Treasury Inflation-Protected Securities

‘The debt limit drama heats up,’ says Moody’s Analytics in new report

Posted on April 26, 2023 by Tipswatch

By David Enna, Tipswatch.com

Here’s an update on my last article, “Looming debt crisis is already roiling Treasury bill market,” which discussed the disruptions rippling through the bond market as the U.S. nears a debt-limit crisis.

Moody’s Analytics, a market research firm that is a subsidiary of Moody’s Corp., just issued an April 2023 analysis with new information about the debt crisis and the approaching X-date, when the Treasury will run out of cash needed to pay the government’s bills on time.

A key point in the analysis is that the date appears to be coming earlier than researchers originally thought:

The Treasury debt limit—the maximum amount of debt that the Treasury can issue to the public or to other federal agencies—was hit on January 19, and since then the Treasury has been using “extraordinary measures” to come up with the additional cash needed to pay the government’s bills.

Nailing down precisely when these extraordinary measures will be exhausted … — the so-called X-date — is difficult. It depends on the timing of highly uncertain tax receipts and government expenditures.

Since Moody’s Analytics began estimating the X-date early this year, we have thought it to be in mid-August. But April tax receipts are running 35% below last year’s pace, which is meaningfully weaker than anticipated. And despite weaker tax refunds than anticipated, it appears that the X-date may come as soon as early June. If not, and Treasury is able to squeak by with enough cash, then the X-date looks more likely to be in late July.

The Moody’s report reinforces my argument that the debt crisis is beginning to be seen in clear disruptions in the bond market. It says:

Time is running out for lawmakers to act and increase or suspend the debt limit, and global investors are suddenly focusing on the risks posed if they do not act in time.

The analysis points out that credit default swaps on U.S. Treasurys — the cost of buying insurance in case the Treasury fails to pay its debt on time — have jumped in recent weeks, to levels even higher than past debt-ceiling disruptions.

At close to 100 basis points, CDS spreads on six-month and one-year Treasury securities are already substantially more than in 2011 when that debt limit drama was so unnerving it caused rating agency Standard & Poor’s to strip the U.S. of its AAA rating.

Cick on the image for a larger version. Source: Moody’s Analytics

The analysis also notes the recent sharp decline in the yield of the 4-week Treasury bill, which was the major point of my article earlier this week:

As it has become clear in recent days that April tax receipts were coming in weak and the X-date may be just a few weeks away, investors have piled into the safety of one-month Treasury securities. Yields have plummeted, from 4.75% at the start of April to less than 3.4% currently. At the same time, yields on three-month Treasury bills have continued to rise. The difference between one- and three-month Treasury bill yields has never been as wide. Global investors thus appear to be attaching non-zero odds that the debt limit drama will end with a default sometime in June or July.

The GOP spending proposal

The analysis goes on to examine the ramifications of the House Speaker Kevin McCarthy’s proposal to roll back discretionary U.S. spending in 2024 to 2022 levels — in exchange for a one-year increase in the debt limit. It’s an interesting analysis, and I’ll let you read it and reach your own conclusions. It seems highly unlikely that McCarthy’s proposal will end up being the final settlement of this issue.

At any rate, the White House issued a statement Tuesday declaring that if McCarthy’s bill reached President Biden’s desk, “He would veto it.”

What’s next

Moody’s Analytics notes that the Treasury debt limit drama is heating up and is likely to get much hotter in coming weeks. It notes:

If the X-date is as soon as early June, it seems a stretch for lawmakers to come to terms fast enough, and they instead will likely decide to pass legislation suspending the limit long enough to line the X-date up with the end of fiscal 2023 at the end of September. This will buy some time …

Getting legislation that funds the government in fiscal 2024 and increases the debt limit across the finish line into law will surely be messy and painful to watch, generating significant volatility in financial markets. Indeed, a stock market selloff, much wider credit spreads in the corporate bond market, and a falling value of the U.S. dollar may be what is required to generate the political will necessary for lawmakers to avoid a government shutdown and breach of the debt limit.

