This week’s 30-year TIPS auction will be another milestone event

Posted on February 12, 2023 by Tipswatch

Real yield to maturity could be the highest in 12 years.

By David Enna, Tipswatch.com

The Treasury on Thursday will offer $9 billion at auction for a new 30-year TIPS, CUSIP 912810TP3. The real yield to maturity and coupon rate will be determined by the auction results, but it’s looking like this TIPS will get the highest real yield at auction for this term since at least 2014, possibly back to 2011.

The U.S. Treasury on Friday was estimating the real yield of a 30-year TIPS at 1.53%, up 20 basis points since the beginning of February. If that real yield holds through the auction on Thursday, this new TIPS would get a coupon rate of 1.5%, the highest since an originating auction in February 2011.

Oh no, nostalgia!

Ah, 2011 … that was the year I created Tipswatch.com, with the first post on April 10, 2011. A couple months later I weighed in on a 30-year TIPS reopening auction, for CUSIP 912810QP6. My preview was fairly negative. In the last few months, a few readers have quoted that article back to me to demonstrate how unpredictable the Treasury market can be. (Oh yes, I am fully aware of that.)

That 30-year TIPS auction on April 10,2011, ended up getting a real yield to maturity of 1.744%, which looks outstanding today, but was rather disappointing at the time. Hard to believe, isn’t it? Here is what I said in my preview article:

The auction yield should be around 1.8%, probably a bit higher. This is 110 basis points higher than the going rate on a 10-year TIPS, and a whopping 230 basis points higher than a 5-year TIPS. You will get that yield for 30 years, on a principal base that is constantly increasing with inflation. …

That yield is not great. In fact, this TIPS was first issued four months ago with a base rate of 2.19%. It is likely that the TIPS rates will begin – eventually – moving more toward ‘normal’ levels, and for a 30-year that would be nearly 3%. However, I have been saying that for quite awhile, and I have been wrong.

Why did I say a real yield of 3% was “more normal”? That was based on data available in 2011. The Treasury had stopped issuing 30-year TIPS from October 2001 to February 2010. So this was the total history of 30-year TIPS auctions at the time:

Still, I did invest in CUSIP 912810QP6, which ended up getting a real yield to maturity of 1.744% (a record-low for this term at the time). In 2011, I was disappointed. Today, I am quite happy and I am still holding that TIPS, which has a solid coupon rate of 2.125% and an inflation index of 1.357.

Point of this history lesson: We can’t accurately predict where interest rates are headed. What looked disappointing in 2011 ended up being a prize investment in my TIPS portfolio.

Back to this week’s auction!

For two kinds of investors, a 30-year TIPS with a real yield of 1.50% could be attractive: 1) a buy-and-hold-to-maturity investor who is young enough to survive 30 years, and 2) a TIPS trader who believes that real yields are likely to fall in the relatively near future, which would bring capital gains on a trade.

I am neither 1 nor 2, so I am no longer interested in investing in 30-year TIPS. These TIPS are highly volatile investments and require discipline to hold through wild swings higher or lower in market value.

Although real yields on the secondary market for this term were higher in October 2022, 1.53% remains attractive. Just a year ago, in February 2022, a new 30-year TIPS auctioned with a real yield of 0.195%.

Definition: The “real yield” of a TIPS is its yield above official future U.S. inflation, over the term of the TIPS. So a real yield of 1.53% means an investment in this TIPS will exceed U.S. inflation by 1.53% for 30 years. If inflation averages 2.3%, you’d get a nominal return of 3.83%, on par with a nominal 30-year U.S. Treasury. But if inflation averages 4.5%, you’d get a nominal return of 6.03%.

This chart shows the history of 30-year real yields since the Treasury reinstated the 30-year TIPS in February 2010:

Click on the image for a larger version.

For much of this 13-year period, the 30-year real yield lingered in a range around 1.0%, but keep in mind that real yields were suppressed by the Federal Reserve’s quantitative easing. Now we are in a period of quantitative tightening, and there is no way to predict how long that will last or the eventual result on real yields.

For an investor of the right age looking to build a buy-and-hold TIPS ladder, this 30-year TIPS looks like a reasonable investment. As long as that investor can ignore market volatility, which could be extreme in either direction.

