This post will assume familiarity with two prior ones.
The question for me is whether I am likely to be better off buying the TIP or the nominal treasury with the same maturity date.
Unfortunately, the answer to that question requires the investor to speculate about the average annual CPI rates until the bond matures.
1. Inflation Expectations: The Break-Even Inflation Rate
The answer to my question will depend in part on the annual average rate of inflation until maturity since the TIP will start out with a lower yield.
There is a rate of inflation where both the TIP and the nominal treasury produce the same total return.
That average annual CPI is called the break-even inflation rate, the annual average rate of inflation needed for the TIP buyer to break-even with the nominal treasury maturing at the same time.
The principal amount of the TIP is increased or decreased by CPI, and the coupon is applied to the original par value as adjusted by subsequent CPI numbers.
If inflation continually moves higher, the return of the TIP will start to catch up and possibly surpass the total return of the non-inflation protected treasury. Deflation numbers will reduce the principal amount, though the principal amount can not be reduced below the original $1K par value. The end result depends on future developments that are not subject to accurate current predictions with uncertainties increasing with time.
If the actual annual average inflation number is higher than the break-even inflation rate at the time of purchase, then the investor is better off buying the TIP now.
If inflation continually moves higher, the return of the TIP will start to catch up and possibly surpass the total return of the non-inflation protected treasury. Deflation numbers will reduce the principal amount, though the principal amount can not be reduced below the original $1K par value. The end result depends on future developments that are not subject to accurate current predictions with uncertainties increasing with time.
If the actual annual average inflation number is higher than the break-even inflation rate at the time of purchase, then the investor is better off buying the TIP now.
If inflation ends up being lower than the break-even, the investor would be worse off buying the TIP compared to the nominal treasury, assuming both have the same maturity date and are bought at the same point in time.
Note that I began the last three sentences with the word "if".
Note that I began the last three sentences with the word "if".
Break-even spreads have been low for several years, but have started to turn up some.
The clearest choice for the 10 TIP over the 10 year nominal was in late 2008 and early 2009 when the Bond Ghouls were pricing almost a zero inflation rate over a ten year period.
For me, it is easier to go with the TIP when the Bond Ghouls are predicting an average annual CPI rate 1.4% over the next ten years as opposed to what I would view as a more rational 2% to 2.5% number. Historically, a 1% to 2% prediction over a continuous ten year period would probably be too low. The average annual inflation rate since 1913 is over 3%. United States Inflation Rate | 1914-2017 | Data | Chart | Calendar There have been four decades where the annual rate of inflation was higher than 5% and only two lower than 2%. US Inflation Long Term Average
The break-even inflation rate for the ten year TIP closed last Friday at 2.04%. The choice is less apparent at that rate. Are TIPS Getting Overpriced? - Income Investing - Barrons.com It depends on the investor's inflation forecast in relation to the break-even inflation rate embodied in the TIP's price.
An investor focused on preservation of capital could rationally choose both. The TIP would be bought primarily as a hedge against problematic inflation and secondarily for current income, while the nominal treasury would be bought to produce more current income.
Neither investment would grow assets sufficiently to meet the financial goals and needs of most households at anywhere near their current yield levels.
2. Nominal Rates and TIP Prices: One of the most important points that I have made repeatedly in the past is that TIP prices are very sensitive to changes in the nominal treasury yields.
If the ten year treasury goes from 1.4% to 2.6%, as it did last year, the ten year TIP will go down in price as well. A TIP bought in the secondary market does not protect the investor from a persistent increase in nominal yields. I sold a TIP maturing in 2019 at 120.94 (5/22/12) . Sold 3 TIP Bonds Maturing in 2019 at 120.45 That TIP is now priced under 106.
The price went down in part due to a rise in nominal yields and an increase in the real coupon demanded by investors due to that rise in nominal yields. The only way for that TIP maturing in 2019 to compensate is go down in price from 120+ to 106+.
3. Trading Long Maturity TIPs and Buying the Shorter Maturities on Dips:
I anticipate that intermediate and longer term treasury rates will trend higher in response to higher inflation numbers and a normalization of inflation expectations.
The long term U.S. bull market in bonds, which started in 1982, ended with a double bottom hit in July 2012 and again in July 2016. The dominant trend is now up in yield and down in price.
There will be rallies triggered by a flight to safety.
I expect that will happen soon enough in response to some action taken by the current administration.
