Take Caution: This Week's 10-Year TIPS Reopening Will Be Pricey

by: Tipswatch

The real yield is likely to come in around 0.57%, well below the coupon rate of 0.875%.

That means buyers could be paying a premium of nearly 3% to capture that coupon rate. Is that too high a price to pay?

The inflation breakeven rate is currently running at about 1.82%, meaning this TIPS is close to fair value versus a nominal Treasury.

The U.S. Treasury announced last week that it will offer $11 billion in a reopening auction Thursday of CUSIP 9128285W6, creating a 9-year, 8-month Treasury Inflation-Protected Security.

This reopening will be another indication of how greatly the market for Treasuries overall and TIPS in particular has changed since the originating auction for this TIPS on January 17. That auction generated a real yield to maturity of 0.919% and resulted in a coupon rate of 0.875%.

The "real yield to maturity" indicates the amount a TIPS investor will earn above inflation. The principal balance of a TIPS is adjusted up (or sometimes down) every month to match non-seasonally adjusted inflation.

Willing to pay a 3% premium?

This TIPS - CUSIP 9128285W6 - trades on the secondary market, so it is simple to track its current yield and value by checking Bloomberg's Current Yields page, which lists real-time quotes for this 10-year TIPS. At Friday's close, it was trading with a real yield to maturity of 0.57% and a price of about $102.91 for $100 of par value. That means buyers will have to pay a premium of close to 3% above par value. Why? Because the real yield has now dipped well below the coupon rate, which holds constant.

Treasury yields - both real and nominal - have declined substantially in 2019. Back in January, that 10-year TIPS originating auction looked rather ho-hum. Now it is looking like it could be the most attractive TIPS auction of the year, for any maturity. Here is the one-year trend in 10-year real yields, showing the dramatic falloff since January. On Friday, the Treasury's estimate of the real yield of a full-term 10-year TIPS dropped to 0.58%, very close to a 52-week low.

10-year real yield (Source: Federal Reserve of St. Louis)

Another point to consider if you are looking to invest in this TIPS: It will carry an inflation index of 1.00655 on the settlement date of May 31, meaning that investors will be buying about 65 cents of additional principal for every $100 they invest. In other words, on top of the nearly 3% premium need to capture the 0.875% coupon rate, buyers will pay an additional 0.65% for the inflation adjustment, but will receive a matching amount of additional principal. Overall, this should push the adjusted price to something like $103.55 for $100.65 of value, based on Friday's close.

Things can change this week. If you are investing in this TIPS reopening, keep an eye on the Bloomberg Current Yields quotes, which are a very good indicator.

Inflation breakeven rate

With a nominal 10-year Treasury closing Friday at 2.39%, this TIPS would currently generate an inflation breakeven rate of 1.82%, which means it would outperform a nominal Treasury if inflation averages more than 1.82% over the next 9 years, 8 months. I consider this number "fair value," making this TIPS fairly valued versus a nominal Treasury of the same term. U.S. inflation is currently running at 2.0%, primarily driven by a recent surge in gas prices.

However, a rate of 1.82% would be lower than recent breakeven rates generated by TIPS auctions of this term, so that could result in some buyer interest from big money buyers like foreign central banks and pension funds. In general, the lower the breakeven rate, the more attractive the TIPS. Here is the one-year trend in the 10-year inflation breakeven rate:

10-year inflation breakeven rate

(Source: Federal Reserve of St. Louis)

Yes or no on this 10-year TIPS?

I won't be a buyer, but if real yields continue dipping, this TIPS could end up looking like a winner. Does the premium price really matter? No, it doesn't. Realistically, you are buying a return of somewhere around 0.57% above inflation. That's the correct way to view it.

But I'm probably like a lot of investors who think paying a 3% premium is too high for an asset that won't mature for nearly 10 years. It's like agreeing to have more than one year of interest and inflation adjustments lopped off, right from the start. I'll pass.

This auction will close to noncompetitive bids at noon EDT Thursday, and finalize at 1 p.m. I'll be posting results as soon as possible after the auction closes. The Treasury will offer a new 10-year TIPS in July and then reopen that one in September and November.

Here's a history of 9- to 10-year TIPS auctions back to 2016:

10-year TIPS auction history

(Source: TIPSWatch.com)

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 be purchased through the Treasury or other providers without fees, commissions or carrying charges.