Inflation breakeven rate

With the 30-year nominal Treasury bond closing Friday with a real yield of 3.83%, a new 30-year TIPS with a real yield of 1.53% would have an inflation breakeven rate of 2.3%, a bit higher than recent auctions of this term. But 2.3% looks reasonable. Over the last 30 years, inflation has averaged 2.5% a year. For all 30-year periods beginning in 1971, only one period has had inflation lower than 2.3% — 1990 to 2020 at 2.2%.

Here is the trend in the 30-year inflation breakeven rate from 2010 to 2023:

Click on the image for a larger version.

Final thoughts

I won’t be a buyer, but that is based on my age and ability to hold to maturity. My current TIPS ladder stretches out to February 2043, when I will be approaching 90. I still have some spots to fill, but I will be focusing on TIPS maturing in 5 to 19 years. For example, next month on March 23 we will have a 10-year TIPS reopening auction, and then on April 20 a new 5-year TIPS will be issued.

Investors looking at this new 30-year TIPS should focus on buying it in a tax-deferred account, but because the coupon rate will be around 1.5%, that should be adequate to cover “phantom income taxes” in a taxable account. Investors in a taxable account have to pay taxes on TIPS inflation accruals in the current year.

You can track the Treasury’s daily Yield Curve updates here. Yields are likely to continue to be volatile into next week. This auction closes at noon Thursday for non-competitive orders at TreasuryDirect. 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. I’ll be posting results soon after the auction closes at 1 p.m. ET Thursday.

Here is a history of all 29- to 30-year TIPS auctions over the last eight years:

• 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 Inflation, Investing in TIPS, TreasuryDirect | 29 Comments

Monthly U.S. inflation for 2022 just got revised … a bit

Posted on February 11, 2023 by Tipswatch

This has no effect on annual inflation or on earnings for TIPS and I Bonds.

By David Enna, Tipswatch.com

While I was searching Friday for consensus estimates on the January inflation report, to be released Tuesday, I noticed something odd. The Bureau of Labor Statistics had altered the seasonally-adjusted inflation rate for December, increasing that month’s inflation to 0.1% from the once-official -0.1%.

Huh? What does that mean? Inflation increased in December, when we all thought it decreased? This is not what I needed heading into Super Bowl weekend, when I want my focus on the other green stuff … guacamole.

To be clear, these are routine revisions to the BLS’s monthly seasonally-adjusted inflation numbers, and don’t affect the annual rates of inflation, or the non-seasonally adjusted inflation numbers that are used to adjust principal balances on Treasury Inflation-Protected Securities and set future interest rates for U.S. Series I Savings Bonds.

But it’s still unsettling to learn that these revisions show monthly inflation was actually higher in October, November and December than was originally reported by the BLS. These reports move the stock and bond markets.

Now, when you go to the BLS homepage, you’ll see this statistic for December inflation, even though the “once-official” number for December was -0.1% when it was released Jan. 12:

The BLS hasn’t really supplied much information on these revisions, other than posting this statement on its website, along with a very complex Excel file:

Updated seasonal factors introduced February 10, 2023

Each year with the release of the January CPI, seasonal adjustment factors are recalculated to reflect price movements from the just-completed calendar year. This routine annual recalculation may result in revisions to seasonally adjusted indexes for the previous 5 years. Recalculated seasonally adjusted indexes as well as recalculated seasonal adjustment factors for the period January 2018 through December 2022 were made available on Friday, February 10, 2023.

Core CPI, which excludes food and energy, also saw upward revisions of 0.1 percentage points in December and November.

In these changes, the BLS is basically re-allocating its seasonal adjustments, which have no effect on the annual numbers. In essence, annual inflation of 6.5% is being reallocated across the 12 months of 2022. However, you have to wonder how consumers and financial markets would have reacted to slightly higher monthly inflation numbers in the last quarter of 2022, when “disinflation” suddenly became a buzzword.

The Reuters report on this change noted that the revisions could indicate a slight uptick in inflation in coming months:

“On the whole, we don’t see major implications for our inflation outlook coming from the updated seasonal factors,” said Daniel Silver, an economist at JPMorgan in New York. “But the stronger recent trend for the seasonally adjusted data does generate some upside risk looking ahead.”

