The U.S. Treasury is reopening CUSIP 912828ZZ6 in an auction Thursday, offering $12 billion in this 9-year, 10 month Treasury Inflation-Protected Security. Even though terms of this TIPS are hardly dazzling, I’m expecting investor interest to be strong.
CUSIP 912828ZZ6 was created in an originating auction on July 23, when investors got a real yield to maturity of -0.93%, the lowest in history for any TIPS auction of this term. That set the coupon rate at 0.125%, the lowest the Treasury will go for a TIPS. Investors had to pay a huge premium for that tiny coupon rate, an adjusted price of about $111.03 for $100 of value.
So to put it another way, investors paid about an 11% premium over par to collect 0.125% on top of U.S. inflation over the next 10 years.
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.
Here is the five-year trend in the 10-year TIPS real yield, showing how yields have declined to all-time lows in reaction to Federal Reserve stimulus in the wake of the Covid-19 pandemic:
CUSIP 912828ZZ6 trades on the secondary market, so it is easy to track its current value on Bloomberg’s Current Yields page, which provides real-time trading information. As of Friday’s market close, this TIPS was trading with a real yield to maturity of -1.00% and a price of about $111.70 for $100 of par value. In addition, investors should note that this TIPS will carry an inflation index of 1.01040, meaning that buyers will pay about $1.04 more for $100 of value, but also receive a matching amount of additional principal.
The Treasury’s estimate of the real yield for a full-term 10-year TIPS has been inching higher in recent weeks, increasing 10 basis points since hitting -1.08% on September 1. That’s potentially good news for investors in Thursday’s auction, but the real yield to maturity still looks likely to set an all-time record low for any 9- to 10-year TIPS.
To recap, an investor in Thursday’s TIPS auction looks likely to pay an 11% premium over par, for an investment that will then out-perform inflation by 0.125%. Why would anyone be interested? The answer: If investors value protection against unexpected future inflation, they may consider this TIPS. It might be unattractive, but it also might make sense.
Inflation breakeven rate
The one investment most directly comparable to a 10-year TIPS — in safety and term — is the nominal 10-year Treasury note, currently yielding 0.67% as of Friday’s close. That investment is also highly unattractive. The 10-year inflation breakeven rate is determined by subtracting the TIPS real yield from the Treasury note’s nominal yield, producing a current value of 1.67% for CUSIP 912828ZZ6 as of Friday’s close.
This chart shows the 5-year trend in the 10-year inflation breakeven rate, showing how inflation expectations have risen sharply since the deep fall amid market turmoil in mid-March. But inflation expectations, even at 1.67%, remain relatively low by historical standards. Since 1971, the lowest U.S. inflation has ever averaged over a 10-year period ending in December was 1.6%, for the period ending in 2017.
A rising inflation breakeven rate is not necessarily a good thing for an investor looking to buy a TIPS, because it means TIPS are getting more expensive versus a nominal Treasury. But it is a good thing for people already holding TIPS (or TIPS mutual funds and ETFs), because it indicates these investments are probably outperforming the overall Treasury market.
The inflation breakeven rate has a direct correlation with the value of a TIPS versus the value of a nominal Treasury. Take a look at how the TIP ETF has performed since the market turmoil of mid-March, versus GOVT (the total Treasury market) and AGG (the total bond market):
So, at this point, are TIPS getting overpriced? I suspect not, especially if inflation expectations continue to rise. Let’s say the Federal Reserve holds to its current intention of keeping the 10-year Treasury note in a yield range of 0.6% to 0.8%. Let’s say 0.7% on average. If inflation expectations rise to 2.1%, fairly normal by historical standards, the 10-year real yield will drop to -1.40%. I don’t think that will happen, but it shows that real yields have room to fall lower, because the current inflation breakeven rate is reasonably low.
If real yields fall lower, the value of a 10-year TIPS will increase. And that is why I think big-money investors will be eager to buy into Thursday’s 10-year TIPS offering. Consider this, if your option is the 10-year TIPS versus a 10-year nominal Treasury, which would you choose?
The 10-year nominal Treasury will outperform a TIPS only if inflation averages less than 1.67% over the next 9 year, 10 months. But if inflation rises higher, which many economists are predicting, the TIPS will look stellar versus the nominal Treasury, even with a real yield of -1%. I believe that a low breakeven rate gives a TIPS a “margin of error” versus a nominal Treasury of the same term. But it works the other way when the breakeven rate reaches lofty levels.
This chart shows that over the last decade, 10-year TIPS — in general — have out-performed nominal Treasurys when the breakeven rate was below 2.0%. The last TIPS that matured on July 15 was off by one basis point, essentially a rounding error:
But keep in mind that the last decade has been marked by lower-than-expected inflation rates. In the next decade, could the opposite be true?
Given current market conditions, CUSIP 912828ZZ6 looks like a reasonable purchase for investors wanting a hedge against unexpected future inflation. But … there is a better alternative.
I Bond versus 10-year TIPS
U.S. Series I Savings Bonds are another inflation-protected investment, but instead of having their principal balances adjusted for inflation, they get an inflation-adjusted interest rate reset in May and November each year. The interest rate — which accurately tracks official U.S. inflation — can never fall below zero, so the accrued balance for an I Bond can never decline during times of deflation. (Not true with a TIPS.)
I write about I Bonds a lot, and while they might seem mundane, a lot of wealthy (and savvy) investors are very interested in them as a way of pushing inflation-protected money into the future. For more on I Bonds, read my Sept. 9 article: “Seeking Yield And Safety? The Best Choice Is U.S. Savings Bonds.”
The current I Bond carries a permanent fixed rate of 0.0% and that rate is likely to hold through May and November resets all the way into 2022. A fixed rate of 0.0% equates to a “real yield to maturity” of 0.0%, versus the 10-year TIPS real yield of -1.00%. That means the I Bond has a 100-basis-point advantage over the 10-year TIPS, along with a flexible redemption date, tax-deferred interest and much better protection against deflation.
This comparison shows how the I Bond shines versus a 10-year TIPS:
The problem with an I Bond, of course, is that the Treasury limits purchases to $10,000 per person per year. I suggest you put the first $10,000 you invest in inflation protection into an I Bond, then look at TIPS as the second alternative.
In current market conditions, with very low real and nominal rates likely to continue for at least a couple years, I think CUSIP 912828ZZ6 looks like a reasonable investment — compared to the alternatives. A lot of investors will choke on the idea of paying an 11% premium to collect 0.125% over inflation for 10 years. Well, that’s the market we are in.
But again, I Bonds are the better investment for conservative, buy-and-hold to maturity investors. Consider TIPS only after purchasing I Bonds to the limit in 2020.
I will be posting the auction result after the close at 1 p.m. EDT Thursday. Until then, here’s a history of all 9- to 10-year TIPS auctions going back to 2016, showing how real yields have moved deeply negative in 2020.
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.