My thinking has been that Congress will eventually have to kick the debt-limit issue down the road to avoid severe disruptions to the bond and stock markets. Moody’s suggests the extension could be to September, when we could relive this crisis again.

But the political divide — and the resulting game of chicken — seem a lot more severe this year, with just a few GOP House members potentially able to block any compromise. In a hopeful note, Moody’s concludes:

But when all is said and done, the legislation that lawmakers ultimately pass will likely be anticlimactic, allowing both House republicans and president Biden to declare political victory.

What should we do?

In a worst-case scenario we could see a repeat of August 2011, a very bad month for the stock market, but quite nice for bonds:

But I suspect that history won’t repeat itself in this way. Bonds benefited in 2011 from increased liquidity supplied by the Federal Reserve, but that might be out of the question in 2023 as the Fed battles inflation. The stock market in recent years has been through the wringer, over and over, and bounced back. But this time, it may not have the Fed as its savior.

I am not a financial adviser and I’ll admit that I am not doing much differently in the lead up to this crisis. For example, some possibilities:

Sell all your stocks and move to cash? One of the big differences between 2011 and today is that cash is much more attractive, with yields above 5% for many short-term Treasurys. In August 2011, the 6-month Treasury bill was paying 0.16%. Today, cash is an appealing alternative. The only problem: How safe are Treasurys in a worst-case scenario? (The answer, in my opinion: still very safe.)

No, I personally won’t be selling out of the stock market. But I could see raising some cash because of the chance to …

Snap up attractive yields when you see them. This week I bolstered my bond ladder by buying a two-year, brokered, non-callable Morgan Stanley CD paying 4.7%. The 2-year Treasury note auctioned Tuesday at 3.97%, so the CD is a better deal. (This is in a tax-deferred account, so the state income tax issue doesn’t apply.)

Watch for market chaos. There could be a buying opportunity, and it could be as short as a few hours of a single day. I’d expect yields on some short-term Treasurys to begin rising higher in coming weeks, as the fear factor sets in. Then … a compromise is announced and everything moves back to what we now call “normal.”

Do nothing. Not a bad option. In the long term, the market will adjust. In 2011, after a miserable August, the S&P 500 ended the year with a total return of 2.1%, followed by 16.0% in 2012 and 32.4% in 2014.

What do you think? Tell us your strategy in the comments section below.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.Please stay on topic and avoid political tirades.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Bank CDs, Cash alternatives, Federal Reserve, Treasury Bills | 46 Comments

Looming debt crisis is already roiling Treasury bill market

Posted on April 23, 2023 by Tipswatch

The 4-week Treasury yield is sending a message of fear.

By David Enna, Tipswatch.com

Update, April 26: ‘The debt limit drama heats up,’ says Moody’s Analytics in new report

On Thursday afternoon, I happened to be watching CNBC during a long on-air interview with Cathie Wood, CEO and founder of Ark Invest, an investment management firm.

Wood is an interesting person, obviously a high-risk investor whose shoot-for -the-moon style is completely opposite mine. I find a lot of her market commentary is designed to bolster the high-risk stocks her funds already own. She’s a believer. But midway through the interview, she said something that made me jump up and say, “NO!”

Listen to the first two minutes of this clip:

Here is the quote that gave me pause:

I think the markets are leading the Fed and I was struck today to learn that the one-month Treasury bill yield is 140 basis points — 1.4% — below the low end of the Fed funds rate. I remember in ’08 and ’09 the Treasury bill rates were an early indicator of how quickly the Fed was going to ease once it realized how much trouble we were in.

What is really happening here?

No, the bond market is not anticipating a quick turnaround by the Fed on short-term interest rates. If that were true, you’d see yields falling across all T-bill maturities. But that isn’t happening. Only the 4-week T-bill has seen yields plummet in the last three weeks, as you can see in this chart:

The chart, from the Treasury’s Yields Curve estimates page, shows that the 4-week T-bill’s yield has fallen 120 basis points in three weeks, while the 8-week is up 8 basis points and the 13-week is up 19 basis points. The same is true across the T-bill spectrum — every issue except the 4-week has seen yields rise in April.