In case you are curious, I did eventually find the consensus estimates for January inflation, which will be released Feb. 14 at 8:30 a.m. Economists are projecting monthly all-items inflation of 0.5% and an annual rate of 6.2%. Core inflation is projected at 0.3% for the month and 5.5% year over year. If those projections are accurate, annual inflation would be continuing a gradual decline.

The BLS revisions shouldn’t affect the year-over-year result for January, which remained at 0.6% in January 2022.

No effect on I Bonds or TIPS

As I noted, the 2022 revisions are focused on seasonal adjustments, so they don’t affect annual inflation or the non-seasonally adjusted numbers that are used to adjust TIPS principal balances or set future interest rates for I Bonds.

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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 I Bond, Inflation, Investing in TIPS | 10 Comments

Mystery solved: ‘Inflation Guy’ explains the upcoming CPI reweightings

Posted on February 8, 2023 by Tipswatch

Is this a conspiracy to make inflation look tamer? No. It’s a routine but important update.

By David Enna, Tipswatch.com

Over the last few weeks, I’ve gotten questions about “surprise” price-index reweightings coming in the January inflation report about to be issued by the Bureau of Labor Statistics.

Uh-oh. Sounds like a conspiracy, right? The BLS is going to find a way to make inflation look tamer than it really is, right? All of our inflation-linked investments are going to suffer, right?

Wrong.

This reweighting of the CPI price indexes is a rather routine affair. Until 2002, the reweighting was done every 10 years, but the BLS realized that was no longer practical. So the schedule was increased to every two years. Now, with this January inflation report, the schedule is being changed to every year, taking effect with the January report each year. The BLS explains:

“Beginning with the January 2023 index, scheduled for publication on February 14, 2023, BLS plans to update the spending weights in the calculation of the CPI every year instead of every 2 years. Spending weights indicate what share of total expenditures each item represents. This change will improve the relevance of CPI spending weights by using the most recent consumer spending information. By improving the relevance of spending weights, BLS can improve the accuracy of the CPI.”

These reweightings are created through surveys by the BLS of consumer spending information. For the 2023 weightings, the BLS will use consumer data collected in 2021.

When I learned about these reweightings, I sent out a plea to Michael Ashton of Enduring Investments for an explanation, minus the conspiracy theories. I guess I wasn’t the only person asking. Ashton, who is known as @inflation_guy on Twitter, created a podcast explaining the logic behind the change in the weighting schedule. Here it is:

In explaining the reasoning behind these reweightings, Ashton talks about the balance between “core goods inflation” and “core services inflation.” In 2022, the BLS was giving a higher weight to core goods inflation, based on its consumer surveys in 2020, during the depths of the pandemic. Supply issues caused the cost of goods to soar in 2020, so goods got a higher weight in 2022. But in 2022, core goods inflation shrank to nearly 2%.

On the flip side, consider the cost of “core services” in 2020: How many times did you eat in a restaurant? Travel by airplane? Get a big raise for working at home? So based on its 2020 surveys, the BLS reduced the weight of core services for 2022. But in 2022 the cost of core services began escalating. So the CPI was missing the real inflation picture, at least slightly.

The BLS is switching to annual reweightings to try to get a more accurate snapshot of U.S. inflation. If the BLS continued to use the 2020 survey weightings, inflation in 2023 would be underestimated because of the skew toward goods over services. Consider this from the Wall Street Journal in its preview of the December inflation report:

The root problem for investors is that inflation itself has become more complicated. Core goods inflation has turned negative in recent months, thanks to increased supply of many products and reduced demand. But services inflation has remained elevated—the result, many argue, of a stubbornly hot jobs market and escalating labor costs.

Ashton notes: “In 2020 we had this thing called Covid and consumption patterns changed dramatically and the BLS very carefully considered if they should use intervention analysis. … but they ultimately decided hands off.

“People are always saying that the BLS monkeys with the CPI to keep inflation reported lower than it really is. There is no conspiracy, but there are factors that … do have that result. And those things happen in both directions, obviously.”

