Treasury Inflation-Protected Securities

Real yields are on the rise: Do you have a strategy?

Posted on July 9, 2023 by Tipswatch

By David Enna, Tipswatch.com

Over the last year (plus a few months) I have been gradually adding to my holdings of Treasury Inflation-Protected Securities. Mostly with nibble purchases, but sometimes — when the opportunity looks good — with larger investments.

And now, suddenly, real yields for TIPS have increased to 14-year highs, across nearly all maturities. It’s been rather stunning. The bond market finally seems to be embracing two ideas: 1) the U.S. economy isn’t falling into recession (near-term at least) and 2) the Federal Reserve isn’t going to ease off on interest rates until well into 2024.

So we are heading into an ideal time for building out a ladder of TIPS investments, extending 20, or maybe even 30 years. With a hold-to-maturity strategy, many of these TIPS are going to provide returns 2% above inflation, risk free.

Here is a look at the real yield curve spectrum through 2023, so far:

Obviously, there has been a lot of volatility. Since April, the 5-year real yield has increased 100 basis points. The 10-year is up 65 basis points. But the longer end of the curve has been more stable, with the 30-year up only 35 basis points.

The shape of this curve makes 5- to 7-year TIPS yields look most appealing. It has prompted me to go hunting for TIPS maturing around 2029 to 2030. On Friday, there were many possibilities with real yields higher than 2.0%, even on small purchase amounts. This is from Vanguard on Friday afternoon:

For the last entry, CUSIP 9128285W6, I clicked on the “show more” link to list the ask-side lot sizes. In this case, at that time, a purchase of just $1,000 could have nailed down a real yield of 2.009%. This was possible with most of the others, too.

Earlier in the week I made a purchase of CUSIP 91282CBF7, not shown on this list, which matures Jan 15 2031. I got a real yield of 1.795%, not bad. But this TIPS closed the week at 1.887%, showing how volatile things were.

In fact, every 5-, 10-, and 30-year TIPS issued or reopened in the last 12 years is now selling at a discount, because real yields are now higher than the coupon rates set over that period. Take a look at Friday’s closing TIPS values from the Wall Street Journal, showing the large number of TIPS with discounted prices and market real yields higher than 2.0%:

The one exception on that list is the TIPS that matures Jan 15 2027. That one is a relic of the past, a 20-year TIPS issued in January 2007 with a real yield of 2.42%. (The Treasury stopped issuing 20-year TIPS in January 2009. Bad move, but that’s another story.)

Bad side of rising yields?

It’s rare to see the entire TIPS yield curve rise to levels we last saw in 2011 — and at that time only the long-term 30-year TIPS had a yield this high.

The problem: All the TIPS you are currently holding have fallen in value over the last couple months. If you are holding to maturity, you should completely ignore these market fluctuations. But what if you have invested in TIPS mutual funds and ETFs? They’ve taken a hit. Morningstar data show that the TIP ETF has had a total return of -2.95% over the last year. Vanguard’s VTIP, with a shorter duration, is down -0.07%.

I could argue that these TIPS mutual funds are actually getting attractive at these yield levels, but I know from reader feedback that these funds aren’t popular right now. So the solution, if you want risk-free inflation protection in your portfolio, is to buy individual TIPS and commit to holding to maturity.

Is there a strategy?

Remember, I am not a financial adviser and just a journalist. I will offer ideas, but do your own research.

I am continuing my strategy of swapping out of VTIP in a tax-deferred account to buy individual TIPS to hold to maturity, in a ladder stretching through the year 2043. A week ago, I “wanted” real yields of 1.8% or higher, especially with maturities ending in the years 2040 to 2043 (there are no TIPS maturing from 2034 to 2039).

My TIPS ladder is pretty solid through 2031, but maybe yours isn’t? I consider the years 2028 to 2031 the prime market right now to nail down real yields at or close to 2.0%, with maturities stretching out more than 5 years.

Maturities beyond 2031 now have real yields in the 1.8% range, but that could change quickly in coming weeks. There is no way to know where this yield surge is heading. Remember that in the month of March real yields fell 50 basis points.

