personally, I am not going there. I don’t short, that’s not my style, and I definitely don’t feel I could accurately predict the future trend of TIPS mutual funds and ETFs, although I don’t own any at the moment and have repeatedly pointed out that mutual funds investing in TIPS are riding near 5-year highs.

So along comes The Inflation Trader blog on SeekingAlpha.com with a post titled, ‘Don’t count Bill Gross out just yet.’ (Not that I would ever count Bill Gross out. … Come on.)

Inflation Trader, I will just call him IT, points out that bonds had a big selloff on Tuesday, and that also affected TIPS, by the way. Since I am following the 30-year TIPS to be auctioned next week, I was interested in this development Tuesday:

That 30-year yield took a very nice leap upward on Tuesday, and anything getting it closer to 2% would make next week’s 30-year TIPS auction a lot more appealing. But the point is, Tuesday was not kind to Treasuries. (Wednesday was another matter, and I will write about that tomorrow.)

Back to IT, who writes:

Maybe bond guys just realize that if all of this bad news is in place, and not many folks are expecting a cheerful resolution from the Greek crisis, there are few reasons for Treasuries to rally further. … I also wonder if it is time to be short TIPS.

IT wrote this before Wednesday’s inflation numbers, which were a little worse than expected, so that counters (somewhat) the rest of his argument, which includes:

A small miss lower on CPI will not change the fact that the overall trend is upward, but it would serve to reduce the fear premium currently embedded in TIPS. A miss higher would keep that fear premium stable or even increase it a little bit, but that would probably be in the context of rapidly rising rates overall.

My point is that there is an anti-TIPS sentiment brewing, versus the overwhelming  pro-TIPS sentiment of the last several months. This is a lot more important for people who invest in TIPS mutual funds and ETFs. It is less important for people – like me – who invest in TIPS and hold them to maturity.

But what about that 30-year TIPS auction next week? Time to ponder.

The Financial Times Alphaville blog has an interesting post today speculating on the U.S economy and interest rates. The blog points out that Credit Suisse’s Andrew Garthwaite is over-weighting equities again, because Credit Suisse sees the stock market’s recent slump as a correction, not the beginning of a longer-term bear market. And it does not believe the U.S. economy is heading into recession.

At least for now.

The post gets  interesting when it points out Credit Suisse’s thinking on U.S. fiscal policy, and when the U.S. government will be forced to pare back its massive deficit.

So, the question becomes: when will the 10-year TIPS yield rise to 2% (for at that level, on our calculation, the fiscal tightening needed to stabilise government debt-to-GDP would rise to 7% of GDP, a level that would threaten the macro outlook and would also be politically hard to deliver forcing the US debt into a vicious circle of rising rates leading to a greater loss of fiscal credibility). Our answer is simple: it happens when either US banks are overweight government securities (when they have 20% of their assets in government securities, compared with 13% currently) or there is a sharp acceleration in private sector loan growth (forcing banks to lend to the private sector, not the government).

The point is … when the base yield rises to 2%, the federal government is going to have a difficult time paying ever-rising interest rates. “We think both events are unlikely to happen until late 2012,”  Credit Suisse says in the blog.

For longer-term investors in TIPS, a 2% base yield (or higher) was the norm for many years through the last decade. Right now that yield is about 0.72%, well below the norm.

Most bond funds, and especially Treasury funds, are considered a safe harbor during a time of stock market decline. But mutual funds and ETFs that hold Treasury Inflation-Protected Securities don’t always follow that pattern. The market value of TIPS is also influenced by inflation expectations, which puts a complex spin on their pricing.

If the stock market is going down because of economic fears – as it has been over the last month – then TIPS may underperform other bond funds. The reason: The fear of inflation is dwindling.

This chart shows how the TIPS ETF has fallen behind other benchmark bond funds:

The real safe harbor? I contend that buying Treasury Inflation-Protected Securities directly through TreasuryDirect.gov, or through your broker in a retirement account, is a true safe harbor. This investment will produce a real return over inflation, and it is super safe.

TIPS mutual funds are a bit of a gamble. They have been an excellent investment over the last few years. But the market price of TIPS will go down if the base yield rises, and the base yield is at a historically low rate.

No one can predict for certain what the yield will be for the reissue of the 30-year TIPS, which the U.S. Treasury will auction June 23. But we can get a pretty good idea. And I’m going to explain how to make that estimate, for this and all TIPS issues.

The announcement will come June 16, and it will include a ‘coupon’ yield of the TIPS being reissued. Most likely it will be a reissue of a TIPS that matures Feb. 15 2041, and that TIPS has a coupon yield of 2.125%. (In addition, as with all TIPS, your principal continues to grow at the rate of inflation for the life of the issue.)

The coupon yield? Ignore it.

The real base yield is set at the auction, and it is likely to be less than 2.125%. That means if you buy $1,000 of this TIPS, you will pay more, let’s say $1,050 for each $1,000 and that effectively lowers your yield.

Since TIPS are traded on the open market, you can get an idea of what the market yield of a 30-year TIPS is right now. You see my Blogroll on the right of this page? There is  a link called Barrons: Current TIPS values. If you click on it, you will go to a page Barrons updates daily with current market yields for TIPS. It is a great resource.

So if you look at that chart, and scroll all the way down to the bottom, you will find the issue that matures Feb. 15, 2041. It says this for Wednesday, June 8:

The yield column is a pretty good estimate of the base yield of this 30-year TIPS, sold Wednesday on the open market. So at this point, two weeks before the auction, you are looking at a base yield of 1.76%, even though the coupon rate is technically 2.215%.

This will change, so it is a good idea to keep an eye on this chart as we approach the auction. In the most recent 10-year and 5-year TIPS auctions, the rate that buyers received was a little better than expected. That could happen again.