We won’t know exactly what the new weights will be until the BLS issues the January inflation report. Ashton expects core services to get a higher weighting, and core goods to get a lesser weighting.

Why does it matter?

“If you believe that inflation is going to fall back to 2% … you have to believe that something is going to happen in core services,” Ashton says. “It’s going to have to happen from the services side,” because core goods is already down to about 2% inflation.

“It’s easy to exaggerate overall how important this is. … Normally the reweighing is a snoozer, it doesn’t matter at all. Nobody cares. It doesn’t really change very much.”

In 2023 we will get bigger-than-normal weighting changes, but they are still what Ashton calls a “rounding error.”

“If you have a 1% change in the weight of a category that is inflating 2% faster than the average, then that adds 2 basis points to the annual inflation. … So it’s not a big deal. Now you know if you should care about it. Probably not.”

For a positive spin, we will let the BLS have the final word: “Transitioning from biennial spending weights to annual spending weights is another milestone towards our goal to improve the accuracy and timeliness of the CPI.”

Who is Michael Ashton?

His audiences know him as the “Inflation Guy.” He is a pioneer in the U.S. inflation derivatives market. Before founding his company, Enduring Investments, Ashton worked in research, sales and trading for several large investment banks including Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003, when he traded the first interbank U.S. CPI swaps, and 2004 when he was the lead market maker for the CME’s CPI Futures contract, he has played an integral role in developing new instruments and methods for accessing and hedging various inflation exposures. In 2016, Ashton published What’s Wrong With Money? The Biggest Bubble of All. He is a graduate of Trinity University and lives in Morristown, New Jersey.

Have a question? Get the Inflation Guy app in the Apple App Store or Google Play, or email InflationGuy@enduringinvestments.com.

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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 Inflation | 10 Comments

TIPS on the secondary market: Things to consider

Posted on February 5, 2023 by Tipswatch

Yes, real yield is important, but there are other factors to consider before making a TIPS purchase. Like: How much is this going to cost?

By David Enna, Tipswatch.com

As real yields continue to slide lower, a lot of investors are feeling a sense of urgency to build a ladder of Treasury Inflation-Protected Securities: Let’s get this done! And that means crawling through the secondary market looking for TIPS to fill year-by-year rungs of an investment ladder.

Of course, the trend of declining yields could reverse, and we could see attractive opportunities later this year. Or … we could see a repeat of 2019, when the 10-year real yield fell from 0.96% on Jan. 2 to 0.15% on Dec. 31. My thinking: This is a reasonable time to work on a TIPS ladder, if that is your goal. Real yields remain attractive, at least by the standards of the last dozen years.

I am getting a lot of questions about TIPS on the secondary market. Is real yield to maturity the only important factor to consider? Why do TIPS with similar maturity dates have different real yields? Is it bad to invest in a TIPS with a high inflation accrual? What about the coupon rate and its effect on price?

In this article I am going to run through five pairs of TIPS with the same or similar maturity dates, but in some cases vastly different up-front investment costs and slightly different real yields. Why does that happen and what is important to consider?

First, some definitions

Par value is the base amount of the TIPS you are purchasing. However, the price you actually pay is going to vary from par value. When you buy a TIPS on the secondary market, you will place a dollar amount in the order box. That is the par value you are purchasing. It is also the amount that is guaranteed to be returned at maturity, even if severe deflation sets in.

For more on the language of TIPS, see my TIPS In-Depth page.

The coupon rate is set by the original TIPS auction. It is the amount of annual interest your TIPS will earn on its inflation-adjusted principal. It is the key factor determining the cost of the TIPS on the secondary market. If the coupon rate is below market real yields for that maturity date, the price will be at a discount. If it is higher, the price of the TIPS will be at a premium.

The real yield to maturity is the amount you will earn above official U.S. inflation as long as you hold the TIPS. It is set through a combination of the coupon rate and the price you paid for the TIPS.

After you buy a TIPS, you are going to earn inflation accruals + coupon rate. That’s it. The price you originally paid — at a discount or a premium — determines your real yield to maturity. While the real yield changes minute-by-minute on the secondary market, once you make a purchase you have locked in your real yield to maturity for that TIPS.