So my journalistic advice is pick your spots depending on your investment needs and look for attractive yields. When you see them, buy and don’t look back. This is the best time in more than a decade to build inflation protection into your overall strategy.

• 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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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 Investing in TIPS | 63 Comments

Medicare Advantage is a profit machine for insurance companies, study finds

Posted on July 2, 2023 by Tipswatch

By David Enna, Tipswatch.com

If you watch any news programming on television, you’ve seen annoying ads for Medicare Advantage running year round. “$0 monthly premiums!” “More benefits!” “Call to see if you qualify!”

Medicare Advantage, also called Part C of Medicare, is a private insurance option for covering hospital and medical costs. These plans bundle in Medicare Parts A and B. You will still pay Part B premiums, but the insurer may cover part of those costs. If you have Medicare Advantage, you don’t need a Medigap supplement and probably won’t need a Part D drug plan.

The industry argues that many of these plans offer extra benefits, such as eyeglasses, gym memberships and dental care, not available under original Medicare. That is appealing to a a lot of consumers.

The federal government requires Medicare Advantage plans to cover everything that is covered by Medicare parts A and B, but Advantage plans may have different deductibles and co-payments. In most cases, with Medicare Advantage you can only only use doctors and other providers who are in your plan’s network and service area. And you may need a referral to see a specialist.

Medicare Advantage plans generally lower the monthly cost of Medicare, although total costs can be higher if you need a lot of medical services. The TV ads focus on the lower monthly costs, of course, and the pitch is working. According to KFF, an independent source for health policy research, in 2022 more than 28 million people were enrolled in a Medicare Advantage plan, accounting for 48% of the eligible Medicare population.

Many people are in excellent health when they first sign up for Medicare. Later, when their health declines, the drawbacks of Advantage plans may become apparent. These plans have limited networks of providers, and enrollees going out of network face higher costs.

A Kiplinger article from April 2018 pointed out that enrollees in poor health were substantially more likely to dump an Advantage plan than those in good health.

Medicare Advantage “tends to work for people when they are relatively well,” says Judith Stein, executive director of the Center for Medicare Advocacy. “But if they become ill or injured and really need a significant length of care, they’re not as well served.”

If you are interested in more information on Advantage plans, read the Centers for Medicare and Medicaid Services’s Guide to Understanding Medicare Advantage Plans (.pdf). From that document:

Why are these plans so heavily marketed?

KFF, formerly known as the Kaiser Family Foundation, found in an analysis of 2021 financial data that health insurers report much higher gross margins per enrollee in the Medicare Advantage market than in other health insurance markets.

In 2021, KFF found, Medicare Advantage insurers reported gross margins averaging $1,730 per enrollee, at least double the margins reported by insurers in the individual/non-group market ($745), the fully insured group/employer market ($689), and the Medicaid managed care market ($768).

How does this work? Private insurance companies contract with Medicare to create HMO or PPO plans to cover beneficiaries. Medicare pays Advantage plans a set amount for each enrollee. The amount paid varies by county, and enrollees defined as “sicker” bring in a higher risk-adjusted payment. Medicare Advantage insurers then have a set amount coming in for each enrollee, and if they can keep their patient costs below that number, they can gain a sizable profit.

As of 2019, the typical federal payment to Advantage insurers was about $11,100 per enrollee a year, but that number could vary widely.

In 2019, according to KFF data, the federal government paid Medicare Advantage plans $11,844 per enrollee, or $321 more per person than Medicare would have spent if these beneficiaries had instead been covered by traditional Medicare.

Medicare Advantage insurers obviously have an interest in cutting costs for health care for beneficiaries. Lower costs mean higher profits. These measures might include 1) a limited number of doctors in the plan’s network, 2) co-pays for office visits, 3) c0-pays for specialist visits, 4) requiring approval before the plan covers certain drugs or services, and 5) denying service requests.

High rate of service denials

AARP notes in a comparison of original Medicare and Medicare Advantage that the Advantage plans might resemble your past employer-sponsored plan: “Under Medicare Advantage, you will essentially be joining a private insurance plan like you probably had through your employer.”

