Adding Five Year TIPS to the Portfolio

Yesterday I bought some Treasury Inflation Protected Securities (TIPS) with a five year maturity at the U.S. Treasury Auction. I did this using a broker through my self-managed 401k brokerage account. This follows my purchase of 10 year TIPS last month. It was an interesting auction to be sure.

When I called to place the order, I was warned that many experts were predicting that the 5-year TIPS would sell with a negative yield. I already expected that because of signals sent by the Fed the previous week. The TIPS I purchased were indeed priced with a negative yield. You may wonder why I would do this. I’ll explain with a little background.

Bernanke and other Fed spokesman talked last week about inadequate consumer demand combined with more than adequate lendable funds at low rates, the concepts of monetary stimulus and deflation entered the picture. Consequently, most folks expect the Fed to initiate a new round of “quantitative easing” i.e., purchasing government debt. This will put a lot more money into our system and, the Fed hopes, add inflationary pressures. The announcement should come next week.

If the predictions are correct, the values of TIPS – even those bought with a negative yield – will increase. The way the 5-year TIPS are priced and adjusted, if the TIPS are held to maturity and annual inflation rate exceeds an average of 1.7% annually, the TIPS will show a positive real return.

The market expects the Fed to be successful in its efforts to boost inflation. Thus, buyers in yesterday’s auction attempted to purchase 2.84 times the amount of TIPS on sale. Any auction that is more than 2x oversubscribed is considered a success. ¬†Indirect bidders (domestic and foreign institutions) including foreign central banks bought 39% of the TIPS sold, which is significant.

You can also look at things this way. The nominal yield on 5-year Treasuries (no inflation adjustment) is just 1.17%. If inflation runs at 2%, that results in a negative real yield. TIPS pricing just makes the negative yield more explicit.

As long as the inflation rate stays in positive territory (no deflation) over the next five years, we can’t lose money.

I think inflation starts ramping up 2-3 years from now, making these TIPS quite valuable.

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