Must-know: Inflation expectations impact Treasury yield curve (Part 5 of 5)
Treasury inflation-protected securities
The U.S. Department of the Treasury sells Treasury inflation-protected securities (or TIPS), at regularly scheduled auctions. Competitive bids at these single-price auctions determine the coupon paid by the government on each issue, which remains fixed once determined by the auction. The interest rate can’t be negative with the Treasury setting a minimum of 0.125%.
How TIPS work
At the time of coupon payment, the principal is adjusted based on inflation, so that the coupon is always paid as a percent of an inflation adjusted principal. Securities are redeemed at the greater of their inflation-adjusted principal or equal the amount at original issue.
Inflation is one of the major causes for interest rate fluctuations in the economy. Certain exchange-traded funds (or ETFs) like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), and the SPDR Barclays Capital TIPS ETF (IPE), are designed to protect the investors against interest rate risk caused by inflation.
30-year TIPS auction results
The U.S. Treasury auctioned $7 billion 30-year Treasury inflation-protected securities (or TIPS) in an issuance on June 19. The demand (as reflected in the bid-to-cover ratio) for these securities came strong, as investors preferred inflation-protected securities based on expectations of an increase in rates due to rising inflation. The $7 billion offering of sovereign securities drew attention from investors to gather enough bids to cover its sale by 2.76 times. The bid-to-cover ratio for TIPS increased from an average of 2.59x over the last six TIPS auctions, to 2.76x at the June 19 auction, indicating that investors have started positioning their portfolios for an uptick in inflation.
The bid-to-cover ratio compares the number of bids received in a Treasury auction with the number of bids accepted (or the amount of securities issued). The higher the ratio, the greater the demand for the auctioned securities. A bid-to-cover ratio over two corresponds to a successful auction, while a ratio of less than one shows an under-bought auction.
Buy-and-hold indirect bidders, a group that includes foreign central banks, bought 59.7%, versus 50.% in recent sales. Direct bidders, which include domestic money managers, purchased another 8.2%, versus an average of 13.3%. Primary dealers settled for a low share of only 32% of the $7 billion offering. Since indirect bidders generally purchase T-bills to be held to maturity, their increase in share corresponds to increasing end-user demand for six-month T-bills.
Popular exchange-traded funds (or ETFs) like the iShares Barclays Treasury Inflation Protected Securities Fund (TIP) and the iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) are invested into Treasury TIPS securities.
To learn how to profit from a rising interest environment, read our earlier Market Realist article Hedging: You can profit from rising rates with fixed income ETFs.
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