In most cases you would have a primary care physician who would direct your care, meaning you would need a referral to a specialist. That request could be denied, and the specialist would have to be in your network. Other medical services — such as chemotherapy or extensive rehab treatments — could also be denied.

KFF issued a report on Feb. 2, 2023, noting that Advantage plans denied 2 million prior authorization requests in 2021, about 6% of all 35 million requests. KFF notes:

Prior authorization is intended to ensure that health care services are medically necessary by requiring providers to obtain approval before a service or other benefit is covered. …

Historically, Medicare beneficiaries were rarely required to receive prior authorization. That is still the case for beneficiaries enrolled in traditional Medicare, who are only required to obtain prior authorization for a limited set of services. However, virtually all Medicare Advantage enrollees (99%) were enrolled in a plan that required prior authorization for some services in 2022. Most commonly, higher cost services, such as chemotherapy or skilled nursing facility stays, require prior authorization. Prior authorization may play a role in helping Medicare Advantage plans reduce costs and maintain profits.

Here is a summary of the report’s finding from 2021 data:

More than 35 million prior authorization requests were submitted to Medicare Advantage insurers on behalf of Medicare Advantage enrollees.
Over 2 million prior authorization requests were fully or partially denied by Medicare Advantage insurers.
Just 11% of prior authorization denials were appealed.
The vast majority (82%) of appeals resulted in fully or partially overturning the initial prior authorization denial.

KFF concludes:

The high frequency of favorable outcomes upon appeal raises questions about whether a larger share of initial determinations should have been approved. … (M)edical care that was ordered by a health care provider and ultimately deemed necessary was potentially delayed because of the additional step of appealing the initial prior authorization decision, which may have negative effects on beneficiaries’ health.

Thoughts: Original Medicare vs. Advantage?

I’ll admit this is not an area of expertise for me. My wife and I are on original Medicare with Plan G Medigap coverage from UnitedHealthcare. This decision was an easy one because we travel frequently and Plan G includes some overseas coverage. Everything has worked well, so far.

I have no personal experience with Medicare Advantage. But I have heard some horror stories from friends about “out-of-network” doctors and denied services. I am sure many of these insurers are fine and many customers are happy with the lower costs and additional services. Plus, I admit that getting some sort of coverage for dental, hearing and eye glasses would be appealing.

Four things concern me:

The AARP’s comparison of Advantage plans to employer health insurance — often a bureaucratic mess — gives me pause. I consider original Medicare with a Plan G supplement to be the “near-Cadillac” plan I want. (And up until now, I will admit, I have been paying more for these coverages than I have received in benefits.)
The intense level of marketing for these Advantage plans indicates they are highly profitable for insurance companies, as the KFF data demonstrate.
Profits are fine, but there is an inherent conflict of interest for the insurers to deny medical services.
The “high-ish” level of service request denials means necessary health care could be delayed upon appeal or never received. That’s potentially dangerous, and a hassle I don’t need.

Site reader Jim of the “I Was Retired” YouTube channel has similar views on this topic, which he posted on YouTube in September 2021. There is a lot of good information in this:

What are your experiences with original Medicare or Medicare Advantage? If you are happy with your Advantage plan, or have other opinions, share your thoughts in the comments section below.

Have a great 4th of July holiday.

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Posted in Medicare, Retirement | 117 Comments

Followup: Bloomberg reports huge outflows from TIPS funds

Posted on June 27, 2023 by Tipswatch

By David Enna, Tipswatch.com

My article yesterday talked about the potential attraction of a “Safe Withdrawal Rate” ETF investing in Treasury Inflation-Protected Securities. Today I noticed this: a Bloomberg report on huge outflows from traditional TIPS funds and ETFs.

Here’s the headline: ‘Bad Ride’ in Inflation-Safe ETFs Fuels Record $17 Billion Exit. This is especially interesting because of comments I noted yesterday from Morningstar’s Jeffrey Ptak on investor clumsiness in investing in these funds. This is from his June 12 article:

While TIPS funds can serve a useful purpose, the data we analyzed suggests that investors have struggled to use them successfully in practice. They’ve chased returns, allocating more to TIPS funds after they’ve gained and fleeing when they falter. Thus, they have little to show for their efforts: By our estimates, the average dollar invested in TIPS funds lost 0.70% per year over the 10 years ended April 30, 2023.

