Treasury Inflation-Protected Securities

The Treasury will offer $9 billion in a new 30-year TIPS at auction Thursday. Here’s what to expect.

By David Enna, Tipswatch.com

It’s been two years since we’ve seen any TIPS auction, of any term, generate a real yield to maturity higher than zero. But that could change Thursday, when the Treasury auctions $9 billion in a new 30-year Treasury Inflation-Protected Security, CUSIP 912810TE8.

The coupon rate and real yield to maturity will be set by the auction, which closes at 1 p.m. EST Thursday. But we can get a pretty good idea where this auction is heading: The coupon rate will almost certainly be set at 0.125%, the lowest the Treasury will go for any TIPS. And the real yield to maturity has a decent chance of rising above zero, making this the first TIPS auction since February 2020 to get a positive real yield.

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.

The U.S. Treasury issues an estimate of the real yield of a full-term 30-year TIPS each day after the market closes. On Friday, this estimate was 0.09%, up 45 basis points since the beginning of the year. A lot could change over the next week (for example, in the Ukraine), but for now, it looks like this auction has a good chance of generating a positive real yield, meaning a yield that will exceed official U.S. inflation over the next 30 years.

Here is the trend in the 30-year real yield over the last two years, a period that began before the pandemic-caused market panic of March 2020 and continued through two years of aggressive economic stimulus by both Congress and the Federal Reserve:

In recent months, as the Federal Reserve has indicated it will end its bond-buying quantitative easing in March, 30-year real yields have been rising steadily, but still remain below pre-pandemic levels. My opinion is that a “normalized” 30-year real yield would be in the range of 1.0% to 1.5%, and even that is low by historical standards. So these long-term real yields have room to rise, if the economy remains strong and the Federal Reserve begins reducing its massive balance sheet of Treasurys.

However, if the U.S. economy shows any sign of weakness, I’d expect long-term real yields to be depressed by a flattening yield curve. But they should still be positive, offering a return above inflation.

Even if it gets a yield positive to inflation, CUSIP 912810TE8 could still end up auctioning with a slight premium price, because the real yield will still be below the coupon rate of 0.125%. Most likely, that premium will be about 1% above par, if the real yield holds at 0.09%. However, this TIPS will carry an inflation index of 1.00142 on the settlement date of Feb. 28. This means investors could end up paying about $101.14 for about $100.14 of value, after accrued inflation is added in. That’s a rough estimate!

Inflation breakeven rate

With a 30-year Treasury bond trading at 2.24% at the market close Friday, a new 30-year TIPS would have an inflation breakeven rate of 2.15%, which seems reasonable. That means this TIPS would outperform a nominal 30-year Treasury if inflation averages more than 2.15% over the next 30 years.

An inflation breakeven rate of 2.15% is in line with 30-year TIPS auctions back in 2017 and 2018, when U.S. inflation was running at about 2.0%. Now that number is a much-more threatening 7.5%. But the financial markets don’t seem worried, and don’t this trend continuing over 30 years. In fact, markets are predicting inflation at a very moderate rate. We’ll see.

Here is the trend in the 30-year inflation breakeven rate over the last 2 years, showing that long-term inflation expectations have stabilized and even declined slightly over the last year:

Thoughts on this auction

I’ve made it clear for years that I am not a fan of 30-year TIPS with real yields this low. This is a highly volatile investment, and a move of 50+ basis points higher, as we have seen in just the last three months, can reduce the market value of a 30-year TIPS by 15%. For example, a 30-year TIPS reopening auction last August had a premium price of about 12.8% above par value, or $112.84 for $100 of value. Today that same TIPS has a market value of $101.50, meaning it has lost more than 10% of its value in just six months.

Of course, volatility can work both ways, and if you are interested in trading TIPS as a speculative investment, a 30-year TIPS can be attractive. Otherwise, the very long term and high volatility make it unattractive for me. Just my opinion.

30-year TIPS versus a 30-year I Bond

So, if this new 30-year TIPS gets a real yield to maturity slightly higher than zero, does it become more attractive than a U.S. Series I Bond, with a fixed rate of 0.0%? I’d say no. I Bonds have several key advantages over a TIPS:

• The holding term of an I Bond is flexible, anywhere from 1 year (with a three-month interest penalty), to 5-plus years with no penalty, all the way to 30 years when they reach final maturity.
• An I Bond will never go down in value during a time of deflation, while a TIPS will lose accrued principal during deflationary times.
• Interest earned on an I Bond can be deferred until it is sold or matures. For TIPS, both the coupon payment and inflation accruals are taxable in the current year. This “phantom income” makes a 30-year TIPS very unattractive for holding in a taxable account.
• I Bonds have an advantage in the way their interest is compounded, since it all gets compounded. With a TIPS, the coupon rate is paid out as current income and is therefore not compounded (but could be reinvested elsewhere).

My feeling is that I Bonds — at this point — remain more attractive than any TIPS of any maturity. My view would change if we see real yields on 5- and 10-year TIPS climb well above zero. But at this point, I Bonds up to the purchase limit of $10,000 per person per year should be your first money invested in inflation protection.

Auction details

Thursday’s auction will close to non-competitive bids — like those made at TreasuryDirect — at noon EST and then finalize at 1 p.m. EST. If you are purchasing this TIPS in a brokerage account, be aware than auction purchases might be closed by 10 a.m. the day of the auction, or even earlier.