Now, why would that happen? The reason is simple: Investors are pouring into the 4-week T-bill, forcing its yield lower, because of the near-certainty of market turmoil coming with the expiration of the U.S. debt ceiling. This is highly likely to reach “crisis” level by June, about 6 weeks from now. From the Washington Post:

If Congress doesn’t increase the limit on how much the Treasury Department can borrow, the federal government will not have enough money to pay all its obligations by as early as June. Such a breach of the debt ceiling — the legal limit on borrowing — would represent an unprecedented breakdown

If you look at the timing of this highly likely crisis, you can see that the 4-week T-bill can be purchased now and mature with a couple weeks to spare. So, in theory, it is much “safer” than the 8-week, which now has a yield 162 basis points higher. Same with the 13-week, which has a yield 178 basis points higher.

The 4-week and 13-week generally follow a similar trend line, but as the debt crisis gets closer, they have diverted:

Click on the image for a larger version.

To be clear: I am not saying that the United State will begin defaulting on its debt in June or August. That would be an utter disaster and I don’t think it will happen. But I also think there will be no resolution to this issue until we approach the brink of calamity. And that is going to cause market uncertainty.

For one thing, the yield on that 4-week T-bill will begin rising dramatically sometime in May, as we approach a potential government shutdown or debt breach.

This has happened before

2011. Back on March 6, 2023, I wrote an article (Debt-limit crisis: Lessons from the 2011 earthquake) looking back on a very similar crisis in mid-2011. This one was the most serious up to this year, but eventually was resolved on August 1. It triggered a frightening stock market collapse and solidified a near-decade of ultra-low Treasury yields. This chart shows the massive moves in Treasurys and the stock market in a single month, August 2011:

The 2011 crisis went to the brink but was resolved. Nevertheless, Standard and Poors lowered its credit rating on U.S. debt from AAA to AA+, a rating that remains in effect today.

But here is the point I wanted to make in this article: The T-bill market began anticipating the approaching crisis, with both the 4-week and 13-week T-bill spiking higher in the days before a potential government shutdown.

Of course, at this time in 2011 the Federal Funds Rate was already as low as it goes, in the range of 0% to 0.25%. So the move higher in the 4-week was only 15 basis points, from 0.01% on July 20 to 0.16% on July 29. But then again, the yield on July 29 was 16 times higher than it was on July 20.

By August 8, two days after the S&P downgrade, the 4-week yield was back down to 0.2%. In other words, the S&P action had zero effect on the U.S. Treasury market. The yield on a 10-year Treasury note was at 2.82% on July 29 and fell to 1.89% on Dec. 30. So when you hear people say, “The 2011 crisis increased U.S. borrowing costs,” just realize this is not true.

2013. A similar debt-ceiling crisis erupted in 2013 after the debt ceiling was technically reached on Dec. 31, 2012. Eventually, the debt ceiling was suspended for a few months, then reinstated. The crisis reached a peak in early October and was resolved on Oct. 16.

The chart shows the extreme, but short-lived, spike in the 4-week T-bill yield as the crisis reached a high point. Again, at the time the Federal Funds Rate was in the range of 0% to 0.25%. The 4-week T-bill yield rose from 0.1% on Sept 9, 2013, to 0.32% on Oct 15, and increase of 32 times.

What happens in a debt-lock?

I don’t think the U.S. is going to default on its debt, but there’s a real possibility we will see a short-term government shutdown and disruption to government payments. No one knows exactly how this would play out.

The Brookings Institution earlier this year issued a paper titled, “How worried should we be if the debt ceiling isn’t lifted?” It starts off with a bang:

“Once again, the debt ceiling is in the news and a cause for concern. If the debt ceiling binds, and the U.S. Treasury does not have the ability to pay its obligations, the negative economic effects would quickly mount and risk triggering a deep recession.”

