Here We Go Again: TIPS Yields Go Negative To Inflation - What's The Best Move Now?

| About: iShares TIPS (TIP)

Summary

TIPS yields have fallen to their lowest levels in three years.

The TIP ETF is up about 6.9% year to date, and it has outperformed the overall bond market.

Thinking you need inflation protection? Consider I Bonds instead of TIPS.

On July 5, the Treasury's estimated real yield on a full-term 10-year TIPS fell below zero for the first time since April 2015. It closed Wednesday at -0.05%, the lowest estimated yield since June 5, 2013.

Negative to inflation means that a 10-year TIPS purchased today is guaranteed to underperform inflation, even if inflation remains at very low levels.

It's been a remarkable fall. Six months ago, you could buy a new 10-year Treasury Inflation-Protected Security at auction with a coupon rate of 0.625% and a real yield to maturity of 0.725%. We've seen a fall of 77 basis points in six months. That TIPS - CUSIP 912828N71 - is now trading on the secondary market with a yield of -0.07% and a cost of $106.63 for $100 of value.

The same pattern holds for the TIP ETF, which contains a broad range of TIPS maturities. It started 2016 at $109.66 and now stands at $117.29, about a 6.9% increase. And it's significant that the TIP ETF has outperformed the overall bond market, as shown in this graph comparing the year-to-date performance of TIP versus AGG (overall bond market) and IEI (intermediate Treasuries):

Click to enlarge

At this point, TIPS look pricey and possibly risky as a buy-and-trade investment. I have long said that a price of $110 or lower on the TIP ETF is a decent 'buy' signal, and we did reach that price for almost the entire month of January 2016. That was a pretty good time to invest in TIPS. July 2016 isn't.

Why is this happening? TIPS yields almost always follow the general trend of the overall Treasury bond market, although the degree of the ups and downs can vary. A nominal 10-year U.S. Treasury opened 2016 with a yield of 2.24%, and that has fallen to 1.39% today. That's a decline of 87 basis points.

Uncertainty in Britain and Europe is certainly a big factor, bringing buyers to U.S. Treasuries in search of a safe-haven investment. Another factor is the strength of the U.S. dollar, which makes dollar-based investments more attractive. And a third factor is the extremely low interest rates on government debt around the world.

Compare these current 10-year bond yields and tell me where you would like to place your investment:

  • Switzerland: -0.602%
  • Japan: -0.274%
  • Germany: -0.170%
  • Netherlands: 0.035%
  • France: 0.134%
  • Britain: 0.781%
  • Italy: 1.243%
  • United States: 1.39%

Where are we heading? Unless inflation ticks strongly higher, there will be zero momentum for higher interest rates. Because of the uncertainty of Brexit, the Federal Reserve will almost certainly pass on any rate increase in 2016. Could there be another attempt at bond-buying quantitative easing? I thought that was possible when the stock market was in freefall, but since it has stabilized I think the Fed would like to maintain the status quo.

Quantitative easing can create a bull market for TIPS because 1) the Treasury is competing with buyers investing in TIPS, and 2) it raises fears of future inflation. But the last stint of QE had almost no effect on inflation.

Negative 'real' yields are different than negative 'nominal' yields like we are seeing in Europe and Japan. Negative real yields have been common since 2011 across many TIPS maturities. But I doubt that the negative-yield trend will reach the depths of 2011 to 2013. Here is a chart showing 10-year TIPS yields since 2004 (the gray area indicates the deep recession of 2008):

Click to enlarge

This chart illustrates how quickly TIPS yields can rise and fall. The other factor to watch is the 10-year inflation breakeven rate, which is determined by comparing the yield of a 10-year TIPS with a nominal 10-year Treasury. That number is currently 1.44%, very low by historical standards:

10-year inflation breakeven rate Click to enlarge

If you take away the recessionary plummet (which was a great time to buy TIPS, by the way), you can see that the 10-year inflation breakeven rate has almost never spent time below the 1.5% level. This indicates that TIPS are 'cheap' when measured against nominal Treasuries.

TIPS vs. Treasuries. Would you rather buy a 10-year Treasury with a yield of 1.39% or a 10-year TIPS with a yield 0.05% below inflation? I think many big-money investors would choose the TIPS, and that is the choice that is pushing TIPS prices higher and yields lower. However, if you think financial Armageddon is coming, a nominal Treasury is the better choice, because it will outperform a TIPS in times of deflation.

What about TIPS mutual funds? I hold a lot of individual TIPS and I Bonds, so I am not interested in TIPS mutual funds as a side investment. In my retirement savings, I prefer plain total bond funds with low management fees. Or bank CDs. I don't think this is a good time to be making a major investment in a TIPS mutual fund. January was the time to buy. Is July the time to sell? Up to you.

I Bonds, the obviously better investment. US Savings I Bonds currently pay a fixed rate of 0.1% and an inflation-adjusted rate of 0.16%, for a composite interest rate of 0.26% for six months. That's certainly not exciting, but it beats a 10-year TIPS paying 0.05% below inflation by 15 basis points.

I Bonds offer many other benefits over TIPS: deferral of income taxes, flexible maturity and rock-solid protection against deflation. The only negative is the Treasury's limit on purchases of $10,000 per person per year.

If you are interested in investing in I Bonds, you could buy them today and lock in the fixed rate of 0.1% for the life of the I Bond. You'd collect 0.26% for the first six months, then a new composite rate, which will be set on November 1, based on inflation from March to September 2016. Here is an update on how that is developing:

At this point, it looks like the inflation-adjusted rate will be well above the current 0.16%, which was based on 0.08% inflation from September 2015 to March 2016.

Should you wait until November 1 to buy I Bonds? That's a topic for another article, but my quick reaction is that the 0.1% fixed rate is likely to drop to 0.0% on November 1 if the 10-year TIPS yield continues below zero.

Coming up: There will be an auction July 21 of a new 10-year TIPS; I'll be writing about that auction next week.

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.