The Treasury sold $26 billion of 5-year Treasury Inflation-Protected Securities, or TIPS, with the following results:
Auction grade: C−
A somewhat softer auction overall. The Treasury needed to offer a yield 0.7 basis point above the WI level to get the issue sold, a larger tail than average. Bid to cover was also below average, while indirect bidders (foreign buyers) took a smaller share. The offset was strong direct demand (domestic buyers), which helped leave dealers with just 5.5% of the issue—well below average. So there were some positives underneath the headline, but the tail and softer overall bidding keep the grade below a C-.
What are TIPS, and how do they work?
TIPS provide investors with protection against inflation by adjusting the security’s principal with the Consumer Price Index. When inflation rises, the principal increases. The coupon rate stays fixed, but the dollar interest payments increase as that rate is applied to a larger principal balance. Payments are made every six months. www.treasurydirect.gov
For example, take $1,000 of principal with a hypothetical 2% coupon. If the inflation adjustment lifts that principal to $1,030, the annualized interest payment rises from $20 to $20.60. The coupon rate stays the same; the principal used to calculate the payment changes. www.treasurydirect.gov
Today’s 2.367% auction yield is a real yield, meaning a yield above the security’s CPI inflation adjustment. It is separate from the coupon rate and does not represent the market’s inflation forecast. The difference between a conventional Treasury yield and a TIPS yield of the same maturity provides a measure known as breakeven inflation. www.treasurydirect.gov
At maturity, investors receive the inflation-adjusted principal or the original principal, whichever is greater. That floor protects the original face amount, although it does not necessarily protect any premium paid when purchasing the security.
With the current 5 year yield at 4.7909% what does that tell traders/investors?
Using the 5-year Treasury yield of 4.7909% and today’s TIPS auction yield of 2.367%, the spread is:
4.7909% − 2.367% = 2.4239 percentage points, or 242.39 basis points.
That is an approximate 5-year breakeven inflation rate of 2.42%, assuming the yields are measured at the same time and have comparable maturities.
In plain English, the conventional Treasury pays a higher yield because its payments do not adjust for inflation. The TIPS offers a lower real yield, with CPI inflation adjustments added through its principal. The spread represents the inflation compensation priced into the comparison. TIPS Yield Curve and Inflation Compensation
For an investor holding to maturity, roughly speaking:
That is an approximation; cash-flow timing and reinvestment also matter.
What does today’s auction tell us? The spread is consistent with investors pricing inflation averaging around the mid-2% area over the next five years. It does not mean inflation will be 2.42% every year, or that this is a precise forecast. Breakevens also reflect inflation-risk compensation and differences in liquidity between conventional Treasuries and TIPS. Tips from TIPS: Update and Discussions
The auction itself was somewhat soft, with a 0.7-basis-point tail. Holding the conventional yield unchanged, that higher TIPS yield would narrow the breakeven spread by 0.7 basis point compared with the pre-auction WI level. But that small auction concession alone does not establish that inflation expectations are falling. We would need the earlier spread, using both yields at matching times, to judge the trend.
This article was written by Greg Michalowski at investinglive.com.
Source: Investing Live - News