In speculating on how a debt-lock could be handled, the authors note that the U.S. government created a contingency plan in 2011 at the height of the crisis:

“Under the plan, there would be no default on Treasury securities. Treasury would continue to pay interest on those Treasury securities as it comes due. And, as securities mature, Treasury would pay that principal by auctioning new securities for the same amount (and thus not increasing the overall stock of debt held by the public). Treasury would delay payments for all other obligations until it had at least enough cash to pay a full day’s obligations. In other words, it will delay payments to agencies, contractors, Social Security beneficiaries, and Medicare providers rather than attempting to pick and choose which payments to make that are due on a given day.”

You can read the full contingency plan here.

Also in March, Moody’s Analytics published a paper titled, “Going down the debt limit rabbit hole.” It predicts the actual “X-date” of potential breach is Aug. 18. It notes:

Investors in short-term Treasury securities are coalescing around a similar X-date, demanding higher yields on securities that mature just after the date given worries that a debt limit breach may occur.

Unless the debt limit is increased, suspended, or done away with by then, someone will not get paid in a timely way. The U.S. government will default on its obligations.

In discussing worst-case scenarios, Moody’s notes:

A more worrisome scenario is that the debt limit is breached, and the Treasury prioritizes who gets paid on time and who does not. The department almost certainly would pay investors in Treasury securities first to avoid defaulting on its debt obligations.

But Moody’s also notes the potential political fallout, saying, “Politically it seems a stretch to think that bond investors, who include many foreign investors, would get their money ahead of American seniors, the military, or even the federal government’s electric bill.”

I highly recommend reading through the entire Moody’s report. It presents an unpolitical and unvarnished point of view.

Final thoughts

My main point here was to show that the short-term Treasury market is already being affected by the looming crisis, and things are likely to get a lot more volatile. I don’t have answers to the “What would happen if …” questions readers often ask. We are moving into an uncertain time and the financial markets don’t like uncertainty.

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Posted in Cash alternatives, Retirement, Social Security, Treasury Bills | 47 Comments

New 5-year TIPS gets a real yield of 1.32%, an attractive result

Posted on April 20, 2023 by Tipswatch

By David Enna, Tipswatch.com

The Treasury’s auction of $21 billion in a new 5-year Treasury Inflation-Protected Security — CUSIP 91282CGW5 — resulted in a real yield to maturity of 1.320%, a bit higher than looked likely through the morning.

Demand appears to have been fairly weak for this 5-year TIPS. The bid-to-cover ratio was 2.34, the lowest for any TIPS auction of this term for as long as I’ve been recording this data (back to June 2019). A similar TIPS was trading on the secondary market all morning with a real yield around 1.29%. So … 1.32% looks good.

Definition: A TIPS is an investment that pays a coupon rate well below that of other Treasury investments of the same term. But with a TIPS, the principal balance adjusts each month (usually up, but sometimes down) to match the current U.S. inflation rate. So, the “real yield to maturity” of a TIPS indicates how much an investor will earn above (or below) inflation.

Pricing: The coupon rate for this TIPS was set at 1.25%. Because the real yield was higher, investors paid an unadjusted priced of about 99.664 for $100 of par value. The inflation index will be 1.00241 on the settlement date of April 28, and that means investors will pay an adjusted price of about 99.91 for about $100.24 in principal. (Plus about 4 cents for accrued interest.)

It’s a small thing, but a lot of TIPS investors tell me they relish the idea of buying a TIPS below par value, because par value is guaranteed to be returned at maturity, even if we hit a period of extended deflation. This TIPS delivered.

The yield. Real yields for all TIPS have risen sharply over the last year, but peaked in fall 2022 and have slid a bit lower since then. Here is the one year trend in the 5-year real yield:

The auction’s result of 1.320% looks in line with the trading range we’ve seen over the last several months. As recently as March 8, the 5-year real yield hit 1.87% but began falling in reaction to the U.S. banking turmoil. It dipped as low as 1.06% on April 6.

Inflation breakeven rate

At the auction’s close, a 5-year nominal Treasury note was yielding 3.63%, giving this TIPS an inflation breakeven rate of 2.31%, which is historically high but looks attractive with U.S. inflation currently running at 5.0%. I’m a bit surprised we didn’t see higher demand for this auction, because the nominal 5-year at 3.63% isn’t very attractive. At least the TIPS protects against unexpected inflation.