In other words, investors poured money into TIPS funds from mid-2020 to 2021 after real yields plummeted, causing the fund prices to soar, and then in mid-2022 ran for the hills as real yields skyrocketed, forcing fund prices lower. Classic mistake: Buy high, sell low.

I know a lot of you probably don’t subscribe to Bloomberg (my opinion: it’s the best financial news site), so here are some highlights from today’s article:

Nearly $17 billion has exited from Treasury-inflation securities ETFs over 10 consecutive months of outflows, an unprecedented streak in data going back to 2016, Bloomberg Intelligence data show. …

That rush to the exits follows a bruising stretch of underperformance for the asset designed to protect against inflation. While TIPS weather against price erosion, real yields — which strip out the impact of inflation — have soared over the past year, shredding returns even as price pressures remain stubbornly high. That’s soured the appetite of investors who piled into TIP and similar ETFs to curb inflation.

Bloomberg’s chart shows how the investor surge into TIPS funds began in mid-March 2020, when the Federal Reserve began an aggressive program of bond-buying, while also slashing short-term interest rates. In less than one month — from March 18 to April 15, 2020, the TIP ETF soared 12.3% in value, rising from $108.75 to $122.77. And that began a 20-month string of net inflows into TIPS funds.

So new-found TIPS investors were pouring into these funds as the assets were becoming more expensive, and more risky. From March 2022 to July 2023, the TIP ETF’s net asset value fell 15.8%. (However, the fund’s total return, which includes inflation-triggered dividends, has been a bit better, somewhere around -10% over that period.)

From Bloomberg:

“You got killed and, in many cases, underperformed nominal Treasuries of similar maturities by owning TIPS,” Laird Landmann, TCW Group co-director of fixed income, said on Bloomberg Television’s Real Yield. “So it really has been a bad ride and it’s not surprising the retail side of the equation bailing out of the ETF at this point.”

The article closes with a negative viewpoint from JP Morgan Asset Management on the value of TIPS as a trading investment, based on interest-rate risk:

“TIPS do not really represent tremendous opportunity in our opinion because the duration — and they do tend to be longer-duration instruments — tend to dominate the risk there,” JPMorgan Asset Management Head of Market Strategy Oksana Aronov said on Bloomberg Television’s Real Yield.

Final thoughts

Although I don’t invest in TIPS funds other than Vanguard’s short-term fund, VTIP, I don’t think this is a particularly horrible time to be putting money into those investments. The TIP ETF is trading today at $107.67, compared to the all-time high of about $131 it hit two years ago, in July 2021.

Because real yields have increased so dramatically over the last 15 months, a lot of the “high” risk has been washed out of these funds. Of course, rates could continue climbing higher. If a recession strikes and interest rates begin falling — and especially if the Federal Reserve caves in and starts bond-buying — these TIPS funds will do very well.

But I think we can eliminate the idea of a Federal Reserve “rescue” through the rest of 2023 and probably into 2024. And if inflation slides into a range around 3%, these TIPS funds won’t deliver outstanding performance.

That doesn’t take away from the appeal of individual TIPS, with good real yields, held to maturity. That’s a winner’s bet.

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Posted in Federal Reserve, Inflation, Investing in TIPS | 34 Comments

Can we build a better TIPS ETF?

Posted on June 26, 2023 by Tipswatch

Financial planner Allan Roth has an idea for using TIPS for retirement security.

By David Enna, Tipswatch.com

It’s no secret that I am not a huge fan of mutual funds and ETFs that invest in Treasury Inflation-Protected Securities, because of my long-standing strategy to buy individual TIPS at good yields and hold them to maturity.

I’m sticking to that view, which dates all the way back to May 2011, when I wrote an article: “Why I am exiting Fidelity Inflation Protected Bond (FINPX)” explaining that I had made an 18.6% profit in the fund over three years, and was ready to depart. I wrote:

My feeling is that TIPS yields are well below the historical norm, and eventually the trend will return to normal. … The TIPS fund is booming with the current surge in Treasury securities. I think that will pass.