I will use that rally, when and if it occurs, to sell some long term TIPs for profits and then buy them back when the dominant trend up in yield and down in price reasserts itself.
I am holding the intermediate term TIPs until maturity, primarily as hedges against unanticipated inflation and economic turmoil that may occur over the next four years. Turmoil may start anywhere, possibly initiated by the U.S. government's actions, the the disintegration of the EU or some other major adverse macro event.
I included a snapshot showing round-trip trades in several long maturity TIPs in the Appendix section of this post as of 10/26/16: Update On Buying TIPs In The Secondary Market - South Gent | Seeking Alpha I had quickly flipped $5K in principal amount for a $283.63 profit, some inflation accretion to the principal and interest.
I picked the .625% TIP maturing in 2043 as an example to highlight more recent trading and what I am attempting to do with these long duration TIPs that do provide me with more interest income than the intermediate term ones.
When looking at that data, it is important to keep in mind that the purchase price is adjusted by the accretion to principal and accrued interest.
I have already sold this 2043 TIP, in just a one bond lot, twice. The goal was to use spikes in the nominal 20 and 30 year treasury, both up and down, to generate profits and to harvest some interest and inflation accretion to the principal amount-just another example of small ball. But those are not the primary trading goal. The goal is to accomplish those tasks while lowering my cost basis and increasing my real yield over time.
So far, I have accomplished those goals. My last purchase was at $90.41, the lowest price paid for this bond to date.
The real yield is 1.044%. I would be content with that yield plus the inflation accretion, assuming I get stuck owning it long term. I would sneer at that total return number when I was a Young Stock Jock or during my asset accumulation years.
My highest sale price was $99.1 and the lowest was at 94.06 earlier this month.
The next transaction would be to sell the bond bought at $90.41 somewhere in the $95 to $100 range (below par value) during the next long term bond rally and to buy it back in the $86 to $90 range during the next downdraft. That lower range will require a significant move up in the 20 to 30 year nominal yields.
4. Bought 1 TIP Maturing in 2026:
Real Yield .478%
The principal accretion was at $1,216.82 or $216.82 over the initial $1000 par value. Future inflation will add to that principal amount. The coupon is 2%.
This security was originally issued as a 20 TIP in January 2006, so it already has under its belt more than a decade of CPI accretion to its original principal amount. 1/15/26 2% TIP (provides information on the CPI Index ratio, referred to as the "inflation factor" in the preceding snapshot that is used to calculate the adjusted principal amount)
I paid the seller that $1,216.82 in adjusted principal amount and a premium payment of $162.75 to acquire a 2% coupon TIP maturing on 1/15/2026. For this security to work better than a nominal treasury maturing in 9 years, I will need an average annual CPI rate of about 2%.
I am likely to hold this TIP to maturity.
I am still subject to rising rates for treasuries maturing at or near January 2026, but that dissipates more quickly than with the more interest rate sensitive, long duration 2043 TIP due to the much shorter duration. I am also likely to be alive in 2026 and most likely will be somewhere else in 2043.
All of this relates back to my current financial situation, the total lack of situational risks or the need to grow capital, and my capital preservation objectives particularly for my Roth IRA accounts. The retirement account is the one suitable for a TIP purchase IMO due the current taxation of the inflation accretion to principal when owned in a taxable account.
The demand at the last 10 year TIP auction, held on 1/19/2017, was described as strong:
TIPS Demand ‘Off the Charts’ as Inflation Expectations Rise - Income Investing - Barrons.com
10 Year TIP Auction Results
The break-even inflation rate for the ten year TIP closed last Friday at 2.04%. The choice is less apparent at that rate. Are TIPS Getting Overpriced? - Income Investing - Barrons.com It depends on the investor's inflation forecast in relation to the break-even inflation rate embodied in the TIP's price.
An investor focused on preservation of capital could rationally choose both. The TIP would be bought primarily as a hedge against problematic inflation and secondarily for current income, while the nominal treasury would be bought to produce more current income.
Neither investment would grow assets sufficiently to meet the financial goals and needs of most households at anywhere near their current yield levels.
2. Nominal Rates and TIP Prices: One of the most important points that I have made repeatedly in the past is that TIP prices are very sensitive to changes in the nominal treasury yields.