Here is the one-year trend in the 5-year inflation breakeven rate, showing that 2.31% is on the low end of recent rates:

Reaction to the auction

How did the market react to the auction results? With a yawn. The TIP ETF, which holds the full range of maturities, barely budged after the auction’s close at 1 p.m. EDT. So it looks like things went as expected, even though demand was weak.

For investors, getting 1.32% above inflation for the next five years is attractive. Just one year ago, on April 29, 2022, a new 5-year TIPS auctioned with a real yield of -0.340%. Times have changed, huh?

I was a buyer at this auction, fulfilling my wish to bolster the 2028 rung of my TIPS ladder. This TIPS will get a reopening auction on June 22 and then a new 5-year TIPS will be auctioned in October and reopened in December.

Here is the recent history of TIPS auctions of this term:

• Confused by TIPS? Read my Q&A on TIPS

• TIPS in depth: Understand the language

• TIPS on the secondary market: Things to consider

• Upcoming schedule of TIPS auctions

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Posted in Inflation, Investing in TIPS | 43 Comments

A 5-year TIPS matured April 15. How did it do as an investment?

Posted on April 18, 2023 by Tipswatch

By David Enna, Tipswatch.com

Back in spring 2018, the Federal Reserve was continuing its wind-down of quantitative easing, raising its key short term interest rate on March 21 to a range of 1.50 – 1.75%.

That led to a very promising TIPS auction on April 19, 2018 — CUSIP 9128284H0, a new 5-year Treasury Inflation-Protected Security. In my preview article for that TIPS auction, I noted it could be “the most attractive in years.”

The result: At auction CUSIP 9128284H0 generated a real yield to maturity of 0.631%, the highest for any 4- to 5-year TIPS auction since October 2009. The coupon rate was set at 0.625%, the first time in 8 years that any TIPS of this term received a coupon rate higher than 0.125%.

This TIPS got an inflation breakeven rate of 2.13%, compared with a nominal 5-year Treasury note yielding 2.76% at the time.

In other words, everything looked great for an investor in this TIPS. But five years later, how did it actually do as investment? Let’s take a look:

Click on the image for a larger version. Find 10-year data on my TIPS vs. Nominals page.

Conclusion: It did very well

Inflation over the next five years averaged 3.3%, much higher than the inflation breakeven rate of 2.13%. That’s an annual variance of 1.17%. According to data compiled by EyeBonds.info, CUSIP 9128284H0’s compounded rate of return was 4.42%, well above the 2.76% offered by a nominal Treasury (before interest reinvestment).

This TIPS was a winner. Keep in mind that a TIPS investment does especially when inflation runs higher than expected. That’s certainly been the case over the last two years.

I have fond memories of just-matured CUSIP 9128284H0. I invested in it at the opening auction (real yield of 0.631%), first reopening in August (0.724%) and last reopening in December (1.129%).

2018 was a fantastic year for TIPS investment, much like 2023.

Notes and qualifications

This analysis is an estimate of performance.

Keep in mind that interest on a nominal Treasury and the TIPS coupon rate is paid out as current-year income and not reinvested. So in the case of a nominal Treasury, the interest earned could be reinvested elsewhere, which would potentially boost the gain. For certain, we don’t know what the investor could have earned precisely on an investment after re-investments.

In the case of a TIPS, the inflation adjustment compounds over time, and that will give TIPS a slight boost in return that isn’t reflected in the “average inflation” numbers presented in the chart.

• Confused by TIPS? Read my Q&A on TIPS

• TIPS in depth: Understand the language

• TIPS on the secondary market: Things to consider

• Upcoming schedule of TIPS auctions

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Posted in Inflation, Investing in TIPS | 8 Comments

Thoughts on this week’s 5-year TIPS auction: It’s complicated

Posted on April 16, 2023 by Tipswatch

By David Enna, Tipswatch.com

The U.S. Treasury on Thursday will auction $21 billion of a new 5-year Treasury Inflation-Protected Security, CUSIP 91282CGW5. The coupon rate and real yield to maturity will be set by the auction results.