You may see “yield to worst” quoted by the brokerage. For a TIPS, that is the real yield to maturity.

The inflation index is the current amount of accrued inflation already earned by the TIPS you are purchasing. This is stated as a number higher or lower than 1.0. If you are buying a new TIPS at auction, the inflation index is likely to be close to 1.0, or even slightly below. But a TIPS on the secondary market usually will have an inflation index above 1.0, even as high as 1.8.

The Wall Street Journal’s daily listing of TIPS values calls the inflation index “accrued principal” and shows it as a number like 1579. Your brokerage would show that as 1.57905. Vanguard calls it “factor.” Fidelity calls it “inflation factor.” What it means is that this particular TIPS has accumulated 57.9% of accrued inflation above the par value.

Adjusted principal is the amount of principal you are actually purchasing. It’s a simple calculation.

Par value x inflation factor = Adjusted principal.

For example: $10,000 par x 1.57905 = $15,790.50 adjusted principal.

Cost factor is the price you are paying for $100 of accrued principal in this TIPS. At the brokerage you will see “bid” and “ask” prices. You will probably be paying the ask price. It will look something like 97.19 for a TIPS selling at a discount or 100.81 for a TIPS selling at a premium. As I noted earlier, this cost factor is based on the coupon rate of the TIPS versus current market real yields for that maturity.

Investment cost is another simple calculation:

Adjusted principal x cost factor = Investment cost

For example: $15,790.50 x 1.0081 = $15,918.40

Note that in this calculation the cost factor is divided by 100 (100.81 / 100 = 1.0081) to reach a dollar-for-dollar multiplier.

And one more thing: Accrued interest will be added on to the investment cost at the settlement. It reflects the amount of unpaid coupon interest up to the date of the settlement. This is generally a small number, and it gets returned to the investor at the next coupon payment.

Here is an example of pricing for the Jan. 19 auction of a new 10-year TIPS, showing the interaction of these price factors:

TIPS vs TIPS: Examples

Because the Treasury used to issue 20-year TIPS (until it stopped in 2009) there are several examples of TIPS maturing on the same day in the future, but with different coupon rates, different prices, different adjusted principal and different real yields. These offer a chance to examine why real yields could vary slightly for these TIPS maturing on the same day. Is one a better investment than the other? That’s up to you to decide.

Example one: 2025

One thing to notice right away is that these two TIPS have real yields that look highly attractive, around 1.95% above inflation. But keep in mind that yields for very short-term TIPS tend to skew high. One has a coupon rate of 2.375%, so it is selling at a slight premium ($100.81), while the other has a coupon rate of 0.250%, so it is has a much lower price ($96.79).

Also notice the inflation accruals. CUSIP 912810FR4 has an inflation index of 1.57905, while CUSIP 912828H45 has an index of 1.25666. So with one you are buying $15,790 of adjusted principal and with the other, $12,566.50.

Opinion: Investors are demanding a slightly higher real yield for CUSIP 912810FR4 because of its higher inflation accrual. Remember, only the par value of $10,000 — not the $15,918.40 investment cost — is guaranteed to be returned at maturity. My opinion: I’d prefer investing in CUSIP 912828H45 and getting the additional principal at a discounted price.

Example two: 2026

This is similar to example one. CUSIP 912810FS2 has a higher coupon rate but also 49.9% extra accrued principal, versus 25.2% for CUSIP 912828N71. Investors are demanding a slightly higher yield for CUSIP 912810FS2 because of the additional principal, which will purchased at a premium price.

Opinion: Again, I would prefer investing in CUSIP 912828N71 to get the additional principal at a discounted price. Why buy additional, unprotected principal at a premium price?

Example three: 2027

Same pattern: Investors are demanding a slightly higher real yield for CUSIP 912810PS1 because of its higher inflation accrual and premium price. Investors in CUSIP 912828V49 are getting additional principal at a discounted price.

I will note that getting a coupon rate of 2.375% versus 0.375% means CUSIP 912810PS1 gets some additional protection against deflation, since the full coupon interest rate will be paid out, even if the semi-annual payments decline with declining inflation accruals. That’s one reason the real yields remain very close.