If the ten year treasury goes from 1.4% to 2.6%, as it did last year, the ten year TIP will go down in price as well. A TIP bought in the secondary market does not protect the investor from a persistent increase in nominal yields. I sold a TIP maturing in 2019 at 120.94 (5/22/12) . Sold 3 TIP Bonds Maturing in 2019 at 120.45 That TIP is now priced under 106.
The price went down in part due to a rise in nominal yields and an increase in the real coupon demanded by investors due to that rise in nominal yields. The only way for that TIP maturing in 2019 to compensate is go down in price from 120+ to 106+.
3. Trading Long Maturity TIPs and Buying the Shorter Maturities on Dips:
I anticipate that intermediate and longer term treasury rates will trend higher in response to higher inflation numbers and a normalization of inflation expectations.
The long term U.S. bull market in bonds, which started in 1982, ended with a double bottom hit in July 2012 and again in July 2016. The dominant trend is now up in yield and down in price.
There will be rallies triggered by a flight to safety.
I expect that will happen soon enough in response to some action taken by the current administration.
I will use that rally, when and if it occurs, to sell some long term TIPs for profits and then buy them back when the dominant trend up in yield and down in price reasserts itself.
I am holding the intermediate term TIPs until maturity, primarily as hedges against unanticipated inflation and economic turmoil that may occur over the next four years. Turmoil may start anywhere, possibly initiated by the U.S. government's actions, the the disintegration of the EU or some other major adverse macro event.
I included a snapshot showing round-trip trades in several long maturity TIPs in the Appendix section of this post as of 10/26/16: Update On Buying TIPs In The Secondary Market - South Gent | Seeking Alpha I had quickly flipped $5K in principal amount for a $283.63 profit, some inflation accretion to the principal and interest.
I picked the .625% TIP maturing in 2043 as an example to highlight more recent trading and what I am attempting to do with these long duration TIPs that do provide me with more interest income than the intermediate term ones.
When looking at that data, it is important to keep in mind that the purchase price is adjusted by the accretion to principal and accrued interest.
I have already sold this 2043 TIP, in just a one bond lot, twice. The goal was to use spikes in the nominal 20 and 30 year treasury, both up and down, to generate profits and to harvest some interest and inflation accretion to the principal amount-just another example of small ball. But those are not the primary trading goal. The goal is to accomplish those tasks while lowering my cost basis and increasing my real yield over time.
So far, I have accomplished those goals. My last purchase was at $90.41, the lowest price paid for this bond to date.
The real yield is 1.044%. I would be content with that yield plus the inflation accretion, assuming I get stuck owning it long term. I would sneer at that total return number when I was a Young Stock Jock or during my asset accumulation years.
My highest sale price was $99.1 and the lowest was at 94.06 earlier this month.
The next transaction would be to sell the bond bought at $90.41 somewhere in the $95 to $100 range (below par value) during the next long term bond rally and to buy it back in the $86 to $90 range during the next downdraft. That lower range will require a significant move up in the 20 to 30 year nominal yields.
4. Bought 1 TIP Maturing in 2026:
Real Yield .478%
The principal accretion was at $1,216.82 or $216.82 over the initial $1000 par value. Future inflation will add to that principal amount. The coupon is 2%.
This security was originally issued as a 20 TIP in January 2006, so it already has under its belt more than a decade of CPI accretion to its original principal amount. 1/15/26 2% TIP (provides information on the CPI Index ratio, referred to as the "inflation factor" in the preceding snapshot that is used to calculate the adjusted principal amount)
I paid the seller that $1,216.82 in adjusted principal amount and a premium payment of $162.75 to acquire a 2% coupon TIP maturing on 1/15/2026. For this security to work better than a nominal treasury maturing in 9 years, I will need an average annual CPI rate of about 2%.
I am likely to hold this TIP to maturity.
I am still subject to rising rates for treasuries maturing at or near January 2026, but that dissipates more quickly than with the more interest rate sensitive, long duration 2043 TIP due to the much shorter duration. I am also likely to be alive in 2026 and most likely will be somewhere else in 2043.
All of this relates back to my current financial situation, the total lack of situational risks or the need to grow capital, and my capital preservation objectives particularly for my Roth IRA accounts. The retirement account is the one suitable for a TIP purchase IMO due the current taxation of the inflation accretion to principal when owned in a taxable account.
The demand at the last 10 year TIP auction, held on 1/19/2017, was described as strong:
TIPS Demand ‘Off the Charts’ as Inflation Expectations Rise - Income Investing - Barrons.com
10 Year TIP Auction Results