Strange thing: A year later Fidelity also exited FINPX, converting it into FIPDX, the Fidelity Inflation-Protected Bond Index Fund. That fund has had a total annual return of 2.18% over the last 10 years — not exciting, but it beats the 1.58% return of Vanguard’s Total Bond Fund (BND).

I understand that a lot of people want to combine inflation protection with the simplicity of an ETF, and TIPS funds can fill that need. But volatility in these funds can be a problem for investors seeking to fill specific income needs in the future. One bad year — like we had in 2022 — can derail longer-term bond investments.

Have TIPS funds failed us?

Yes, these big TIPS funds failed to keep up with inflation. And that is utterly embarrassing at time when inflation was surging to a 40-year high.

That happened for two reasons: 1) The Federal Reserve’s repeated bouts of quantitative easing sent real yields deeply negative for much of the last decade, ensuring that this investment would lag inflation, and then 2) a massive 250-basis-point increase over the last 15 months sent TIPS values plummeting. Moving from a 10-year real yield of -1.04% in March 2022 to 1.53% at Friday’s close put a pounding on TIPS funds (and the entire bond market).

Morningstar took on this issue June 12 with a Jeffrey Ptak article with a savage headline: “The Inflation Hedge That Cost Investors 17% of Their Purchasing Power.” Ptak pointed out that investors poured money into TIPS funds after seeing 10%+ plus returns in 2020, followed by a growing surge in U.S. inflation.

Most of those investors flocked to TIPS funds seeking an inflation hedge. But they got more than they bargained for, with TIPS selling off sharply in 2022 as real yields reversed direction. All told, the average inflation-protected securities fund fell 9.5% in 2022. Taken together with the 7.5% inflation rate that year, investors in TIPS funds saw a 17% loss of purchasing power in 2022.

The author points out that using TIPS funds as trading vehicles has given investors even worse performance — buying at highs and selling out at lows.

While TIPS funds can serve a useful purpose, the data we analyzed suggests that investors have struggled to use them successfully in practice. They’ve chased returns, allocating more to TIPS funds after they’ve gained and fleeing when they falter. Thus, they have little to show for their efforts: By our estimates, the average dollar invested in TIPS funds lost 0.70% per year over the 10 years ended April 30, 2023.

I can’t argue with the premise of this article, even though it is negative about the usefulness of TIPS investments. But the author hits the main point I have been stressing for a decade: Buy individual TIPS and hold them to maturity.

Other investors might want to consider bypassing TIPS funds altogether and instead investing directly in individual inflation-indexed Treasuries. To be sure, this is administratively burdensome, as the investor must select the appropriate TIPS maturities and maintain their portfolio over time. But it’s inexpensive and a TIPS ladder might give a buy-and-hold investor seeking the inflation guarantee peace of mind.

Allan Roth’s ‘new 4% rule’

Allan Roth, a well-known author and hourly-fee financial adviser (one I have used in the past and will use again) made waves in the financial world last year when he suggested using a 30-year ladder of TIPS investments to guarantee a safe inflation-adjusted 4% withdrawal rate over that span.

That Oct. 24, 2022, article titled “The 4% Rule Just Became a Whole Lot Easier” detailed a technique for building a TIPS ladder — taking advantage of highly positive real yields — that could produce a 4.3% annualized real withdrawal rate for 30 years with no risk.

One day later, Roth’s idea launched a heated discussion and thorough analysis on the Bogleheads forum, generating 329 posts in just a couple days.

In December 2022, Morningstar weighed with an analysis of this idea by the site’s director of research, John Rekenthaler. He wrote:

With some effort, investors can create a TIPS portfolio that does, in fact, provide inflation-adjusted certainty of returns.

There’s even a website, Tipsladder.com, that provides a tool for designing a TIPS ladder based on the 4% withdrawal rate. (One complicating factor is that there are no TIPS maturing from 2034 to 2039. The solution is to buy a larger supply of TIPS maturing in 2033 and 2040 to cover the gap, or possibly to use I Bonds to help fill the gap.)