Opinion: I’d still go with CUSIP 912828V49’s lower investment cost and lower cost on the inflation accrual.

Example four: 2029

No surprise here: CUSIP 912810PZ5, with its premium price and much higher inflation accrual, gets a higher real yield than its January 2029 partner. Investors want to be compensated for the additional risk — although slight — of the higher above-par principal.

Opinion: I’d actually be a fan of buying lots of additional principal, if it was coming at a discounted price. But in this case, only CUSIP 9128285W6 fits that requirement.

Example five: 2030

Because the Treasury stopped issuing 20-year TIPS in 2009, there is only one TIPS maturing in January 2030, CUSIP 912828Z37. I am comparing it with CUSIP 912828ZZ6, a TIPS that matures six months later in July 2030. I like this comparison because these TIPS are very much alike, both with coupon rates of 0.125%.

But take a look at the inflation indexes. The older TIPS, CUSIP 912828Z37, actually has a lower inflation index that the newer TIPS, 1.15688 versus 1.16090. Why would that happen? Because CUSIP 912828Z37 was issued in January 2020 and got hit by deflationary months in November 2019 (-0.05%), December 2019 (-0.09%), March 2020 (-0.22%) and April 2020 (-0.67%).

By the time CUSIP 912828ZZ6 was issued in July 2020, that deflationary spurt was completed. So even though it has six fewer months of inflation accruals, it has a higher inflation index.

But the interesting thing is that CUSIP 912828Z37 has a higher real yield: 1.21% versus 1.16% and a lower total cost of investment in $10,000 par.

Opinion: It’s a close call, but in this case I’d prefer CUSIP 912828Z37, with its higher real yield, lower inflation accrual and lower total investment cost.

Final thoughts

Sorry for this long-winded post. I hope it doesn’t add to investor confusion. Yes, a TIPS seems like it should be a simple, no-nonsense investment, offering inflation protection and capital preservation. But the deeper you dive into the TIPS market, the more complex it seems. Questions to ask before you make a secondary market investment in a TIPS:

  1. How much am I actually looking to invest? For many of these TIPS, the actual investment cost will be much higher than the par value you enter when you make the order. Adjust accordingly.
  2. What is the market real yield for the maturity I am considering? You can check the Wall Street Journal listing to get a decent idea of current trends.
  3. Do I care if I am buying a substantial amount of inflation-accrued principal that is not protected against deflation? (Some investors do care; many don’t worry about it.)
  4. Do I care if I am paying a premium price for that inflation-accrued principal?
  5. Is there a reason I would prefer a higher coupon rate (at a higher cost) versus a lower coupon rate (at a lower cost)? Or vice versa?
  6. If I am buying a small investment, am I OK with the fact that I will probably get a lower real yield based on the bid-ask spread?
  7. Is a higher real yield to maturity the overriding decision-maker for you? Or do these other factors matter?

Have additional thoughts? Post them in the comments section below.

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

• TIPS in depth: Understand the language

• Upcoming schedule of TIPS auctions

* * *

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 | 59 Comments

Let’s take a look back at IVOL, a once-hot inflation-fighting ETF

Posted on January 30, 2023 by Tipswatch

By David Enna, Tipswatch.com

Back in the fall of 2020, when I was still writing for SeekingAlpha, I was getting a lot of questions about a new ETF with a tongue-twisting title: the Quadratic Interest Rate Volatility and Inflation Hedge ETF. Fortunately, everyone knew this fund by its ticker: IVOL.

The ETF’s creator, Nancy Davis of Quadratic Capital, was hailed as an innovator for this fund. Barron’s named her one of its top 200 Women in Finance in March 2020. But for me, IVOL was never particularly attractive. It was very new, with just a year of trading history. It was a fixed-income fund with a 1% expense ratio and a complex hedging strategy I couldn’t understand.

But … the interesting thing about IVOL is that it holds about 85% of its assets in SCHP, Schwab’s U.S. TIPS ETF, my favorite full-maturity-spectrum TIPS fund. On top of that, it overlays hedging strategies that seek to benefit from interest rate volatility. Quadratic’s information on the fund includes this summary of its strategy:

IVOL is a fixed income ETF that seeks to hedge relative interest rate movements, whether these movements arise from falling short-term interest rates or rising long-term interest rates, and to benefit from market stress when fixed income volatility increases, while providing the potential for enhanced, inflation-protected income.

