Treasury Inflation-Protected Securities

Yes, you can make sense of the complex pricing of Treasury Inflation-Protected Securities.

By David Enna, Tipswatch.com

Last week, I decided to buy $15,000 of the new 10-year Treasury Inflation-Protected Security — CUSIP 91282CEZ0 — being offered at auction by the U.S. Treasury. I was making this purchase in a Vanguard brokerage account (a traditional IRA), where I had set aside $15,095 in cash for the purchase.

The problem was: Would that $15,095 cover the cost, after any premium/discount to par value, plus any additional accrued principal and interest? The Treasury’s official announcement for the auction wasn’t much help, with all the important pricing details to be “Determined at Auction”:

So I did a quick calculation:

1. I was buying $15,000 of par value.
2. I knew the real yield to maturity would be at least 0.50%, because that was where the 10-year TIPS market was trading. That would mean the real yield would NOT be below the coupon rate, which only happens when the real yield is less than 0.125%.
3. Therefore, this TIPS would be sold with at least a slight discount to par.
4. But … this TIPS would have an inflation index of 1.00495 on the settlement date of July 29, so that would add to my purchased principal, and the cost, along with a small interest adjustment for 14 days of the coupon payment (from the July 15 issue date to the July 29 settlement date).
5. So, I figured, the highest cost I would end up paying wound be about $15,000 x 1.00495 = $15,074. And I concluded that my $15,095 would cover the cost.

Let’s see what happened

The auction ended up producing a real yield to maturity of 0.630%, which then caused the Treasury to set the coupon rate at 0.625%. When a TIPS has a real yield of 0.125% or higher, the Treasury always sets the coupon rate to the 1/8% below the real yield … 0.125%, 0.250%, 0.375%, o.500%, 0.625% … and so on. A real yield of 0.630% gets a coupon rate of 0.625%, and the price is set at a very small discount to par. A real yield of 0.620% gets a coupon rate of 0.500%, and the price gets a bigger discount.

Here are the auction results, as reported by the Treasury in its official announcement:

So, what does this all mean — high yield, adjusted price, unadjusted price, adjusted accrued interest, index ratio — and how does it affect the price I paid?

The high yield becomes the TIPS’ official real yield to maturity in the auction records. It is the highest yield the Treasury had to grant to complete the $17 billion offering of this TIPS, and it is the real yield granted to all non-competitive bidders (that’s pretty much anyone putting in a purchase order at TreasuryDirect or through a brokerage).

After the auction was completed, Vanguard reported my cost for $15,000 of par value to be $15,070.55. What factors went into setting that price? Once the high yield was set, all the other pricing fell into place Let’s take a look:

The key factor in this chart is the unadjusted price, which was $99.9517 for $100 of par value, and that meant my core cost for the $15,000 in par value was $14,992.75.

But, because of the inflation index of 1.00495, I will be purchasing 14 days of inflation-adjusted additional principal on the settlement date of July 29. That raises my cost to $15,066.97.

In addition, I will have to pay for the 14 days of coupon rate interest that will have accumulated by July 29. Since the coupon rate is 0.625%, 14 days of interest would be about 0.0239%. That is why the adjusted accrued interest is set at $0.239 per $1,000 of par value. Since my accumulated principal will equal about $15,066.87 on July 29, my accrued interest is about $3.60.

And that sets the total cost of the investment: Inflation adjusted value + accrued interest. $15,066.87 + $3.60 = $15,070.57. (OK, Vanguard said it was 2 cents less. I’ll take it. Savings!)

The last line on that chart shows the total value of the investment on July 29, which is simply par value ($15,000) x the inflation index (1.00495) = $15,077.85. In this calculation, I am ignoring the coupon interest which will be paid out as current income twice a year. Also, don’t confuse “total value” with “market value.” Total value reflects only par value + inflation accruals. Market value adds in the fact that the price of a TIPS changes daily on the secondary market. If you are holding to maturity, you can more or less ignore market value.

Happy side note: The inflation index for this TIPS on Aug. 31 will be 1.01939, up 1.3% for the month because of the high rate of non-seasonally adjusted inflation in June. That will put its total value at $15,290.85. Not bad.

Conclusion

I hope this primer on TIPS pricing is helpful. The July 21 auction was an easy one because the real yield ended up just a hair above the coupon rate, making the unadjusted price very close to par. In the last two years that hasn’t be true, with negative real yields far below the lowest possible coupon rate of 0.125%. I am hoping we are entering a new era of positive real yields and much more sensible TIPS pricing.

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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.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

A weak bid-to-cover ratio of 2.18 indicates lousy demand from big-money investors.