Roth’s Big Idea: A new TIPS ETF

On May 30, Roth wrote an article for ETF.com titled “An ETF Proposal for the 4% Rule.” He pointed out the problems with trying to build a 30-year TIPS ladder with equal amounts maturing each year:

1 It was complex and took hours to buy each of these bonds, with many of the trades not going through the first time.

2 The bid/ask spreads from buying a very small number of bonds were large and therefore took from returns.

3 While the cash flows average 4.38%, from buying a small number of bonds, the annual payouts varied a bit from that average. You can’t buy fractional amounts of TIPS as you can in a fund.

An ETF could easily solve all three of these problems.

Roth calls his ETF idea the Safe Withdrawal Rate ETF, or SWR for short. Here is how he says it could work:

The prospective consumer clicks on the SWR website to see its current real yield and annualized real cash flow. As of the time of this writing (May 2023), it would show 1.70% and 4.27%, respectively.

With a few simple clicks, one buys SWR with the intent never to sell. Let’s use $100,000 in this example. The authorized participant aggregates this purchase with many others to buy large volumes of TIPS to build the ladder ….

Then all the consumer or the ETF issuer has to do is nothing other than hold it forever. As the underlying TIPS mature, SWR would distribute the annual amount, $4,270 in this case, plus accumulated inflation.

The value of the ETF would decline over time as the TIPS mature, and would eventually reach zero in 30 years. Roth says, “In other words, SWR would be a self-liquidating ETF.” The funds could be offered in different maturities, of course. And the expense ratio in theory could be low (Roth suggests 0.05%) because no trading would happen once the fund is set.

Reaction to the idea

Roth’s idea prompted a June 16 article from Morningstar’s John Rekenthaler with the title “TIPS Ladder Funds Don’t Yet Exist, but They Should.” He points out that a such a fund would offer three advantages:

First, TIPS ladders are unique. No current fund behaves similarly. In a fund world dominated by me-too products, being different is valuable.

Second, TIPS ladders aren’t just distinctive—they’re distinctive and useful. True inflation hedges are rare. …

Third, TIPS ladders are laborious for retail investors to construct.

OK, but why not just buy a single-life annuity paying out lifetime fixed interest of maybe 6%? The problem is inflation, as Rekenthaler notes:

Why accept 4.27% from an immolating investment when one can buy a lifetime annuity that currently pays more, and which carries no expiration date? Two reasons. First … the annuity’s lifetime feature cuts both ways. Second, if inflation is substantial the real value of a nominal distribution, as made by annuities and conventional bonds, shrivels. Twelve years of 6% annual inflation halves purchasing power.

Inflation protection is the reason this SWR ETF idea is attractive. Rekenthaler points out that “every inflation-adjusted penny from a TIPS ladder is known in advance … No other investments can make such a claim.” He concludes:

Retirees need simple, effective methods for protecting their portfolios against inflation’s ravages. A TIPS ladder fund would expand their current options. It’s time for this idea to arrive.

Final thoughts

Building a long-term TIPS ladder is a laborious process, but at this point with real yields at decade-plus highs, it’s an investing opportunity for anyone who wants to preserve capital and ensure future cash flows, no matter the future rate of inflation.

Of course, for the risk-free strategy to work, the ladder-builder needs to commit to holding to maturity, using only money that can be set aside for years.

Roth’s ETF idea would simplify the process, but could face investor push-back over the idea of holding a 20- to 30-year investment to maturity, even if it was providing an inflation-adjusted, continuous return of 4.3% a year. Many of my readers, I think, would prefer the freedom to build their own TIPS ladders to meet specific needs.

But this kind of investment would simplify the process of funding retirement spending, and bring risk-free inflation protection to an entirely new market. Would it be too complicated for the average investor to grasp? Would the expense ratio truly be ultra-low, eliminating the need for self-building a TIPS ladder?

I like to see it happen.

• 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

Disclosure: I own VTIP in a traditional IRA account. I use it as a holding fund to make future purchases of individual TIPS.

