After A Surreal Surge, This 10-Year TIPS Is Now Depressingly Normal

Summary

• The Treasury will reopen a 10-year TIPS at auction on Thursday, with the real yield to maturity expected to be well below zero.
• This TIPS -- CUSIP 912828Z37 -- had an amazing reopening auction in March, just as Treasury yields were surging.
• It's not an attractive investment for small-scale investors, but the inflation breakeven rate of about 1.18% will make it appealing to big-money investors.

The U.S. Treasury will offer $12 billion in a reopened 10-year Treasury Inflation-Protected Security -- CUSIP 912828Z37 -- at auction Thursday, in an event that will reveal just how depressing the TIPS market has become.

This TIPS originated at auction on January 23 with a real yield to maturity of 0.036%, barely positive to inflation, and a coupon rate of 0.125%, the lowest the Treasury will go on a TIPS. That was the lowest real yield for any 9- to 10-year TIPS auction since May 2013.

That was January ... a lifetime ago.

Then CUSIP 912828Z37 had a reopening auction on March 19, right in the middle of a three-day span of incredible volatility in the U.S. Treasury market. Investors were dumping everything -- equities, bonds, gold.

• The S&P 500 index hit 2,237.4 on March 23, its low for the year. It's now at 2,953.9, an increase of 32%.
• The TIP ETF hit $108.31 on March 18, its low for the year. It's now at $121.54, an increase of 12.2%.
• TLT, the long-term Treasury ETF, hit $147.87 on March 19. It's now at $163.05, an increase of 10.3%.

Amid this turmoil, CUSIP 912828Z37 had a reopening auction with an amazing result: a real yield to maturity of 0.68%, at least 60 basis points higher than looked likely three days earlier. I called that a "gorgeous result" for investors, who nabbed this TIPS at a big discount: about $94.99 for about $100.26 of value.

Four days after that eventful auction, the Federal Reserve stepped in with a massive effort to stabilize the entire bond market, sending yields for nominal Treasurys and TIPS plummeting within a week.

What to expect Thursday

And now, two months later, the TIPS market has returned to what we call "depressingly normal" during times of economic distress and Federal Reserve intervention. All standard TIPS maturities -- 5-year, 10-year and 30-year -- are now trading with yields negative to inflation. This isn't a great time to be a buyer of TIPS.

CUSIP 912828Z37 trades on the secondary market, so investors can track its current price on Bloomberg's Current Yields page. This morning it is trading with a real yield to maturity of -0.45% and a price of about $105.70 for $100 of par value. Compare that to two months ago: This value of this TIPS has surged about 11% in two months. (If I owned it -- I don't -- I'd probably sell it immediately. Your work is done, CUSIP 912828Z37.)

So, investors at Thursday's auction will need to accept a long-term return that will trail official U.S. inflation by about -0.45%, plus pay a rather large premium to collect a 0.125% coupon rate for 9 years, 8 months. Any buyers?

In addition, this TIPS will carry an inflation index of 1.00344 on the settlement date of May 29, meaning that investors will pay slightly more than par (about 34 cents per $100) for a matching amount of accumulated principal.

Here is the trend in 10-year real yields over the last five years, showing the unusual spike in yield that matched the auction date of March 19:

Inflation breakeven rate

With a nominal 10-year Treasury note trading today at 0.73%, this TIPS would get an inflation breakeven rate of 1.18%, meaning the TIPS would outperform a nominal Treasury if inflation averages higher than 1.18% over the next 10 years. This is an extremely low number, and reflects an expectation of many months of deflation in 2020, before the economy recovers.

I believe that anytime the 10-year inflation breakeven rate dips below 1.6% -- the current 10-year inflation average -- TIPS are much more attractive than nominal Treasurys. For that reason, CUSIP 912828Z37 is going to be appealing to big money investors like hedge funds, pension funds and foreign central banks.

Since 1970, there has never been a 10-year period with average inflation lower than 1.6%. For investors desperate for inflation protection, this TIPS is a worthy investment.

Here is the trend in the 10-year inflation breakeven rate over the last five years, showing the incredible dip (briefly) to 0.50% in mid-March as panic seized the Treasury market:

I track how 10-year TIPS perform versus nominal 10-year Treasurys, and in general over the last decade, TIPS have been lousy investments. But when the inflation breakeven rate falls well below 2.0%, TIPS generally outperform nominal Treasurys. That's the case now, and the breakeven rate favors TIPS.

Yes or no on this TIPS reopening?

Sure, I regret not buying CUSIP 912828Z37 at auction on March 19. The surge in yield was so fast that I didn't trust it would last through the auction's close at 1 p.m. That auction will easily be the best TIPS auction of the year. I expect it could be the last 5- to 10-year TIPS auction of the year with a yield positive to inflation.

But now, two months later, this TIPS has become quite unattractive, with a real yield well below inflation, a paltry coupon rate of 0.125% and a price well above par value.

So, no, I won't be an investor. And I don't expect any surprises this week because the Federal Reserve is stepping in to smooth out any hints of chaos in the bond market.

I will be posting the auction result after the close at 1 p.m. on Thursday.

Here is a history of all 9- to 10-year TIPS auctions since 2016, showing that no TIPS of this term has auctioned with a yield negative to inflation in that time. Thursday's auction will be the first since May 2013 to go negative.

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.