By David Enna, Tipswatch.com

The Treasury’s offering of $17 billion in a new 10-year Treasury Inflation-Protected Security — CUSIP 91282CEZ0 — generated a real yield to maturity of 0.630% at auction Thursday, the highest yield at auction for this term in two years.

The coupon rate was set at 0.625%, the highest coupon for a new TIPS in three years. In fact, this auction broke a string of 15 consecutive auctions of 9- to 10-year TIPS with a coupon rate of 0.125%, the lowest the Treasury will go for a TIPS.

Definition: The “real yield” of a TIPS is its yield above or below official future U.S. inflation, over the term of the TIPS. So a real yield of 0.630% means an investment in this TIPS will exceed U.S. inflation by 0.630% for 10 years.

Investors in today’s auction should be pleased, because a surprise rate hike this morning by the European Central Bank had set both nominal and real yields sliding lower. Nothing drastic, but for much of the morning it looked like this auction’s real yield might dip below 0.60%. The bid-to-cover ratio was 2.18, a very low number and an indication that weak demand forced the real yield higher.

Because the Treasury set the coupon rate at 0.625%, slightly below the auctioned yield, investors paid an unadjusted price of about $99.95 for $100 of par value. However, because this TIPS will have an inflation index of 1.00495 on the settlement date of July 29, the adjusted price was about $100.45 for $100.49 of value, after the inflation accrual is added in.

Here is the trend in 10-year real yields in 2022, showing the strong surge higher since the Federal Reserve committed to future rate hikes in March, in an effort to slow soaring U.S. inflation:

Inflation breakeven rate

With a 10-year nominal Treasury trading today with a yield of 2.96%, this TIPS gets an inflation breakeven rate of 2.33%, which looks like an attractive number. It means this TIPS will out-perform a nominal Treasury if inflation averages higher than 2.33% over the next 10 years.

U.S. inflation is currently running at an annual rate of 9.1%. While that number is expected to begin falling in future months, most experts agree it is likely to remain in the 4% to 5% range well into 2023, maybe higher. So again, this auction looks like a positive result for investors.

Here is the trend in the 10-year inflation breakeven rate through 2022, showing how inflation expectations have been falling in reaction to the Federal Reserve’s commitment to fight inflation:

Reaction to this auction

I was a buyer at today’s auction, so I was keeping my eye on TIPS trends through the morning. The European Central Bank’s surprise rate hike (the first in more than 10 years) did appear to roil the bond market, but the moves weren’t dramatic. One effect of the rate hike could be a stronger Euro and weaker dollar, which could slightly elevate inflation in the U.S., but also boost profits of U.S. corporations doing business in Europe.

It’s possible big money investors decided to sit this auction out, especially as real yields appeared to be declining through the morning. Bloomberg’s report noted that demand was “soft” at this auction. The bid-to-cover ratio of 2.18 indicates weak demand, which forced the Treasury to accept a higher real yield. But as shown in this chart for the TIP ETF, the market reacted to the auction’s close at 1 p.m. with a yawn. Nothing to see here.

But for buyers at today’s auction, a real yield of 0.630% and a price very close to par is a welcome result. Keep in mind that principal balances for this TIPS will rise 1.37% in August, based on non-seasonally adjusted inflation in June 2022. That’s a darn good first month. (And as a side note, I will point out that the nominal 10-year German bond is currently yielding 1.22% annually, less that the upcoming one-month inflation accrual for this TIPS.)

Today’s auction of CUSIP 91282CEZ0 is the first of three for this issue. It will reopened at auctions in September and November. I think there is a reasonable chance yields will be higher at those future auctions, but a lot will depend on the state of the U.S. economy and the Federal Reserve’s commitment to fighting inflation.

Here is a chart of all 9- to 10-year TIPS auctions going back to January 2019, the last auction before the Fed abandoned its tightening policy that began, very slowly, in 2015:

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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.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

But beware: Real yields are volatile; even hour to hour

By David Enna, Tipswatch.com

Update, July 21: New 10-year TIPS gets real yield of 0.630% at auction, a nice result for investors

The Treasury on Thursday will auction $17 billion in a new 10-year TIPS, CUSIP 91282CEZ0, and this offering should be somewhat historic, for several reasons:

• That $17 billion number is the highest auction amount in history for a 10-year TIPS opening or reopening. The last auction of a new 10-year, on January 20, was for $16 billion. A year before, on Jan. 21, 2021, the size was $15 billion.
• So the amount is increasing even as the Federal Reserve is reducing its balance sheet of TIPS and other Treasurys, meaning it won’t be rolling over its current holdings. The Treasury is trusting that investor demand will pick up the slack.
• The Treasury on Friday estimated the real yield of a 10-year TIPS at 0.57%, which would be the highest real yield at auction for this term since an auction on March 20, 2020, in the midst of pandemic panic.
• Unfortunately, that Treasury estimate has fallen 15 basis points in the last week. This is the sort of volatility we are seeing in the Treasury market, every week, as the market reacts to potential Fed actions to combat inflation.
• If the auctioned real yield holds above 0.50%, the coupon rate for this TIPS will be set at 0.50%, or possibly even 0.625% if the real yield can break through to 0.625% or higher. A coupon rate of 0.50% would be highest for a new TIPS since an auction on Jan. 17, 2019.

