The U.S. Treasury will be offering $7 billion Thursday in a reopening auction of CUSIP 912810SM1, creating a 29-year, 6-month Treasury Inflation Protected Security. Do I think you should invest in this TIPS? No. But let’s look at it anyway.
This TIPS was created in an originating auction on February 20, when it generated a real yield to maturity of 0.261%, the lowest in history for any 29- to 30-year TIPS auction. February 20? That seems like a lifetime ago. Consider this: I wrote about that auction from a hotel room in Cairo, Egypt, where I was wrapping up a two-week vacation. This photo was taken a few hours before the auction’s close, at the Giza Pyramids outside Cairo.
The world has changed since February 20, and just about the entire globe has been on lockdown ever since. The stock market has made a round trip to hell and back. In the Treasury market, both nominal and real yields have declined to record-low levels and remain very, very low.
Back in February, CUSIP 912810SM1 ended up with a coupon rate of 0.25%, much lower than the previous record of 0.625% for any TIPS auction of this term. Investors got it at a slight discount, about $99.68 for $100 of par value.
I wasn’t a fan of this TIPS in February, because the very low yield and 30-year term made it highly undesirable for me, a buy-and-hold-to-maturity investor. But you know what? I was wrong.
How things change
A 30-year TIPS is a very volatile investment, even though it offers the superb safety of being issued by the U.S. Treasury. And that volatility makes it attractive to speculators, who thrive on volatility. So CUSIP 912810SM1 has turned into a huge winner for the buy-and-trade investors who bought in February.
Just six months later, this TIPS now trades on the secondary market with a real yield to maturity of -0.26%, 51 basis points lower than the originating auction. Its price is now about $115.77 for $100 of value, an amazing gain of 16.1% in just six months.
If I owned this TIPS, I would declare victory and sell it.
Here is the 10-year trend, from 2010 to 2020, showing the real yield for 30-year TIPS, a decade of remarkably low interest rates. But today’s yield is sharply lower than even those historically low rates:
So now we are heading into Thursday’s reopening auction, where investors are going to have to pay a premium of about 15% to 16% over par value to collect a coupon rate of 0.25% a year. Plus, this TIPS will carry an inflation index of 1.00255, meaning investors will pay a slightly higher price and get a bit more accrued principal. Let’s set up a scenario:
- An investor wants to put $10,000 into this reopened TIPS.
- The actual principal purchased will be $10,025 because of the small inflation accrual.
- The cost will be about $11,607 for that $10,025 in value.
- This investment will pay out about $25.06 in interest a year, and that total will rise with inflation as the accrual balance grows.
- The principal balance will rise (or fall) to match official U.S. inflation over the next 29 years, 6 months.
Buy and hold investor? Say no
In this scenario, it makes no sense to pay about $11,607 upfront to collect about $25 in immediate cash flow a year. Yes, you will also get accrued inflation added to your principal balance, but you won’t be able to collect that for 29 years, 6 months. This is a shockingly bad buy-and-hold investment, in my opinion.
And absolutely, under no circumstances, buy this TIPS in taxable account. You will get $25 a year in cash flow, but owe possibly $65 to $70 a year in federal income taxes, assuming inflation of 2% a year and inflation accruals of $200 a year. This investment will be cash-flow negative for its entire life, and things get worse if inflation rises to levels higher than 2%.
Buy and trade investor? Your call
Do you think real yields will be declining much lower in future months as the United States struggles to deal with the effects of Covid-19? As of today, no 29- to 30-year TIPS auction in history has ended with a negative real yield, but that looks highly likely Thursday. Can they go even lower? Obviously, they can. A savvy trader could take advantage of that.
But eventually, things will swing. An investment that can gain 16% in value in six months can see its value swing lower, sharply and quickly. The Treasury’s estimate of the 30-year real yield hit an all-time low of -0.46% on August 4, less than two weeks ago. Since then, the yield has bounced up to -0.26%, a 20-basis-point swing. For a 30-year TIPS, a 20-point swing upward means about a 6% drop in value.
So conditions could be setting up for another downward plunge in real yields, and that would make CUSIP 912810SM1 a potentially profitable target for speculation.
But that’s not my style, so I am not encouraging anyone to speculate. Here is the one-month trend in the 30-year real yield, showing the gradual swing to less-deeply-negative numbers:
Inflation breakeven rates have also been climbing in recent weeks, indicating that investors see the massive stimulus programs from Congress and the Federal Reserve as raising the specter of future higher inflation. Let’s just note: 29 years, 6 months, is a LOT of future.
At Friday’s market close, a 30-year nominal Treasury bond was yielding 1.45%, creating a current inflation breakeven rate of about 1.71% for CUSIP 912810SM1. That is a historically low number for a 30-year TIPS but well above the lows hit earlier in 2020.
Here is the 10-year trend in the 30-year inflation breakeven rate, showing how the rate has climbed from an ultra-low level in mid-March (0.96% on March 17) but remains very low by historical standards:
My gut feeling is that inflation will average higher than 1.71% over the next 30 years, and that makes this TIPS a preferable investment to a 30-year Treasury bond yielding 1.45%. And should mean that Thursday’s auction will be met with reasonably strong demand from big-money investors, such as foreign central banks and pension funds.
Inflation protection is a hot topic these days, and many investors are looking for entry points into TIPS. But I think that the 5- and 10-year auctions are much better targets for investment, and offer more reasonable real yields versus maturity terms.
An even better option, of course, is the U.S. Series I Savings Bond, which currently has a real yield of 0.0%, or 26 basis points better than a 30-year TIPS. I Bonds also offer tax-deferred interest, a flexible maturity date and much better deflation protection. Under current market conditions, in my opinion, investors should buy I Bonds up to the cap of $10,000 per person per year before investing in TIPS.
But I Bonds aren’t attractive to speculators, because they do not swing up or down in value with market shifts. This 30-year TIPS could be attractive, but will be volatile, and therefore … risky.
I will be reporting on the auction result soon after it closes at 1 p.m. Thursday. In the meantime, here’s a history of all 29- to 30-year TIPS auctions since 2013, showing the recent severe decline in both coupon rate and yield:
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.