I will be reporting the auction results soon after the close. Here’s a listing of recent 29- to 30-year TIPS auctions, showing that the string of three consecutive negative yields is actually an aberration for this term, even during earlier times of Federal Reserve quantitative easing:

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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 purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Real yields are rising. Noticed that your TIPS fund or ETF has taken a hit?

By David Enna, Tipswatch.com

Maybe it’s not really an Earth-shattering event, but something significant happened Friday: The real yield on a 30-year Treasury Inflation-Protected Security rose above zero for the first time since May 21, 2021.

At Friday’s market close, the U.S. Treasury estimated the real yield of a full-term 30-year TIPS at 0.06%, up 39 basis points since the beginning of the year. This happened the day after the Treasury revamped the presentation of its Yields Curve site, which sent my head spinning. But Bloomberg’s Current Yields site showed that a 29-year, 6-month TIPS closed Friday with a real yield to maturity of 0.04%, so there you go … confirmation that the entire TIPS yield curve is no longer negative to inflation.

Bloomberg took note of this in a story posted Friday morning, noting the surge in yields after an important jobs report surprised to the upside earlier Friday:

It’s already been a tough start to a year for Treasury investors. U.S. government bonds lost about 2.1% this year through Thursday, according to the Bloomberg U.S. Treasury Total Return Index. The loss is already approaching the full-year decline of 2.3% last year, which was the first annual decline since 2013.

“We have to price in more risk that the Fed goes really aggressively, so we’re seeing most of the pressure on the front end of the curve,” said Michael Cloherty, head of U.S. rates strategy at UBS Securities. “As central banks get tighter that should push up real rates.”

I have been speculating that both real and nominal yields could quickly surge higher as the Federal Reserve approaches actions to raise short-term interest rates and eventually to pare back its massive balance sheet of Treasurys and mortgage-backed securities. It turns out that 2022 is starting to look a lot like 2013, when real and nominal yields burst higher in anticipation of Fed actions:

Note in this chart that annual inflation was running at a muted 1.5% through 2013, which allowed the Federal Reserve to delay tightening. This year, with inflation running at 7.0%, the Fed can’t put off decisive actions, and the market is adjusting quickly to that reality.

Here is the trend in the 30-year real yield over the last three years:

These three years have been a remarkable era for Fed policy, beginning in 2019 with the tail end of a period of tightening, through a period of moderate interest rate cuts in 2019, to all-out massive stimulus in 2020 and 2021 to calm the market shock that resulted from the pandemic surge in March 2020.

Now we are entering the “next era,” with inflation surging and the Federal Reserve almost certainly ready to raise short-term interest rates multiple times in 2022. Here is how real yields have increased over the last five months:

It’s no surprise that short-term real yields are rising faster than the longer-term yields. Fed actions to raise short-term nominal interest rates will have the greatest effect on the 5-year TIPS because it is the shortest maturity. Eventually, as short-term rates rise, longer-term yields may ease off, flattening or even inverting the yield curve. This happened in late 2018, setting off stock market panic and forcing the Fed to back off on tightening in 2019.

What’s happening to TIPS funds?

When real yields rise, the value of a TIPS falls. So, obviously, TIPS mutual funds and ETFs have hit a difficult stretch in recent months, but returns have been aided by high inflation accruals over the last year. This is why it is important to analyze TIPS funds based on total return, not net asset value.

The chart compares total returns for Vanguard’s Short-Term TIPS ETF (VTIP), the iShares TIPS ETF (TIP) and Vanguard’s Total Bond Market ETF (BND). Even though shorter-term real yields have been rising faster than longer-term yields, VTIP has outperformed the overall TIPS market and the overall bond market. TIPS funds have the advantage of inflation accruals, and as long as inflation continues running hot, these funds can balance off some of their net-asset-value losses caused by rising interest rates.

But I would still expect TIPS mutual funds and ETFs to have a difficult year in 2022, as interest rates rise. VTIP, with its shorter duration, should perform the best in this scenario, but it could still end up with a negative return for the year. Taking a longer view, higher real and nominal interest rates will be a positive for investors looking to add new money in inflation-protected investments.

Is the I Bond’s fixed rate affected at all?

The U.S. Treasury will reset the fixed rate of the U.S. Series I Savings Bond on May 2. The rate is currently 0.0%, and in my opinion looks very likely to remain at 0.0% through the May reset. The 10-year real yield is currently -0.48% and would need to rise at least 75 basis points in the next three months to make a higher fixed rate at all likely. I don’t see that happening, but you never know.

If real yields surge higher through 2022, it’s possible the fixed rate could rise in November. Still, the current annualized variable rate of 7.12% on I Bonds is too attractive to pass up. I think an investment before May 1 is the wisest course. The next variable rate, also to be reset on May 2, should be at least 4.5%, maybe much higher. Can’t pass up 12 months of very strong returns for the outside chance for a higher fixed rate in the future.

Look back at the Fed’s last tightening cycle

Back in July I did a series of articles looking at how real and nominal yields reacted when the Fed first began discussing tightening in 2013, stopped bond buying in 2014, and eventually began raising interest rates in late 2015. Through most of this period, surprisingly, the stock market did very well. Bond markets took some hits, but eventually recovered.

2013: A year of surging real and nominal yields
2014: The deck was stacked against TIPS funds
2015: The Fed actually did something!
2016: Inflation rises; TIPS out-perform the overall bond market
2017: ‘The calm before the storm’
2018: Did the Federal Reserve go too far?
2019: The Fed cries ‘uncle’; bond investors celebrate
2020: Chaotic year of pandemic fears, stunning stimulus
2021 and beyond: What’s ahead for U.S. financial markets?

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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 purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.