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Posted in ETFs, Investing in TIPS, Retirement | 38 Comments

5-year TIPS reopening gets real yield of 1.832%, highest in 14 years

Posted on June 22, 2023 by Tipswatch

By David Enna, Tipswatch.com

The Treasury just announced results of its $19 billion offering of a reopened 5-year TIPS, CUSIP 91282CGW5, and investors should be pleased.

This 4-year, 10-month Treasury Inflation-Protected Security got an auctioned real yield of 1.832%, the highest for any auction of this term since October 2008. There have been 46 auctions of 4- to 5-year TIPS over that time and only one other — in October 2022, got a real yield higher than 1.7%.

Real yields (meaning the yield an investor will earn above U.S. inflation) have been moving higher in recent weeks, reacting to the Federal Reserve’s potential plan to raise short-term interest rates once or twice again this year.

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 inflation.

So, if inflation averages 2.5% over the next 4 years, 10 months, an investor in this TIPS would earn a nominal annualized return of 4.33%. If inflation averages 4%, the return would be 5.83% … and so on.

Here is a history of 5-year real yields over the last 14 years, showing the long periods of deeply negative real yields, right up until March 2022, when the Fed began aggressively battling inflation with higher interest rates:

Click on the image for a larger version.

Auction result, pricing

Here are details from the Treasury announcement:

Key factors for investors: 1) the unadjusted price of 97.339740 and 2) the inflation index of 1.01121 on the settlement date of June 30, 2023. This is how the investment pricing works out:

In essence, a $1,000 investment at par for this TIPS will cost $984.31 on the closing date, even though the investor will have $1,011.21 of principal on that date. From that point forward, the investor will earn the coupon rate of 1.25% applied to the principal balance, which will rise (or possibly fall) with future monthly inflation.

The prepayment of accrued interest will be returned at the first coupon payment on Oct. 15, 2023.

Calculation of real yield to maturity

Several readers have asked about how to do a calculation to check the real yield to maturity. Since this is a Treasury issue, I am confident the 1.832% real yield is accurate, and my rough estimate comes to close to that number. But reader Jim came up with the answer in the comments section below:

The real yield (“High Yield” in Treasury Auction Results) is a classic Yield To Maturity calculation using the issue date, maturity date, coupon rate, coupon frequency, unadjusted price and face value of the bond. It also is based on the day count assumption of a 30/360. If you wish to replicate the computation the easiest way is to use the YIELD function in excel. For this auction it would look like this, YIELD(6/30/2023,4/15/2028,1.25%,97.339740, 100,2,0). YTM is found by finding the rate necessary in the basic bond value equation so that the discounted future coupon payments and bond face amount equals the price paid for the bond. This is done by iterations using different rates until you find the correct value. Best to let a computer do it for you!

So, using Excel’s YIELD function, this is how you can set up the formula and find the result:

Inflation breakeven rate

At the auction’s close at 1 p.m. EDT, a 5-year Treasury note was trading with a nominal yield of 4.03%, creating an inflation breakeven rate of 2.2% for this TIPS. That is the lowest auctioned breakeven rate for this term since an auction in December 2020.

Although 2.2% is a relatively “highish” breakeven rate by historical standards, it seems quite reasonable at a time when U.S. inflation is running at 4.0%. In indicates that this TIPS is cheaply priced versus the nominal Treasury of the same term.

Here is the history of the 5-year inflation breakeven rate over the last 14 years:

Reaction to the auction

Things seemed to go smoothly. Through the morning, CUSIP 91282CGW5 was trading on the secondary market with a real yield in the range of 1.82% to 1.86%. The bid to cover ratio was a solid 2.56, so demand looked reasonably strong. After the auction’s close, the TIP ETF — which holds the broad range of maturities — moved slightly higher, indicating slightly lower yields. That’s an indication of a positive market reaction to the auction.

I was a buyer at this auction, even though I already purchased CUSIP 91282CGW5 at the April auction. A real yield of 1.83% was impossible to pass up. I might (or might not) have been able to do better earlier in the day on the secondary market, but Vanguard’s brokerage was only offering lot sizes of $100,000 or more.

No problem. I am happy with today’s result. If you were a buyer today, post your thoughts in the comments section below. Here are auction results for TIPS of this term over the last 5 years: