Frightened by a phantom? TIPS are fine in a taxable account, until …

Posted on April 2, 2021 by Tipswatch

By David Enna, Tipswatch.com

A couple years ago, just as my wife and I were both retiring, we went through a rigorous financial planning exercise with an hourly-fee adviser. We were in sync on almost all his advice, except when the adviser insisted: “You need to get these TIPS investments out of a taxable account and into an IRA.”

My response: “Not gonna happen.”

For nearly a decade, I had been writing about Treasury Inflation-Protected Securities and I Bonds, both inflation-protected investments. And with TIPS, my routine was to buy them at auction directly from Treasury Direct, and hold them to maturity. I’ve never sold a TIPS before maturity, and I wasn’t interested in moving them out of Treasury Direct and selling them to fund new purchases.

The adviser (the rather famous Allan Roth of Wealth Logic) was totally correct in his advice, which follows the tenets of of proper “asset location.” Taxable investment accounts, in general, should be focused on equity-oriented, low-cost index funds that generate little annual tax exposure, while traditional tax-deferred accounts should focus on interest-bearing bond funds, REITS, insured CDs, and possibly managed stock funds that generate taxable payouts.

Roth accounts, in this asset location theory, should be focused on longer-term equity investments, since this should be the last money you will withdraw in retirement. The longer investment horizon means you can take more risk.

Realistically, TIPS do work best in a traditional (non-Roth) tax-deferred account. That could mean investing in TIPS mutual funds or ETFs, or using a brokerage account to buy Treasurys with (hopefully) near-zero commissions. But while holding TIPS in a tax-deferred account is preferable, I say holding them as a taxable investment at Treasury Direct is also acceptable as part of your overall fixed-income asset allocation. Up to a point. More on that later.

TIPS and the ultra-scary ‘phantom income’

Treasury Direct isn’t user friendly. While every brokerage and investment firm on Earth mails you tax forms (or at least notifies you they are ready to download), Treasury Direct does nothing. You’ll get nothing in the mail, you won’t receive an e-mail alert. You are expected to remember to log in to the site and retrieve your tax forms:

  • Form 1099-INT shows the sum of the semiannual interest payments made in a given year. This income is generated by the TIPS’ coupon rate, and is taxable at the federal level but tax-fee at the state.
  • Form 1099-OID shows the amount the principal of your TIPS increased due to inflation or decreased due to deflation. Increases in principal are taxable for the year in which they occur, even if your TIPS hasn’t matured, so you haven’t yet received that payment of principal.

Form 1099-OID is a key to the conventional wisdom to invest in TIPS in tax-deferred accounts. You are paying tax on money you have not yet received. This is often called “phantom income,” and it sounds scary, doesn’t it? However, if you have a Total Bond Fund or GNMA Fund in a taxable account and reinvest the dividends, or have a 5-year CD at a bank and are reinvesting interest, you are doing exactly the same thing. You are paying tax on money you have not yet received.

(Read this for a scholarly treatise, including incomprehensible formulas, debunking the conventional wisdom about holding TIPS in a taxable account.)

What’s the cash flow?

A common strategy for investments in TIPS is to build a ladder of inflation-protected investments that will stretch into your retirement, with issues maturing each year, which can then provide the money for re-investments or spendable cash. Let’s take a look at a theoretical TIPS ladder, with issues maturing every year through 2029, and then one longer-term TIPS maturing in 2041. It would look something like this (modeled as a typical ladder of purchases at least once a year, sometimes more):

TIPS in a taxable account

This portfolio of TIPS investments in 2021 would pay $2,929 in coupon payments and also generate $6,088 in inflation accruals, based on inflation running at 1.8%. The $6,088 is the “phantom income” that is not paid out in the current year, but is taxable in the current year. As long the coupon payments can cover the tax on the phantom income, you will have a positive cash flow.

Here’s an analysis of the immediate-year cash flow, based on varying tax brackets:

When each TIPS matures, here’s the good thing: You don’t owe any tax on the accumulated inflation-adjusted principal, because you’ve prepaid it. So if you bought a $20,000 10-year TIPS in 2010 and it matured in 2020 with a 18% inflation boost to principal, you collected $23,600 at maturity and owed no tax. This could work in your favor for allocating spending money in retirement.

After retirement, the game changes?

At various times over the last decade — including now — TIPS have been issued with negative real yields to maturity, meaning their returns will not match official U.S. inflation. TIPS haven’t been attractive, and I have haven’t purchased any. This was part of my deal with my financial adviser: I’d let the TIPS I hold at Treasury Direct mature out and then make all further purchases in a traditional IRA brokerage account.

Instead of buying TIPS with the maturing issues, I have re-invested the proceeds in I Bonds, which will at least perfectly match future U.S. inflation. I haven’t bought any individual TIPS issue since a March 21, 2019, 10-year TIPS reopening resulted in a real yield to maturity of 0.578%.

The key problem is: How do you fund net-higher new investments when you no longer have a source of current income? This is difficult in a taxable account when you are retired, because it means either 1) using your cash, which will have to be replenished, or 2) selling other assets in taxable accounts, possibly incurring taxes, or 3) withdrawing money from a tax-deferred account, which will incur a tax. That would make no sense. When you are retired, taxes enter into just about every financial decision .

So the obvious solution is: Use a traditional IRA brokerage account to fund future purchases of TIPS, when yields become attractive again.

But I am fine with my current TIPS investments, which will continue maturing through 2029 and providing cash for other investments, or just for fun in retirement.

* * *

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.

Posted in Investing in TIPS, Retirement | 18 Comments

10-year TIPS reopening auction generates a real yield of -0.580%

Posted on March 18, 2021 by Tipswatch

By David Enna, Tipswatch.com

Reflecting a trend of both rising real yields and rising inflation expectations, the U.S. Treasury’s reopening auction today of a 10-year Treasury Inflation-Protected Security — CUSIP 91282CBF7 — generated a real yield to maturity of -0.580%, an expected result that was higher than recent yields for this term.

This TIPS was created in an originating auction on Jan. 21, 2021, with a record low real yield to maturity for this term, -0.987%. Today’s auction result was 38 basis points higher, a big move in just two months.

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

CUSIP 91282CBF7 carries a coupon rate of 0.125%, the lowest the Treasury will allow on a TIPS. Because the auctioned real yield to maturity was well below the coupon rate, buyers at today’s auction had to pay a premium price — about $107.62 for about $100.73 of value, after accrued inflation and interest is added in. This TIPS will have an inflation index of 1.00473 on the settlement date of March 31.

But today’s price was well below the $111.64 cost of the originating auction, which reflects the big increase in real yields over the last two months.

It looks like the auction went off as expected, in line with the trend of overall increases in both real and nominal yields. At mid-morning, CUSIP 91282CBF7 was trading on the secondary market with a real yield of -0.59%, close to the auction result. So, no surprises. However, the bid-to-cover ratio was 2.42, a middling number that reflects decent, but not strong, demand.

Here is the trend in 10-year real yields over the the last two years, showing the brief bounce higher a year ago during pandemic-related market turmoil, and then a deep decline amid economic gloom, and the gradual rise higher since the beginning of 2021 as COVID vaccines were rolled out and Congress approved economic stimulus packages:

This recent rise in yields is driving prices lower for broad-based TIPS mutual funds and ETFs. The TIP ETF is trading down about 0.6% today at a price of $124.81, indicating higher market yields. But today’s auction had little effect on the price, which indicates the result matched expectations.

Inflation breakeven rate

With a nominal 10-year Treasury trading at the auction close at 1.73%, this 9-year, 10-month TIPS gets an inflation breakeven rate of 2.31%, a big surge higher than numbers from similar auctions over the last year:

  • March 19, 2020: 0.43%
  • May 21, 2020: 1.14%
  • July 23, 2020: 1.52%
  • Sept. 17, 2020: 1.65%
  • Nov. 19, 2020: 1.72%
  • Jan. 21, 2021: 2.09%
  • March 18, 2021: 2.31%

Investors are “all-in” in committing to higher future U.S. inflation, given the Federal Reserve’s commitment to continued economic stimulus, combined with the lofty cash payments and credits to individuals included in the newest economic package passed by Congress. But these same forces are driving both nominal and real interest rates higher.

Inflation has been running at 1.7% over the last year, and has averaged 1.7% over the last 10 years. Will inflation move dramatically higher, as the market is predicting? It could happen, but I am thinking the 2.31% inflation breakeven reflected in this auction could be nearing a top, at least until we start to see actual higher inflation in the United States. Future inflation is nearly impossible to predict.

Here is the trend in the 10-year inflation breakeven rate over the last two years, showing the dramatic climb higher from the market depths of March 2020:

What’s ahead?

Today’s auction was the first of two reopenings for CUSIP 91282CBF7. The Treasury will offer another reopening in May, and then offer a new 10-year TIPS in July.

Next month’s offering will be a new 5-year TIPS, with the auction on Thursday, April 22.

Here’s a history of recent 9- to 10-year TIPS auctions:

* * *

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.

Posted in Investing in TIPS | 3 Comments

Next up: 10-year TIPS will reopen at auction on March 18, one year after turmoil hit markets

Posted on March 13, 2021 by Tipswatch

By David Enna, Tipswatch.com

The U.S. Treasury will offer $13 billion in a March 18 auction reopening CUSIP 91282CBF7, creating a 9-year, 10-month Treasury Inflation-Protected Security. Real yields have been climbing recently, but are yields up enough to make this reopening an attractive investment?

I plan to take a look, but first …

Let’s look back one year

Thursday’s auction will mark the one-year anniversary of the strangest TIPS auction in history — March 19, 2020 — which came just as awareness of the COVID-19 pandemic was exploding across the United States. This was a reopening auction offering $12 billion in CUSIP 912828Z37, also a 9-year, 10-month TIPS.

At the time, the Federal Reserve had already begun lowering its key short-term interest rate and had announced plans for a launch of a new quantitative easing program to hold down Treasury yields. By any indication, Treasury yields across the board should have been plummeting. But instead, for a brief few days, the bond market was seized by near panic and Treasury yields skyrocketed.

The Saturday before this TIPS auction, when its real yield had climbed to 0.04% on the secondary market, I noted in my preview article:

“The U.S. stock and bond markets are covered in fog this morning. Investors are up in the air and it’s not safe for landing. …

In past times when the U.S. economy sank into distress, the Federal Reserve launched bond-buying programs that propped up U.S. Treasury prices, and sent yields plummeting. … So for a TIPS trader, there is potential for a quick capital gain if the 10-year TIPS yield falls 50 basis points or more, just to the level where it was (-0.57%) on March 6. …

“What about buy-and-hold TIPS investors? A real yield of around zero isn’t attractive, but it might be the best yield you’ll get for the remainder of 2020.”

Less than a week later, CUSIP 912828Z37 reopened at auction with a real yield of 0.680%, a mind-boggling explosion of 125 basis points in just 13 days. I called it a “gorgeous result” for investors. This surge in real yields happened very quickly, practically a matter of hours.

I didn’t end up buying that TIPS because I didn’t trust that the surging yield could hold through an auction. Instead, when I saw the TIP ETF drop to below $110 a share on March 18, I jumped in with an investment in Schwab’s ETF, SCHP. I sold it 40 days later for an 11% gain. (Reminder: I’m not a TIPS trader! But this was a very weird market moment.)

In the weeks and months after that auction on March 19, 2020, 10-year TIPS real yields did plummet, down to -0.25% by March 30, and eventually down to -1.08% on Jan. 4, 2021. And then a gradual rise began, spurred by positive trends in the U.S. economy.

Here is the trend in 10-year real yields over the last five years, showing the very brief spike higher than happened to coincide with the TIPS auction on March 19, 2020, and then the very sudden drop deeply negative to inflation:

So now, back to the present

Real and nominal yields have been climbing recently, reflecting positive U.S. trends toward limiting the effects of the COVID-19 virus and aggressive stimulus programs launched by Congress. The Treasury’s estimate of the real yield of a 10-year TIPS has increased from -1.06% on Jan. 28 to -0.62% as of the market’s close on March 12. That’s a jump of 44 basis points, and that’s significant.

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.

CUSIP 91282CBF7, which is being reopened Thursday, currently trades on the secondary market and you can track its real yield in real time on Bloomberg’s Current Yields page. As of Friday’s market close, it was trading with a real yield to maturity of -0.65% and a cost of about $107.94 for $100 of par value. It is trading at a premium to par because the real yield of -0.65% is far below the coupon rate of 0.125%.

In addition, it will carry an inflation index of 1.00473 on the settlement date of March 21. This means that investors seeking to buy $10,000 in this TIPS will pay about $10,845 for about $10,047 of value, after the rate premium and accrued inflation are added in. (This could change before Thursday’s auction, of course.)

Inflation breakeven rate

With a nominal 10-year Treasury note currently yielding 1.62%, this TIPS as of Friday’s market close has an inflation breakeven rate of 2.27%, rather high, even by historical standards. It means this TIPS will out-perform a nominal Treasury if inflation averages more than 2.27% over the next 10 years. U.S. inflation is currently running at 1.7% and has averaged 1.7% over the last 10 years. So investors are bidding up TIPS prices in anticipation of higher future inflation.

I agree that higher U.S. inflation seems likely, but 2.27% over the next 10 years might be about right. At the best, this TIPS is fairly priced versus a nominal U.S. Treasury, and and the worst, it’s overpriced. It’s definitely not cheap.

Here is the trend in 10-year inflation breakeven rate over the last 5 years, showing the impressive move higher since the extremely negative outlook of March 2020. This chart clearly shows inflation expectations are at the highest levels of recent years:

Disclosure: I’m biased

I’m not buying TIPS in this current market, with yields deeply negative to inflation. I’d get interested in investing in 10-year TIPS when the real yield can at least rise higher than the 0.0% real yield offered by a U.S. Series I Savings Bond.

But that doesn’t mean TIPS are lousy investments, especially for buy-and-hold-to-maturity investors building multi-year ladders for future retirement income. If you are buying a consistent amount each year, adding a year 10 years out to the ladder, Thursday’s auction certainly looks a lot more attractive than 91282CBF7’s originating auction on Jan. 21, which generated a real yield of -0.987%, the lowest in history for 9- to 10-year TIPS auctions.

I will be posting the auction results soon after it closes at 1 p.m. EDT Thursday. Non-competitive bids need to be made before noon Thursday.

Here’s a history of recent 9- to 10-year TIPS auction, with the “gorgeous result” of March 19, 2020 highlighted:

* * *

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.

Posted in Investing in TIPS | 4 Comments

February inflation rose 0.4%: What does it mean for TIPS and I Bonds?

Posted on March 10, 2021 by Tipswatch

By David Enna, Tipswatch.com

As expected, U.S. inflation surged 0.4% in February, triggered primarily by rising gasoline prices. But the overall February inflation report from the Bureau of Labor Statistics, released this morning, is a bag of mixed messages. One interesting detail is that offers some good-looking data for the next interest-rate adjustment for U.S. Series I Savings Bonds.

The BLS reported that the Consumer Price Index for All Urban Consumers increased 0.4% in February on a seasonally adjusted basis. Over the last 12 months, the all-items index increased 1.7%. Those numbers exactly matched the consensus forecasts.

But the core inflation numbers, which remove data for food and energy, came in at 0.1% for the month and 1.6% year over year, below the consensus estimates. So while gas prices are forcing overall inflation higher, core inflation continues to slumber along at a moderate level.

The BLS noted that gasoline prices surged 6.4% in February and accounted for more than half of the overall increase in CPI-U. Gasoline prices are now up 1.5% year over year, after falling deeply negative throughout 2020. Prices for fuel oil were also up a sharp 9.9%. The electricity and natural gas indexes also increased, and the energy index rose 3.9% over the month.

Food prices were up 0.2% in February and rose 3.6% over the last 12 months. The index for fresh fruits increased 1.8%, the largest increase in that index since March 2014. But the index for dairy and related products declined 0.2% in February after falling 0.4% the previous month.

Some other highlights from the report:

  • Apparel prices fell 0.7% and are now down 3.6% year over year.
  • The index for used cars and trucks dropped 0.9% in the month but is up 9.3% year over year.
  • Shelter costs increased 0.2% in the month and are up 1.5% for the year. But keep in mind that eviction moratoriums are holding down rent costs. That could change in coming months.
  • The cost of medical care services increased 0.5% and are up 3.0% year over year.
  • The index for airline fares continued to decline in February, falling 5.1% following a 3.2% decrease in January.

Here is the overall trend for all-items and core U.S. inflation over the last 12 months, showing the deep decline after the pandemic erupted in March 2020, and the gradual climb higher in all-items inflation, even as core inflation has remained relatively stable:

What does this mean for TIPS and I Bonds?

Investors in Treasury Inflation Protected Securities and U.S. Series I Savings Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust principal balances on TIPS and set future interest rates for I Bonds. For February, the BLS set the inflation index at 263.014, an increase of 0.55% over the January number.

For TIPS. February’s inflation report means that principal balances for all TIPS will increase 0.55% in April, following a 0.43% increase in March. This is welcome news for TIPS investors, but keep in mind that in this case, non-seasonal adjusted inflation was slightly outpacing adjusted inflation, and eventually those numbers will balance out over a year.

Here are the new April Inflation Indexes for all TIPS.

For I Bonds. The February report was the fifth in a six-month series that will set the future inflation-adjusted variable rate for U.S. Series I Savings Bonds. At this point, five months in, inflation has increased 1.05%, which translates to an annualized variable rate of 2.10%, higher than the current rate of 1.68%. Because gasoline prices are continuing to rise in March, we should see that variable rate climb even higher. But … inflation is highly unpredictable.

After the March inflation report, to be issued April 13, we will then know the I Bond’s new variable rate. I’ll have more to say about this after that report, but here’s a hint: I Bonds are going to be a very attractive investment in our current low-interest-rate environment. Could they get as popular as Bitcoin? Er …. no.

Here are the numbers, with one month remaining:

What does this mean for future interest rates?

The weaker-than-expected core inflation numbers give the Federal Reserve a lot of leeway to continue easy money policies, but those policies were going to continue anyway, no matter what this report said. I am expecting short-term interest rates to continue at near zero through 2021. Longer-term interest rates have been rising recently, but this report shouldn’t push them higher.

Inflation should rise at a higher pace in the next few months, as gas and other prices continue climbing, and the Fed knows this. It won’t be a surprise. Inflation numbers for March, April and May will be compared with very weak numbers from a year ago, so “surprisingly high” increases seem likely, and won’t actually be a surprise.

* * *

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.

Posted in I Bond, Inflation, Investing in TIPS, Savings Bond | 7 Comments

Inflation expectations are soaring, with a short-term twist

Posted on March 7, 2021 by Tipswatch

By David Enna, Tipswatch.com

I’ve been writing about inflation and inflation breakeven rates for 10 years, and I’ve never seen anything quite like the picture presented by this chart, which shows the trend in the 5-year inflation breakeven rate over the last decade:

Inflation expectations are soaring, in a way that is historically unique.

So, what is this inflation breakeven rate? It is a measure of investor sentiment toward inflation, and it is calculated by subtracting the real yield of a Treasury Inflation Protected Security from the nominal yield of a U.S. Treasury of the same term. So, in the case of the 5-year inflation breakeven rate, the calculation goes like this:

  • Five-year nominal Treasury note yield = 0.79%.
  • Five-year TIPS real yield = -1.64%
  • 0.79% – (-1.64%) = 2.43%

So, the market is forecasting that U.S. inflation will run at 2.43% over the next five years, the highest rate of market-predicted inflation since the 5-year breakeven rate hit 2.63% on July 7, 2008. That was just before the housing market crash sent stock values plummeting. Five months later, on Nov. 28, 2008, the 5-year breakeven fell to -2.24%, a remarkable crash of 487 basis points.

U.S. inflation is currently running at 1.4% and has been consistently below 2.0% since March 2020. Economists are predicting that the year-over-year number will rise to 1.7% with the February inflation report, to be issued at 8:30 a.m. EST Wednesday. That’s still a long way from an average of 2.43% over five years, but investors seem to be taking the Federal Reserve at its word when it says it is willing to force U.S. inflation above 2.0% and let it remain there for a period of time.

Still, the market-determined inflation breakeven rate measures sentiment and should not be viewed as an accurate prediction. In fact, the market often does a lousy job of predicting future inflation. The fact is, over the last decade, investors have been betting on higher inflation than actually resulted, and that has led to TIPS (in general) under-performing nominal Treasuries of the same term.

Inflation higher in the short term?

One interesting aspect of this sudden inflation mania is that is is focused more on the short term (meaning 5 years out) instead of the longer term (10 to 30 years out). The logic here, I assume, is the combination of massive fiscal stimulus from Congress, along with a Fed committed to easy-money policies well into the future.

Both real and nominal yields have been on the rise since February 1, but nominal yields are rising faster than real yields, and real yields in the shorter term have been fairly stable. And that is how you get a soaring inflation breakeven rate. Here are the numbers comparing the market yields on February 1 versus March 5:

This chart indicates that shorter-term TIPS should have been the best performing Treasury investment over the last month, and that’s true, with the Vanguard’s 0-5 year TIPS ETF (VTIP) gaining 0.33% since February 1, while the broad-based TIP ETF was down 1.93% and overall bond market (BND) was down 2.54%.

Can the inflation breakeven rate signal trouble?

Of course, no one is cheering for strongly higher future inflation, but a strongly higher inflation breakeven rate does indicate that TIPS overall are starting to get “pricey” versus nominal Treasurys. An inflation breakeven rate over 2.5% is expensive for the TIPS investor.

As the TIPS versus nominals chart showed, TIPS usually under-perform nominal Treasurys when inflation expectations get very high, in anticipation of higher inflation that never arrives.

At this point, we don’t know where inflation is heading, but my gut says it should be going higher. And yet, that is what my gut has been telling me for a decade. Must of been heartburn instead of an omen.

Buying TIPS and I Bonds provides insurance against unexpected future inflation. Although we haven’t needed that insurance over the last decade, I still like the idea of insurance.

* * *

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.

Posted in Inflation, Investing in TIPS | 9 Comments