An awful auction. A decent result.
By David Enna, Tipswatch.com
Back on October 22, 2020, a new 5-year Treasury Inflation-Protected Security — CUSIP 91282CAQ4 — auctioned with a depressingly low real yield to maturity of -1.320%, which at the time was the second-lowest real yield ever recorded for a 5-year TIPS at auction.
Think back: Just five years ago, investors were willing to accept a real yield that was guaranteed to under-perform inflation by 1.320% for five years. Seems mind-boggling today. But that was the investment reality in 2020, as the Federal Reserve ramped up bond-buying quantitative easing at the height of the COVID-19 pandemic. At one point, the Fed held more than one-fifth of total TIPS outstanding.
It is therefore amazing that this TIPS ended up being a decent investment, especially if you compare it to a nominal 5-year Treasury note at the time, which was yielding an insanely low 0.37%. That created an inflation breakeven rate of 1.69%. (At the time U.S. inflation was running at 1.2%.)
In my preview article for this auction, I noted the seriously ugly real yield still offered appeal versus the nominal Treasury:
In the current environment of ultra-low interest rates for safe investments, this TIPS should be considered “above average.” Why? Because it provides a hedge against unexpected future inflation. The Federal Reserve has openly committed to forcing annual U.S. inflation higher than 2% a year, for an extended period of time, as long as the labor market remains weak.
I also pointed out that the Series I Savings Bond was a much better investment with a fixed rate of 0.0%, more than 120 basis points higher than the 5-year TIPS:
I Bonds are better than TIPS, across the entire maturity spectrum.
How did this TIPS do?
As it turned out, inflation over the last 5 years averaged 4.5%, well above the auction’s inflation breakeven rate of 1.69%. So CUSIP 91282CAQ4 outperformed the nominal 5-year Treasury by a whopping 2.81% a year. It ended up producing a nominal return of 3.117%, versus the 5-year Treasury note’s 0.37%.
This result continues a five-year string of out-performance of TIPS over nominal Treasurys, thanks to the 40-year-high surge in inflation that peaked in June 2022 at 9.1%. Inflation continues today at 2.9%, well above the expectation of 1.69% in October 2020.
I Bond was the winner
Obviously, an I Bond with a 0.0% fixed rate (which is equivalent to its real yield) is going to out-perform a TIPS with a negative real yield. If you purchased an I Bond in October 2020 with a fixed rate of 0.0%, it will have created a nominal yield of 4.03% through April 2026, about 91 basis points better than the TIPS (Source: Eyebonds.info).
And bond funds?
Vanguard’s Total Bond Fund ETF (BND) has had a total annual return of -0.33% over the last five years, according to Morningstar. That poor performance was caused by the beating it took in 2022, when its annual return was -13.1%.
Vanguard’s Short-Term TIPS ETF (VTIP) has had a total annual return of 3.71% over the last 5 years, a bit better than CUSIP 91282CAQ4’s performance. It benefits from a shorter duration and counter-acting gains from higher inflation.
The iShares TIPS ETF (TIP), which holds the full range of maturities, has had a total annual return of 1.32% over the last five years, under-performing CUSIP 91282CAQ4.
Moral of the story
Two very important takeaways: 1) An I Bond with a fixed rate of 0.0% will be a very attractive investment any time the Federal Reserve decides to repress interest rates through quantitative easing. (Let’s hope we don’t see that again.) And 2) Even a TIPS with a negative real yield can be “relatively” attractive if the inflation breakeven rate is lower than seems likely.
Notes and qualifications
My TIPS vs. Nominals chart is an estimate of performance.
Keep in mind that interest on a nominal Treasury and the TIPS coupon rate is paid out as current-year income and not reinvested. So in the case of a nominal Treasury, the interest earned could be reinvested elsewhere, which would potentially boost the gain. For certain, we don’t know what the investor could have earned precisely on an investment after re-investments.
In the case of a TIPS, the inflation adjustment compounds over time, and that will give TIPS a slight boost in return that isn’t reflected in the “average inflation” numbers presented in the chart.
• Confused by TIPS? Read my Q&A on TIPS
• TIPS in depth: Understand the language
• TIPS on the secondary market: Things to consider
• TIPS investor: Don’t over-think the threat of deflation
• Upcoming schedule of TIPS auctions
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
