The Year's Most Attractive TIPS Auction Could Be Coming Dec. 21

Summary

• Short-term TIPS have attractive real yields, at least compared with longer maturities.
• Watch out for volatility in the Treasury market next week in the days leading up to the auction.
• The current inflation breakeven rate is about 1.81%, not cheap. This TIPS is fairly priced versus a nominal Treasury.

The U.S. Treasury announced today it will reopen CUSIP 912828X39 at auction on December 21, creating a 4-year, 4-month Treasury Inflation-Protected Security. Because of favorable trends in the short-term Treasury market, this could be the most attractive TIPS auction of 2017.

Of course, I am speaking of most attractive, 'relatively.'

The real yield curve has been flattening all year, and Wednesday's action by the Federal Reserve to raise its key short-term rate should continue that trend. With short-term rates rising, and longer-term rates declining, the yield curve is sending a strong message: Buy short-term.

Here is the 8-year trend line comparing real yields for 5-, 10- and 30-year TIPS. It's been rare to see the gaps narrow as much as they have today. The chart clearly shows how short-term rates are rising while longer terms are stable or dipping.

The chart below shows how the real yield on 5-year TIPS, currently 0.38% based on Treasury estimates, is just 10 basis points below the yield on a 10-year TIPS and 41 basis points below a 30-year. That is well below the average spreads over the last eight years of 0.52% and 1.17%, respectively.

In recent years, December has been an interesting month for Treasury yields - especially short-term yields - because the Federal Reserve has raised its key short-term interest rate in mid-December in 2015, 2016 and 2017. Those moves usually come one week before the last TIPS auction of the year, creating a 4-year, 4-month TIPS. Because of that, the December TIPS auction is often fairly attractive. I think that will be true again next week.

So let's take a look at CUSIP 912828X39, which originally auctioned on April 20, 2017, with a real yield to maturity of -0.049%. That's right, it had a negative real yield, which set its coupon rate at 0.125%, the lowest possible. It cost investors $101 for $100 of par value. In my preview of this auction, I called it a 'loser' because I Bonds and bank CDs were more attractive alternatives. This TIPS then reopened on August 24 with a real yield of 0.117%.

CUSIP 912828X39 is trading on the secondary market, so it's easy to track the current market yield and price.

• The best data source for reopening auctions is Bloomberg's Current Yields page, which posts real-time data. As of about 2:30 p.m. Thursday, this TIPS was trading with a real yield of 0.32% and a cost of about $99.18 for $100 of value. It is trading at a discount because the real yield is higher than the coupon rate of 0.125%.
• You can also use the Treasury's Real Yield Curves page to track estimates of yields for full term TIPS. As of Wednesday's close, a full-term 5-year TIPS was yielding 0.38%.

Inflation breakeven rate. With a 5-year nominal Treasury currently yielding 2.13%, this TIPS has an inflation breakeven rate of about 1.81%. That's in the middle-to-high range of breakevens over the last five years. In my opinion, this TIPS is fairly priced versus a nominal Treasury.

You could also compare this TIPS to best-in-nation 5-year bank CDS, which are paying about 2.40%. That pushes the inflation breakeven rate up to 2.08%, making the CD versus TIPS investment a toss-up. Want the yield? Buy the bank CD. Want inflation protection? Buy the TIPS. Or ... buy both.

Yes or no on this TIPS? I think we can expect a fair amount of volatility in the days leading to next Thursday's auction, which closes at noon for noncompetitive bids. It's possible that Congress will approve a tax reform package by then, which some investors could view as inflationary. If that package gives a boost to the stock market, how will the Treasury market react?

As of today, a week before the auction, we're heading toward a real yield above 0.30% on the shortest-term TIPS the Treasury auctions. It's not a screaming buy, but it is attractive enough to consider for an investment. As long as yields hold, I will be a buyer.

Note: Keep in mind that this TIPS will have an inflation index of 1.01432 on the settlement date of December 29. That means investors will be buying about 1.4% of additional principal, which could raise the adjusted price above $100 for $101.43 of principal.

Here is the history of every 4- to 5-year TIPS auction since 2007:

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.