Why was the demand for TIPS so high last week?

Market Realist

Weekly review: How the US Treasuries and corporate bonds performed (Part 5 of 10)

(Continued from Part 4)

Treasury inflation-protected securities

Treasury inflation-protected securities (TIPS), as the name suggests, are designed to shield investors from inflation risk. Announced usually at the beginning of January and July, the ten-year TIPS are reopened for auction in March, May, September, and November. Competitive bids at these single-price auctions determine the interest rate paid on each issue, which remains fixed. Last week, a $13 billion ten-year TIPS auction was reopened to be issued on March 31 (settlement date). The issue will mature on January 15, 2024.

How TIPS work

The principal amount of TIPS is adjusted for interest rate volatility caused by inflation. When an investor buys a TIPS security, they not only receive the initial investment amount and the periodic interest, but also the inflation-adjusted principal amount at maturity. If there is inflation, the adjustment is made upward; in deflationary conditions, the adjustment is made downward.

For example, an investor pays $1,000 for a TIPS note and receives interest payments every six months based on the inflation-adjusted principal at the time of payment. If the coupon is 3% to be paid semiannually, supposing that the inflation rate rises to 10% by the end of first six months, then as the principal amount of TIPS is adjusted to inflation, the principal at the end of six months will be $1000*1.1 = $1100. Thus, the investor will get the first semiannual coupon payment of $16.5 ($1100*1.03 divided by two) at the end of six months. Plus, at the time of maturity, an investor would receive a principal payment of $1,100 upward adjusted to account for the 10% inflation rate.

Many economist and policymakers consider the differential between yields on ten-year TIPS (TIP) and regular ten-year notes (TLH) as a proxy for estimate of investors’ inflation expectations.

At present, the inflation rate in the U.S. is 1.1%. In the recent FOMC meeting conducted on March 18-19, 2014, the Fed kept the estimates for inflation rates unchanged. The Consumer Price Inflation Index (Or PCE) is expected to rise to 1.6% by the end of 2014 and is expected to reach 2.0% by 2015—the threshold set by the Fed to start raising the fed funds rate. The expectation of higher inflation over the short-to-medium term resulted in a greater demand for the ten-year TIPS (SPTZ) auction held on Thursday, March 20, 2014, as reflected in bid-cover ratio of 2.48x compared to previous week’s bid-cover ratio of 2.31x.

Upcoming Treasury notes and bonds auction

A range of mid-term and long-term Treasuries are expected to be auctioned this week (March 24-28). A $13 billion two-year FRN (floating rate note) (TFLO) is scheduled for auction on March 26, 2014. A FRN is a security that has an interest payment that can change over time. As interest rates rise, the security’s interest payments will increase. Similarly, as interest rates fall, the security’s interest payments will decrease.

A $32 billion two-year fixed interest rate (SHY) note is scheduled for auction on March 25, 2014. A $35 billion five-year note is scheduled for an auction in March 26, 2014. Plus, a $29 billion seven-year note is scheduled for an auction in March 27, 2014. The Treasury announces the amounts, dates, and time of the five-year and seven-year notes auction monthly, usually in the third week of the month (on Thursday). These are then auctioned the following week.

Both two-year and five-year Treasury yields are currently trading at a two-month high, while seven-year Treasury yield at 2.30% was 0.13% up from the previous week.

Continue to Part 6

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