This Week's 30-Year TIPS Auction Is Priced For Disaster

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Includes: IPE, LTPZ, PBTP, SCHP, STIP, STPZ, TDTF, TDTT, TIP, TIPX, TIPZ, VTIP
by: Tipswatch
Summary

The real yield looks likely to come in around 0.46%, down 63 basis points from the originating auction in February.

Buyers will be paying a steep premium for the coupon rate of 1.0%, about 15% above par value.

The inflation breakeven rate is currently running at a very low 1.57%, which should make this auction attractive for big-money investors.

I've been writing about Treasury Inflation-Protected Securities for eight years, and I've always been clear: I'm not a fan of 30-year TIPS. Too long a maturity, too volatile, too much risk, horrible cash flow, too little return.

But Thursday's reopening auction of CUSIP 912810SG4 - creating a 29-year, 6-months TIPS - is a particularly gruesome offering. The Treasury is selling $7 billion of this reopened TIPS, but no one outside of a central bank or pension fund should touch it.

TIPS are Treasury investments that pay a coupon rate well below that of other Treasury investments of the same term. But with 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 TIPS indicates how much an investor will earn above inflation.

Let's set the stage: CUSIP 912810SG4 was born in an originating auction on February 21, 2019. That was just six months ago, but we might want to call it "The Good Old Days." I wasn't a big fan of this auction; I called it "rather unimpressive." But investors at the February auction ended up getting a very good deal, especially if they were TIPS traders.

The originating auction for CUSIP 912810SG4 generated a real yield to maturity of 1.093% and a coupon rate of 1.0%. Investors got it a decent discount, paying about $97.48 for about $100 of par value. The inflation breakeven rate came in at 1.96%, a "neutral" number versus a nominal 30-year Treasury.

So much has changed

CUSIP 912810SG4 trades on the secondary market, so you can track its current real yield and price on Bloomberg's Current Yields page. As of Friday's close, this TIPS had a real yield of 0.46% - down 63 basis points from the originating auction - and a whopping price of about $114.85 for $100 of value.

So, you can see why TIPS traders were big winners at the February auction. As its real yield has plummeted, the value of this TIPS has increased about 17% in only six months. And there's the important lesson: 30-year TIPS can be extremely volatile.

Investors at Thursday's reopening auction will be looking at a real yield somewhere around 0.46% and a price of about $117 for about $101.79 of principal, after accrued inflation is added in. (This TIPS will have an inflation index of 1.0179 on the settlement date of August 30.)

To make this clear: Investors will be paying a premium of almost 15% for this TIPS to draw a coupon rate of 1.0% over the next 29 years, 6 months. That premium price is not protected against deflation, and the investor won't get access to that money until the TIPS matures in 2049 or is sold on the secondary market.

These real yields are ugly

A real yield of 0.46% on a 30-year TIPS isn't an all-time low, but historically, it is extremely low. There has been only one other period of time when the 30-year TIPS yield dipped below 0.5% - in the dark days of 2012 into 2013, when the Federal Reserve was buying long-term bonds in an aggressive quantitative easing program. Take a look at this chart of the real yield for a full-term 30-year TIPS, from 2010 to Friday:

30-year real yield

Take a closer look at what happened later in 2013. Although the 30-year real yield hit an all-time low of 0.24% on December 10, 2012, it had jumped up to 0.47% by January 2, 2013, and broke above 1.00% by June 2012. It hit a high for that year of 1.66% on December 5.

That's amazing volatility. I repeat: 30-year TIPS are risky investments, offering the possibility of sudden gains or sudden losses.

Buying a 30-year TIPS at today's yield of 0.46% doesn't make any sense at all for a buy-and-hold investor. But for a trader...

Could real yields continue declining?

Yes, it's certainly possible, because central banks across the world are waging a currency war via ultra-low, and even negative, nominal interest rates. The lower the rate, the theory goes, the weaker the currency. And a weak currency results in stronger exports.

As of Friday, the 10-year German bund was yielding -0.69%, near a record low. In Japan, the 10-year was yielding -0.24%. In France, it was yielding -0.42%. Even in the U.K., with no-deal Brexit looming, the 10-year bond was yielding 0.46%, about 109 basis points below the U.S. yield of 1.55%.

As long as these foreign yields remain so low, investors will pour money into the safety and higher yields of U.S. Treasurys. And the Federal Reserve is likely to continue to gradually lower short-term interest rates.

But today's yields seem priced for "disaster," anticipating a severe decline in the global and U.S. economies. How bad is it out there? Back in December 2012, when the 30-year yield hit its all-time low, the U.S. unemployment rate stood at 7.9%. Today, it is 3.7%. U.S. GDP growth in the 4th quarter of 2012 was -0.1%. Today, in the most recent quarter, it is 2.1.%.

Until we see real evidence of a decline in the U.S. economy, I'm thinking that U.S. Treasurys are overbought and yields should be much higher.

Investors don't see inflation looming

One positive aspect for this week's TIPS reopening is a very low - by historical standards - inflation breakeven rate. With a 30-year Treasury yielding 2.01% at Friday's close, a full-term 30-year TIPS would have an inflation breakeven rate of 1.57%, a remarkably low number for an investment maturing in 30 years.

With an inflation breakeven rate that low, big-money investors should see appeal in this TIPS reopening, at least versus a nominal 30-year Treasury yielding 2.01%. Here is the trend in the 30-year inflation breakeven rate since 2010:

30-year inflation breakeven rate

As of Friday, the 30-year inflation breakeven rate was just 10 basis points above the all-time low of 1.47% hit on February 11, 2016. If you look at the chart, you can see that 30-year inflation expectations have rarely dipped below 1.6% over the past 10 years.

This is a positive for Thursday's auction, at least for the big-money investors who need predictable yields over a long term. If inflation averages 2.2% over the next 30 years, this TIPS will return about 2.62%, trouncing the nominal Treasury at 2.01%.

And if you look back at historical inflation data, you'll see that since the 1960s, no 30-year span in the United States has had average inflation lower than 2.5%. (That span ended in 2018.) Could we see much lower inflation? Certainly. Could that trend last for the 30 years? Doubtful.

Conclusion

This 30-year TIPS reopening isn't a sensible investment for a buy-and-hold bond investor. The term is too long, the real yield is too low, and the risk is too high. In addition, it makes sense only in a tax-deferred account, because the coupon rate of 1% will barely cover the annual federal income taxes due on potential inflation accruals. However, for a bond trader who believes long-term yields are about to drop dramatically, it could be attractive.

I'll be posting the auction results Thursday, soon after the 1 p.m. ET close.

Here is the history of every 29- to 30-year TIPS auction, showing how real yields - and the resulting bond prices - have been extremely volatile:

30-year TIPS history

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.