Watching market coverage this week, I was catching the drift from “experts” that the Fed will raise short-term interest rates, probably 75 basis points, later this month and then again — possibly 50 basis points? — in September and then go quiet, waiting to see how the economy reacts. The current Federal Funds Rate is in the range of 1.50% to 1.75%, but effectively 1.75%. An increase of 75 basis points brings it to 2.50% and another 50 to 3.00%.

At this point, short-term Treasury bills are already pricing for those increases, with the 13-week Treasury yielding 2.37% and the 1 year at 3.12%. But beyond those short-term rates, the yield curve goes flat, with the 5-year Treasury note at 3.05%, the 10 year at 2.93% and the 30 year at 3.10%. That’s not good news for investors in a 10-year TIPS, because lower nominal yields will drag real yields lower, most of the time.

All this could change next week, as the bond market slushes around based on the latest “theory” of the Fed’s future actions and the effects on the U.S. economy. Inflation expectations have also been sliding lower, even after last week’s dreary June inflation report, which set annual U.S. inflation at 9.1%.

Definition: The “real yield” of a TIPS is its yield above or below official future U.S. inflation, over the term of the TIPS. So a real yield of 0.57% means an investment in this TIPS will exceed U.S. inflation by 0.57% for 10 years.

I tend to believe that if inflation continues at a pace around 4% to 5%, which seems likely for many months, real yields will have to rise as the Fed continues stepping on the brakes. So is a 10-year TIPS yielding 0.57% attractive? I’d say yes, even knowing future rates could be higher. Here is a history of the 10-year real yield from 2010 to today:

Note that we have now reached the mid-point of 10-year real yields during the Fed’s last tightening cycle, which peaked in late 2018. At that time, the 10-year real yield rose to about 1.15%. Also at that time, U.S. inflation was running at 2.2%, far below today’s 9.1%. The Fed has a long way to go before it can end the current tightening cycle.

Pricing. If the real yield of this TIPS holds above 0.50%, the coupon rate will be 0.50% and the unadjusted price should be a little less than par value. However, this brand new TIPS will have an inflation index of 1.00495 on the settlement date of July 29. Why? Because non-seasonally adjusted inflation ran at 1.1% in May, so the half-month inflation accrual for this TIPS is 0.49% on the settlement date.

The inflation accrual means that investors could be paying an adjusted price of about $100.49 for about $100.49 of value, with accrued inflation. But the price will be a bit lower because the real yield will end up being higher than the coupon rate. It could balance out, but will probably be a bit above $100.00.

Inflation breakeven rate

With a 10-year Treasury note yielding 2.93% at Friday’s close, this new TIPS would have an inflation breakeven rate of 2.36%, which seems very attractive given current conditions. I’d prefer to invest in a TIPS with a yield exceeding inflation by 0.57%, versus a straight nominal yield of 2.93%.

Here is the trend in the 10-year inflation breakeven rate from 2010 to 2022:

In this chart, note that the current inflation breakeven rate of 2.36% is 20 basis points below the rate in March 2013, when annual inflation was running at a paltry 1.5%. Markets can be weird.

The recent decline in the 10-year inflation breakeven rate indicates that real yields have been holding up better than nominal yields. It also seems to indicate fairly weak demand for TIPS right now. That could be a factor in Thursday’s auction, with the Treasury issuing a record-high $17 billion in a 10-year TIPS.

Conclusion

The dip in real yields last week is a negative for investors, but I’d still be very interested in this TIPS if the real yield can hold above 0.50%. If the economy seriously weakens, we have to be prepared for the Fed to attempt a rescue, as it has continuously done over the last 20+ years. This TIPS isn’t attractive enough to “bet the house,” but a sensible investment seems fine to me.

You can check the Treasury’s real yield estimates for a full-term 10-year TIPS on its Real Yield Curve page. This auction closes at noon Thursday for non-competitive bids, like those made 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 report the results after the auction closes at 1 p.m. EDT Thursday.

Here is a recent history of 9- to 10-year TIPS auctions, showing the long string of negative real yields in the aftermath of the pandemic outbreak, beginning in March 2020:

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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.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.