Just when it seems we really need inflation protection, investments in inflation protection are looking awful. Or, more accurately, just when it seems like we need safe investments, safe investments are looking awful.
Welcome to June 2020 in our virus-stricken United States.
The U.S. Treasury on Thursday will offer $15 billion in a reopening auction of CUSIP 912828ZJ2, creating a 4-year, 10-month Treasury Inflation Protected Security. Depending on how you look at our nation’s near-term future, this offering is either enticing (for solid reasons) or total garbage (also for solid reasons). I’m leaning 75% toward garbage.
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.
One thing you can say about a TIPS: It is a very safe investment. An investor is guaranteed to get a full return of at least par value when the TIPS matures, in this case on April 15, 2025. But things get complicated for an investor in a TIPS with a negative real yield to maturity, as this one will have. For an investor at Thursday’s auction, the total investment will not be guaranteed.
CUSIP 912828ZJ2 was created on April 23, 2020, when it auctioned with a real yield to maturity of -0.320%, which set its coupon rate at 0.125%, the lowest the Treasury will go for a TIPS. Buyers had to pay a premium for that meager coupon rate, about $102.37 for about $100.14 of principal, after accrued inflation was added in.
This TIPS is currently trading on the secondary market, so it is easy to track its current yield to maturity and price. As of Friday’s market close, Bloomberg’s Current Yields page listed this TIPS with a price of $103.80 for $100 of value, and a real yield to maturity of -0.65%. If Thursday’s auction gets a result around that level, it would be the lowest real yield for any 4- to 5-year TIPS at auction since April 2013, when the 5-year real yield plummeted to -1.311%.
Real yields have been declining over the last week, down about 14 basis points since June 5. So, the price is likely to shift before Thursday’s auction. But investors can expect to pay at least a 3.5% premium for the 0.125% coupon rate attached to this TIPS, getting a yield that is guaranteed to lag official U.S. inflation by 0.6% or more.
That premium above par value is not guaranteed to be returned at maturity in April 2025. If we suffer through five years of zero or lower inflation, only the par value will be returned at maturity. The premium is lost. So, it adds a touch of risk (albeit a small one) to this investment.
Another factor will slightly lower the cost of this investment at Thursday’s auction. It will carry an inflation index of 0.99282 on the settlement date of June 30, the after-effect of deflation in April 2020. This means investors will pay a lower adjusted price, but also receive a lower amount of principal.
Why would anyone invest in this TIPS?
A lot of investors see inflation looming just beyond the near-term horizon, the result of massive stimulus programs by the Federal Reserve and U.S. Congress. So, there is a desire for inflation protection, but possibly not in the near term. Another factor making this TIPS desirable is the fact that even though 5-year real yields are at a 7-year low, they could go lower. A lot lower.
Here is a chart showing 5-year real yields from January 2011 to this week, showing how bond-buying actions by the Federal Reserve caused real yields to plummet to much lower levels from 2012 to 2013:
I’m a believer in the “Inflation Is Looming” theory, and I think it’s wise for all investors to look for safe and reasonable ways to add inflation protection to their portfolios. But I’m not a believer in buying a 5-year TIPS with a deeply negative real yield, plus a premium cost that isn’t guaranteed safe.
On the other hand, one thing you can always say about a 5-year TIPS: It’s term is only five years, or in this case, 4 years, 10 months. In a short time, you’ll get your money back to reinvest elsewhere.
Inflation breakeven rate
With the 5-year nominal Treasury closing Friday with an incredibly low yield of 0.33%, this TIPS currently has an inflation breakeven rate of 0.98%, a low number. This means it will outperform a nominal Treasury if inflation averages more than 0.98% over the next 4 years, 10 months. Obviously, investors are factoring in a period of near-term deflation.
If you look at inflation data going back to 1970, the lowest inflation averaged for any 5-year period (ending in December) was 1.4%, for the periods ending in 2016 and 2017. So, the market is currently pricing in a beyond-historic level of ultra-low inflation over the next five years. And that is a reason this TIPS should draw reasonable demand at Thursday’s auction.
Here is the trend in the 5-year inflation breakeven rate since 2011, showing that inflation expectations remain at very low levels:
I track how 5-year TIPS that have reached maturity performed versus nominal Treasurys of the same term, and the news isn’t good: 5-year TIPS have been lousy investments over the last 10 years. But that is because investors consistently priced the inflation breakeven rate at 1.85% or higher, when in reality it turned out to be more in the range of 1.75% or lower.
Note the one exception on this chart, the TIPS issued in April 2009, in the heart of the financial crisis. Investors were pricing in inflation of 0.77%, but the actual 5-year average inflation turned out to be 2.1%. That made this TIPS a big winner, at least versus a nominal Treasury. I’d contend this Thursday’s auction could have a very similar result.
Author Michael Ashton, who writes on inflation, made the point this week that inflation expectations have reached almost absurdly low levels, making TIPS a much more attractive investment versus nominal Treasurys. He said:
“Short-maturity TIPS, not surprisingly, trade at very low implied inflation rates even though energy prices have aggressively rebounded – right now, TIPS carry is awful and if you own a short TIPS bond you’re not looking at next year’s inflation. Beyond the front end of the TIPS curve, though, pricing of inflation-linked bonds relative to nominal bonds is almost comical. Yes, real yields are very low and it’s hard to love TIPS just for TIPS. I don’t understand, though, why TIPS aren’t currently beloved compared to all forms of fixed-rate debt.”
What are equally safe alternatives?
5-year Treasury note. It’s yielding 0.33%. Forget it.
Treasury money market fund. Vanguard’s Federal Money Market Fund (VMFXX) has a current 7-day yield of 0.15%. I’d expect to see that yield hold well into 2021. But as a place to hold cash for current needs, it is fine.
Insured savings account. You can find savings accounts paying 1.35% to 1.50%, but of course, these have “changeable” terms. There’s no telling how long those rates will last.
Insured 1-year bank CD. Many banks are offering 1-year CD rates in the range of 1.25% to 1.30%. That yield is low, but keep in mind that if we suffer deflation of 0.75% over the next year, that CD will pay a real return of around 2.0%, and you’ll get your money back in a year to reinvest. In a deflationary scenario, a TIPS with a real yield of -0.65% will be crushed by a CD paying 1.25%.
Insured 5-year bank CD. Going from 1 year to 5 years doesn’t get you much of a yield benefit, with best-in-nation rates falling into the range of 1.35% to 1.45%. I’d stick with the 1-year CD, which is often used as a promotional rate.
U.S. Series I Savings Bonds. Because I Bonds can be sold after five years with no penalty, they are directly comparable to the 5-year TIPS being auctioned Thursday. I Bonds purchased today have a fixed rate of 0.0%, which is equivalent to their real yield to maturity. So, I Bonds have a 65-basis-point advantage over a 5-year TIPS, plus rock-solid protection against deflation. This is a no brainer: An I Bond is a much more attractive investment than a 5-year TIPS. The only problem is you are limited to purchasing $10,000 per person per year.
Because of the low inflation breakeven rate – even amid rumbles of inflation fears – I’d expect Thursday’s auction to see fairly strong demand. It’s not a great investment, but because it offers insurance against unexpected inflation, it is a reasonable and even prudent investment. Investors, though, should be aware they will be paying an unprotected premium for a real yield well below inflation.
I will be posting the auction results Thursday, soon after the close at 1 p.m. EDT. Meanwhile, here is the history of every 4- to 5-year TIPS auction since 2013:
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.