Treasury Inflation-Protected Securities

Thursday’s auction of 10-year Treasury Inflation Protected Securites was greeted with tepid demand — the resulting yield was 0.887 percent, higher than the rate that looked likely a week ago.

Inflation fears have diminished in the last few days, because the economy isn’t showing any signs of heating up.

The dated date of the 10-year TIPS is Jan. 15, 2011. The issue date is May 31, 2011. The TIPS mature Jan. 15, 2021.

The CUSIP number is 912828PP9.

From the announcement press release:

The S&P/BGCantor U.S. Treasury Inflation Protected Security Index is a broad, comprehensive, market value-weighted index that seeks to measure the performance of the U.S. Treasury Inflation-Protected Securities (TIPS) market.

You can track the index here, but since it just launched on Tuesday, there is very little to see except for the current numbers.

I bought into FINPX on Dec. 8, 2008, when the price per share was $10.25. I am selling today when the price is $12.16. This is a tax-free account. That is a capital gain of 18.6% over three years, above and beyond the regular interest distributions.

Honestly, I did expect some capital gain in this fund, because I was buying in the heart of the U.S. financial crisis. But in reality, the capital gain is the reason I am selling. My feeling is that TIPS yields are well below the historical norm, and eventually the trend will return to normal. This is the case with all Treasury issues, not just TIPS. This is the last TIPS mutual fund I own. I don’t own a TIPS ETF.

(As I have noted before, I do advocate buying and holding TIPS to maturity, either through TreasuryDirect.gov or in a tax-free retirement account. I am not dismissing TIPS as an investment, quite the contrary, I still a large portion of my portfolio in TIPS and I Bonds. But I feel TIPS mutual funds and ETFs are reaching a risky point.)

So, where did I reinvest this money? In another ‘boring’ investment, Fidelity Total Bond Market (FTBFX). The other fund I considered was Fidelity Intermediate Bond (FTHRX), which tracks very close to the Total Bond Market.

Here is a chart of the performance of these three funds over the last two years:

Amazingly, all three funds have a very similar capital return (and a very nice return) over the last two years. But the FINPX TIPS fund shows much stronger swings, and is on a very strong upswing right now. That is why I am exiting.

I prefer the boredom of the Total Bond Fund. Boring is good.

The TIPS fund is booming with the current surge in Treasury securities. I think that will pass. When it does pass, and TIPS yields return to a more historical level, I would be fine with returning to FINPX.

Brett Arends of MarketWatch.com wrote an ROI column this week sharply criticizing TIPS and the ‘suckers’ who buy them. Great headline: ‘Holding TIPS will make you poorer.’

Would you buy an investment that was absolutely guaranteed to lose money? No ifs, ands or buts: This sucker will make you poorer! How’s that sound? You might think this is a crazy question. You’re probably thinking, who would choose to own an investment that is guaranteed to lose money?

Arends argues that buying a 10-year TIPS with a base interest rate of less than 1% – or a 5-year with a base yield dipping into the negative – is ‘crazy, totally nuts.’ He also points out that the Consumer Price Index is a lousy way to measure inflation.

I agree with and understand his points.

My criticism: Arends doesn’t offer an investment alternative for the super-safe portion of your portfolio. And that is the problem.

Would you rather buy a 5-year CD at the local bank, now paying about 2.4%, or have a Treasury instrument (no state income taxes) that pays the rate of inflation minus 0.18% (the rate of the last 5-year auction)? At the least, it is a tossup, since the TIPS has inflation protection and the CD doesn’t.

Would you rather buy a conventional 5-year Treasury today, now paying an absurd 1.78%? That is an easy choice: I would go with the TIPS in this case. The inflation protection is a lot more valuable than getting 1.78% on your money, which is highly likely to produce a real return well below the -0.18% of the April 5-year TIPS.

(I contend that for a small investor, the U.S. I Bond is a better investment for your first $5,000 invested, since its base yield is locked at zero and it offers the same inflation protection. Zero is better than negative.)

The reason TIPS yields have gone negative is because the conventional Treasury yields have dipped to extreme lows, well below the likely rate of inflation over the next 5 years. So there is some logic to buying TIPS, to capture the rate of inflation (even at a slight penalty).

But I agree: Buying TIPS and holding them to maturity is not a ‘fabulous’ investment right now. It is OK. It is safe. It is a do-it-and-forget-it investment. (But I definitely would not dump a major portion of a portfolio into TIPS at the moment.)

And TIPS mutual funds are risky. Eventually the base rate on TIPS is going to climb back toward the historical yield of 2%, and TIPS mutual funds will get clobbered.