Since IVOL launched in May 2019, we’ve certainly had a lot of interest rate volatility, but not in the way IVOL was targeting. Short-term interest rates have surged dramatically higher, while long-term rates have stabilized well below short-term rates, resulting in an inverted yield curve. So the performance of IVOL has suffered.

Remember, IVOL holds 85% of its assets in SCHP, but has an expense ratio about 25x higher than SCHP, 1% versus 0.04%. Here is a comparison of the total return for IVOL over the last three years versus SCHP, the total bond market ETF (BND) and Vanguard’s short-term TIPS ETF (VTIP).

Click on the image for a larger version.

From the chart, it is easy to see why IVOL, a shiny new invention, was such a hot fund in 2020, when it trounced the performance of similar investments, nearly doubling the return of the total bond market, 14.6% versus 7.7%. It benefited from having hedged positions that gained from falling short-term interest rates. The yield on a 13-week Treasury fell from 1.54% on Jan. 2, 2020, to 0.09% on Dec. 31.

In 2021, as both short- and long-term interest rates stabilized at very low levels, IVOL under-performed its two TIPS fund competitors by a wide margin. In 2022, when interest rates across all maturities surged strongly higher, all of these funds did poorly with the exception of the shorter-duration VTIP.

In summary, over the last three years, IVOL has out-performed the overall bond market, while under-performing the overall TIPS market. So I conclude that it has failed, so far, in its goal to provide “enhanced, inflation-protected income.” As a high-expense bond fund, I’d give it a B rating. But as a high-expense TIPS funds, it gets a C-.

A trial investment?

In September 2020 I decided to make small investments ($5,000) in both SCHP and IVOL and then track the results over time, with dividends being reinvested. But when I went to purchase IVOL, Vanguard informed me that its trading volume was too small for dividend reinvestments. I threw out that story idea and pretty much forgot about IVOL: too new, too small, too complex, and too expensive.

IVOL today

Nancy Davis still pops up often on Bloomberg and CNBC as a financial expert, and that makes sense because she has a lot of insight into the bond market. Here is a recent CNBC interview where she expresses a view I agree with: That we should see a less-inverted yield curve going forward:

A Forbes article this week took a look at IVOL, noting its celebrated launch in 2019 but mediocre performance since late in 2021. Here is a chart from the article, which is behind the Forbes paywall but also appears on MSN.com here:

Click on image for larger version.

The author, Brandon Kochkodin, has a certain way with words. Just take a look:

While others were asking whether inflation was dead, Davis was pitching her firm’s Interest Rate Volatility & Inflation Hedge ETF (IVOL). IVOL is a chimera, a lion with a goat’s head sticking out of its back. Most of its assets are held in a bond ETF that any mom or pop can buy. The rest of the money goes to options bets that are off limits to even many professional asset managers because of the sophisticated ways they offer investors of losing their shirts. It’s the options, however, that make IVOL unique and what could, if inflation expectations rise sharply and quickly enough, provide a windfall.

Davis’ timing couldn’t have been more perfect. By 2021, fretting about inflation moved from the fringe to the frontline. IVOL’s assets under management soared to more than $3.5 billion …

Nearly four years after raising the curtains … IVOL is in a rut.

Now, after attracting $3.5 billion in assets under management during its surge of popularity two years ago, IVOL today has total assets of $929.1 million. It’s daily volume is about 426,339 shares, compared with 2.47 million for SCHP and 3.46 million for VTIP.

I was wary of IVOL back in 2020, but that is my nature: I am wary of every new-fangled idea I can’t quite understand. The expense ratio of 1% turned me off. The complexity turned me off. The newness and small trading volume turned me off. That was 4 strikes, and I was out.

In coming months, if the yield curve does indeed begin widening back to normal, IVOL should do better. But it still doesn’t interest me.

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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 ETFs, Inflation, Investing in TIPS | 8 Comments