Treasury Inflation-Protected Securities

Jason Zweig makes an excellent observations in his April 30 Intelligent Investor column in the Wall Street Journal: Don’t trust the yield quotes you see for some (not all) TIPS mutual funds.

Among the 173 TIPS mutual funds tracked by Morningstar, the reported “SEC yields” as of March 31 ranged from minus-0.77% to 5.58%, with 12 funds yielding at least 5%. Four of the seven exchange-traded funds that specialize in TIPS displayed yields greater than 5%, with Pimco 15+ Year U.S. TIPS Index leading the pack at 6.07%.

Yet no TIPS yield more than 1.75%. How could anyone but an alchemist generate 5% or more out of 1.75% or less?

The answer lies hidden in the term “SEC yield.”

In theory, since inflation can jump in a single month, as is did recently to 0.5%, you could annualize that rate to look like inflation is running at 6%, which it isn’t.

Take a look at the iShares TIP ETF, which can demonstrate the issue. On the fund’s data page, the 30-day SEC yield is listed as 5.59% — accurate but misleading. On the other hand, iShares also lists the Average Real Yield to maturity as 0.2% and the 12-month yield as 2.76%.

The data page for the Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX) intentionally underestimates its annualized yield, which is a ‘miserable’ -0.09%. But on Vanguard’s Website a box also pops up when you mouse over that rate:

The yield quoted is the real yield, or the yield before adjusting for inflation. The actual yield of Vanguard Inflation-Protected Securities Fund will be a combination of the real yield and an inflation adjustment. A complete estimate of the fund’s yield requires that an estimate of future inflation be added to the real yield. Because inflation fluctuates, it cannot be projected into the future precisely enough to be included in the yield quote. The inflation adjustment is based on changes to the Consumer Price Index (CPI) and can be either positive or negative, based on the change to the CPI. Investors interested in maintaining the purchasing power of their investment should invest their dividend distributions.

Vanguard is doing this right.

The results are in for the 5-year Treasury Inflation-Protected Security auctioned April 21, 2011. The CUSIP is 912828QD5.

As expected, the 5-year TIPS carries a coupon rate of 0.125%. But because of high demand, bidders are paying $101.75 for $100 of this security. That results in a yield of negative 0.18%. (However, in addition to the base yield, investors in TIPS see their principal grow at the rate of inflation until maturity. This one matures April 15, 2016.)

That yield of -0.18% was a little better than I expected. Since I was a buyer of this TIPS, I wanted that negative yield as close to zero as possible. A few days ago it looked like -0.2% to -0.3% might be possible.

This works out well if …

Right now the regular 5-year Treasury is paying 2.13%. The 5-year TIPS auctioned today will do better than that if inflation averages more than 2.31% over the next five years.

So 2.31% is the breakeven rate. Since the TIPS offers protection against inflation, my opinion is that it is a better investment than the 5-year Treasury, or any five-year CD you can find out there. Not great, just a little better.

Glen Bradford is trashing the TIP ETF today on SeekingAlpha.com:

Frankly, anyone that thinks buying the iShares Barclays TIPS Bond Fund (AMEX: TIP) is going to protect you from inflation is a joker. If you want to protect yourself from inflation, you have to buy commodities. The problem with TIP is that the way they measure inflation is designed to understate true inflation.

The TIP ETF has had a great run over the last two years.

My opinion: This ETF isn’t useful as a long-term investment, but it can be used for short- to medium-term trades. If you think the TIPS base rate is going to keep falling,  then this ETF makes sense. That’s a risky bet.

My preference is to hold TIPS to maturity — forming a secure basis for my overall portfolio.

Update: This 5-year TIPS was auctioned April 21 with a base yield of -0.18%.

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Although the base rate of the 5-year TIPS being auctioned Thursday (April 21) will be ‘positive’, the resulting yield from the auction will be negative. How does that happen? Bidders will have to pay more than $1 for $1 of principal.

In other words, as an example, you would pay $10,025 for $10,000 of this TIPS, which in effect lowers your real yield.

The auction will probably carry a coupon of 0.125%. That is the base rate. In addition, the principal of a TIPS increases with inflation until it matures.

This is what Marketwatch is reporting today:

Yields on 5-year inflation-linked Treasury bonds are currently trading below zero, but Thursday’s auction of the new security will carry a positive coupon, analysts at TD Securities said Wednesday. That will still make this the second 5-year Treasury Inflation Protected Securities auction with a negative yield, as low yields on regular Treasury securities and higher inflation worries keep up demand for TIPS.

“The real yield of -20 to -25 basis points at auction will just mean that the price is further over par,” said Richard Gilhooly, director of rates strategy at TD Securities.

A real yield of -0.25% would be better than some predictions of -0.5% to -0.7% I have seen in recent days.

Update: The Wall Street Journal reports on April 21:

The Treasury Department has had to make some rule changes to deal with soaring demand for its inflation-indexed securities, which had raised the technical possibility of a negative interest rate coupon in one of its auctions. The rule change, which went into effect on April 1, placed a minimum rate of 0.125% on all Treasury securities that pay an interest coupon, assuring investors that they could never face the unpleasant task of writing the Treasury a check in return for the right to lend it money.

Update: Bloomberg’s prediction is for a yield of negative 0.1825%:

The government’s sale of $14 billion of five-year Treasury Inflation Protected Securities, may draw a yield of negative 0.1825 percent, according to the average forecast of 6 of the Federal Reserve’s 20 primary dealers in a Bloomberg News survey.

On Thursday, April 21, the Treasury plans to sell $14 billion in five-year inflation-protected securities. The issue date is April 29. The TIPS mature April 15, 2016. Cusip number is 912828QD5.

Here is a .pdf with full details of the auction.

Buy it or skip it? I decided to buy it, in a small amount. Because I have been buying TIPS for about 12 years, I have TIPS that mature each each year, plus I earn interest that I want to reinvest. This amounts to a reinvestment, not a major investment. That makes the choice easier. I don’t think this issue is appealing for a major investment.

What are the positives? 1) It matures in five years, 2) It is super safe (no matter the S&P’s outlook) and 3) It is protected against a spike in inflation. I will hold it to maturity.

What are the negatives? 1) It will have a negative base interest rate, probably in the range of -0.2% to -0.4% and 2) Inflation is not likely to soar in the next five years.

A five-year regular Treasury is yielding 2.09% as of Monday, so that means the breakeven inflation rate for this 5-year TIPS will be about 2.49%, if the TIP yields -0.4%. (It could be even larger if there is high demand for this TIPS.)

So … not a great deal.

Alternatives? Not much out there for super safe investments.

The regular five-year Treasury is paying 2.09%, also not a great deal, with no inflation protection. In fact, I think that rate is insanely low.

The best rate out there for a 5-year CD is from Aurora Bank at 2.43%. I would buy that CD before I bought a regular five-year Treasury. But this has no inflation protection.

My tax-free money market fund is paying 0.12%. Ouch.

Municipal bonds? The going rate is 1.63% for a 5-year AAA issue.

With this 5-year TIPS, I am going to buy it and forget it. Done.