Treasury Inflation-Protected Securities

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.

So Standard & Poors issues a negative outlook on U.S. Treasuries this morning, and the stock market falls into turmoil. The Dow average ended up rallying to close at -1.14% for the day. (In reality, that is a non-event, isn’t it?)

But you would expect some shakeup in Treasury issues. A negative outlook should mean the risk premium rises, and that means higher interest rates.

Wrong.

Here is the chart of the iShares Barclays TIPS ETF for today:

One-day chart for TIP ETF

The news wasn’t greeted well in the morning, but by the end of the day this ETF managed to squeak out a 0.3% gain. Impressive.

For the record, I am not high on this TIP ETF at these levels. Here is the five-year chart, and my advice is … don’t get excited when your investment hits a five-year high, especially an investment that is completely controlled by monetary policy:

5-year chart fot TIP ETF

The bigger immediate issue is the 5-year Treasury Inflation-Protected Security that will be auctioned Thursday. It is likely to go off at a negative base interest rate, something in the range of -0.25% best case to -0.7% worst case. (But the principal will rise with the inflation rate over the next five years.)

Here are the rates I am finding today on Barrons.com:

First of all, note that all these issues were positive today. The closest to a 5-year TIPS issued this week is the July 15 2016 issue, which has a base yield of -0.306%. But the issue one year earlier is yielding -0.693%.

It is all going to come down to demand on this week’s auction. If there is heavy demand — and I wonder about that with today’s positive move — then how negative will the yield go?

Conclusion: Still looks iffy on this issue. A negative base yield doesn’t appeal to me. However, if the cash is in a money market account, the inflation-adjusted rate of 2.5% to 3.0% does look a little more attractive.

My mind has been wandering to municipal bonds — but safety is more of an issue there.

If you have thoughts, please post them. I’d love to start a discussion about this week’s 5-year TIPS issue.

These are words that investors in Treasury securities don’t like to read:

Standard & Poor’s cut its ratings outlook on the U.S. to negative from stable while keeping its triple-A rating on the world’s largest economy. Relative to its AAA-rated peers, the U.S. has very large budget deficits and rising government indebtedness, and the path to addressing those issues is unclear, S&P analysts said.

Yes, the U.S. keeps its AAA rating, but the massively high deficits are worrying the world, even as the rest of the world is acting to slow down inflation by inching up interest rates. (U.S. fiscal policy has also been rewarding borrowing and risk, while slamming savers with near-zero interest rates.)

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

The stock market is not liking this — the Dow average is down nearly 2% this morning.

This needs to serve as a wake-up call to Washington.

The Treasury’s response

A senior Treasury department official – assistant secretary Mary Miller – had this response to the S&P action:  “We believe S&P’s negative outlook underestimates the ability of America’s leaders to come together to address the difficult fiscal challenges facing the nation.”

Another interesting video from FT.com on inflation:

George Goncalves, head of US interest rates strategy at Nomura Securities, tells the FT’s Michael Mackenzie that he does not expect to see substantial inflation in the near future. Mr Goncalves says higher commodity prices are a tax on society but not inflationary.

Watch the video

Point to ponder: If you agree with Goncalves that inflation is being overestimated, this week’s 5-year TIPS, which will probably go at a negative base interest rate, is pretty unattractive. It’s still a no-risk investment when held to maturity, but better opportunities might arise within a year.