For months, I have been considering this auction as a sure-fire purchase, because my TIPS ladder is quite weak for the year this one matures, 2028. I will still be a buyer, but I can see why some investors might opt out. There are equally safe and equally attractive nominal investments out there. And that makes this investment decision complicated.

As of Friday, the U.S. Treasury was estimating the real yield (meaning the yield above inflation) of a 5-year TIPS at 1.29%, well below the 2023-high of 1.87%, set on March 8 just before the Silicon Valley Bank collapse. But 1.29% is okay, in my opinion. Take a look at 5-year real yields over the last 8 years:

After a decade-plus of extremely low or even negative real yields, I can’t complain about getting 1.29% above inflation. It’s fine.

The complicating issue is that you can capture nominal yields with non-callable 5-year bank CDs — either direct or brokered — that are competitive with this 5-year TIPS. A best-in-nation 5-year CD paying around 4.50% creates an inflation breakeven rate of 3.21% against this TIPS, meaning the CD will out-perform if inflation averages less than 3.21% over the next five years.

Will inflation average more than 3.21% through April 2028? I think it’s possible, even likely, but it is going to be close. The CD also looks like a sensible investment. However, forget about the 5-year nominal Treasury note, with a current yield of just 3.60%. The CD and TIPS are much more attractive.

This chart shows how each 5-year investment will perform under different inflation scenarios. At low inflation rates, the bank CD is the winner, with even better real returns if deflation strikes. When inflation rises above 3.21%, the TIPS is the winner, with unlimited upside potential if severe inflation strikes. But there is no scenario where the 5-year Treasury note is the winner.

One thing to consider is that interest from TIPS is exempt from state income taxes, which isn’t true for bank CDs. But if you are putting these in a tax-exempt account, that issue is moot.

So is this Thursday’s 5-year TIPS auction attractive? Yes, it is, as long as real yields hold around current levels through the week. But you could consider pairing it with nominal investments like T-bills (paying 5%+ for a six-month term) or solid bank CDs (paying around 5.15% for 1 year or 4.50% for 5 years.)

Or, just buy the TIPS. It will do fine if you hold it to maturity.

Pricing

If the real yield holds at 1.29%, this new TIPS will get a coupon rate of 1.25% and should be priced just below par. It also will carry an inflation index of 1.00241 on the settlement date of April 28. So at this point the price should be very close to $100 for $100 of par. There will also be a very small amount of accrued interest.

Inflation breakeven rate

The official inflation breakeven rate will be set by the spread in yield between the 5-year Treasury note (currently yielding 3.60%) and the TIPS real yield (let’s estimate 1.29%). That creates an inflation breakeven rate of 2.31%, fairly high by historical standards but fairly low compared with recent auctions.

Here is the trend in the 5-year inflation breakeven rate over the last 8 years:

U.S. inflation has been trending downward over the last year, going from an annual rate of 9.1% in June 2022 to 5.0% in March 2023. I think that trend will continue for several more months before stabilizing around 3.5%. But that is a guess, of course. No one can accurately predict future inflation.

Over the last 5 years, U.S. inflation has averaged 3.3%.

Final thoughts

Although I still plan to be a buyer at this auction, on April 10 I took half of my planned investment and bought a non-callable 5-year brokered CD yielding 4.61%. It’s hard to pass up these attractive nominal yields, even for an inflation-fighter like me.

We are finally in a prosperous time for ultra-safe fixed-income investing, something we didn’t see for more than a decade. Will this trend continue for years? Possibly. I hope so. But enjoy it while it lasts.

If you are considering bidding at Thursday’s auction, keep an eye on the Treasury’s Yield Curve estimates, which update at the close of the market each day. Non-competitive bids at TreasuryDirect must be placed by noon Thursday. If you are putting an order in through a brokerage, make sure to place your order Wednesday or very early Thursday, because brokers cut off auction orders before the noon deadline.

What are your thoughts on this TIPS auction? Post your comments below.

I’ll be posting results Thursday after the auction closes at 1 p.m. EDT. Here is a look at auctions of this term back to 2015. Note that you only have to go back one year, to April 29, 2022, to find a negative real yield: