Very high yields on 1-2 year TIPS

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richard
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Very high yields on 1-2 year TIPS

Post by richard »

Does anyone have a good explanation for 8.5% real yield on TIPS maturing Jan 2009 and 4% real yield on TIPS maturing Jan 2010?

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Tramper Al
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Re: Very high yields on 1-2 year TIPS

Post by Tramper Al »

richard wrote:Does anyone have a good explanation for 8.5% real yield on TIPS maturing Jan 2009 and 4% real yield on TIPS maturing Jan 2010?

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I have seen this before, both with TIPS and nominal Treasurys, where shortest remaining term issues had crazy high yields. Just a couple of months ago, when TIPS were perhaps more like 2.2 - 2.5% range, I saw that Jan 2009 was available at Fidelity for something like 3.5% real. It disappeared from inventory before I could buy any, but I would not have considered at the time that its yield could go to 8%.

So, no I don't have an explanation, though I have asked about it here before. I remember wondering at the time if maybe an interest payment was being incorporated in the price, but not actually to be received. You now, a quirk of the way the bond was being listed.

There is one explanation floating around that 8% real to Jan 2009 obviously indicates a market consensus for horrible deflation. Between now and January? Anyway, I don't buy that at all.

Can we get a volunteer to purchase a Jan 2009 TIPS today and report back on total return to maturity in January? The shortest maturity I can find at Fidelity remains the Jan 2010 issue, real yield 4.26% - 4.75%.
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Post by Tramper Al »

Several threads on TIPS are going strong today, but an opinion on a short term issue sporting an 8% real rates is quite rare.

Actually I see that it is up to 9.2% real! Anyone?
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drjdpowell
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

Tramper Al wrote:There is one explanation floating around that 8% real to Jan 2009 obviously indicates a market consensus for horrible deflation. Between now and January? Anyway, I don't buy that at all.
How much deflation would be required? An 8% annualized deflation rate over three months is a drop in prices of 2%. Oil prices have dropped significantly, so that will have some effect. Prices went up over 2% in a three-month period earlier this year I believe, so a reverse move seems not impossible.

-- James
Tramper Al
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Re: Very high yields on 1-2 year TIPS

Post by Tramper Al »

drjdpowell wrote:
Tramper Al wrote:There is one explanation floating around that 8% real to Jan 2009 obviously indicates a market consensus for horrible deflation. Between now and January? Anyway, I don't buy that at all.
How much deflation would be required? An 8% annualized deflation rate over three months is a drop in prices of 2%. Oil prices have dropped significantly, so that will have some effect. Prices went up over 2% in a three-month period earlier this year I believe, so a reverse move seems not impossible.

-- James
OK, not impossible, surely, but would not this yield imply the market's best guess or consensus? Is it so much a forecast, or is it that relatively more of this TIPS future CPI adjustment is already in the past and thus known?

From that same VG source, I am seeing the 3 month T-Bill yield of 0.39%?

If so, that would help me understand the rather narrow nominal - TIPS yield spread at like 5 years, for example.
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drjdpowell
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

Tramper Al wrote:OK, not impossible, surely, but would not this yield imply the market's best guess or consensus? Is it so much a forecast, or is it that relatively more of this TIPS future CPI adjustment is already in the past and thus known?
I don't know the details of TIPS, but I imagine the remaining CPI-U adjustments for the Jan 2009 maturing TIPS are those for October, November, and December. October is half over and major changes have occurred, so estimating the October CPI-U is less a forecast than a measurement. Also, near-term forecasting is a lot easier than long-term; "low oil prices in October lead to lower gas prices in November lead to lower airline prices in December" is not the wildest speculation the market can engage in.

-- James
DickBenson
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Re: Very high yields on 1-2 year TIPS

Post by DickBenson »

Tramper Al wrote: Can we get a volunteer to purchase a Jan 2009 TIPS today and report back on total return to maturity in January? The shortest maturity I can find at Fidelity remains the Jan 2010 issue, real yield 4.26% - 4.75%.
Just made a small purchase of a 4/11 TIP at Fidelity and got a 3.7% YTM. Not sure why this is so high. Could there be some unusual tax situation associated with this?

There briefly was an offering of a 4/10 (0.875) bond at 4.83%, but this disappeared when I returned to the offerings.

Can the YTM calculation be suspect?

Dick
Last edited by DickBenson on Thu Oct 16, 2008 1:51 pm, edited 1 time in total.
Tramper Al
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Re: Very high yields on 1-2 year TIPS

Post by Tramper Al »

drjdpowell wrote:
Tramper Al wrote:OK, not impossible, surely, but would not this yield imply the market's best guess or consensus? Is it so much a forecast, or is it that relatively more of this TIPS future CPI adjustment is already in the past and thus known?
I don't know the details of TIPS, but I imagine the remaining CPI-U adjustments for the Jan 2009 maturing TIPS are those for October, November, and December. October is half over and major changes have occurred, so estimating the October CPI-U is less a forecast than a measurement. Also, near-term forecasting is a lot easier than long-term; "low oil prices in October lead to lower gas prices in November lead to lower airline prices in December" is not the wildest speculation the market can engage in.

-- James
Nice, I think you may be on to something there. Hopefully someone who knows well how and when these CPI adjustments are made will weigh in.
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Post by HueyLD »

Just made a small purchase of a 4/11 TIP at Fidelity and got a 3.7% YTM. Not sure why this is so high. Could there be some unusual tax situation associated with this? ...Can the YTM calculation be suspect?
I plugged in your purchase price, coupon rate and maturity date into the Fidelity calculator and did get the 3.7% YTM. I also verified this 3.7% in Excel using the NPV function. So, it looks like the 3.7% YTM is real.

However, the inflation factor of 1.10592 is not considered in either calculation because we do not know what the future inflation rates may be. So, my main concern about paying for the current built-in inflation adjustment is "deflation" during my holding period. Unless you buy TIPS at the IPO, you are not guaranteed to get all your money back at maturity.
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Post by Tramper Al »

HueyLD wrote:
Just made a small purchase of a 4/11 TIP at Fidelity and got a 3.7% YTM. Not sure why this is so high. Could there be some unusual tax situation associated with this? ...Can the YTM calculation be suspect?
I plugged in your purchase price, coupon rate and maturity date into the Fidelity calculator and did get the 3.7% YTM. I also verified this 3.7% in Excel using the NPV function. So, it looks like the 3.7% YTM is real.

However, the inflation factor of 1.10592 is not considered in either calculation because we do not know what the future inflation rates may be. So, my main concern about paying for the current built-in inflation adjustment is "deflation" during my holding period. Unless you buy TIPS at the IPO, you are not guaranteed to get all your money back at maturity.
OK, let me see if I can get my head around this one, if only so that others can correct me and I will learn something.

I believe that in real terms, you will indeed receive the 3.7% to maturity, based on your purchase price. In your price, there is reflected a forecast of inflation/deflation for the relevant period.

Your issue does have the inflation factor of 1.10592, true, but you also bought it at a (unadjusted) discount to par, yes? So the price was actually something like 106.6, right? Not 110.6. I believe that the 6.6 is the maximum amount of loss of (nominal) principal that could occur between now and maturity, if in fact deflation amounted to that much or more over that period of time, yes?

In the event of deflation, I believe that your real purchasing power is actually maintained. Down to 100, however, you do not receive a bonus at maturity due to deflation. If deflation went further than that, however, I think you do begin to receive a bonus (that is more than maintain your principal's purchasing power) due to the par floor. Your principal at maturity has a nominal minimum of 100, though with falling prices that becomes more and more valuable.

Is that correct?
RobG
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Re: Very high yields on 1-2 year TIPS

Post by RobG »

I've been curious about this too so I ran the numbers... it looks like a relatively small amount of deflation will bring the yield down to what you could get with money markets, etc.

The numbers (I can't say for sure that I'm doing this correctly):
For the 1/15/2009 bond with 3.875% coupon ($1.9375 ever 6 months)

The price is 98.66 + ~3 months interest = 99.62875

in three month you will get $101.9375

Your percentage gain will be (101.9375/99.62875) = 1.02317 (9.6% annualized)

HOWEVER, if the inflation is -1.54% over that period the final amount will be
(1.02317)*(1-0.0154)=1.0078, which is 3.0% return (annualized).

2% deflation will reduce the return to 1%, which is worse than you can make with money markets. Maybe 1.5-2% deflation is way out of line... I don't know, but this would certainly explain the price.

rg
matt
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Post by matt »

Commodity prices are down 40% in the past 10 weeks or so. Lower energy prices have and will continue to make an immediate reduction in CPI data over the next few months. Other commodity price effects will occur with a lag and keep inflation low in the near-term. Long-term is another story. If you are a conservative investor or are willing to make tactical adjustments within the fixed income category, TIPS with 20+ years to maturity are attractive to buy and hold onto.
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Post by Tramper Al »

matt wrote:Commodity prices are down 40% in the past 10 weeks or so. Lower energy prices have and will continue to make an immediate reduction in CPI data over the next few months. Other commodity price effects will occur with a lag and keep inflation low in the near-term.
Again, though, do you have a strong sense as to whether the CPI outlook reflected in near-term TIPS pricing is in fact consensus forecast (and thus expected) or is it a delay in the adjustment mechanism (and thus truly known).
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Post by matt »

TIPS accrue with a three-month lag to CPI, correct? If so, it would seem that today's CPI release is probably the last one that will be incorporated into a TIPS maturity of Jan 09. If so, the market price should yield about the same as a 3-month T-bill. I'm not going to do the math since I can't justify putting a lot of effort into determining the expected return when I already know that the return will be really close to zero. There are huge bargains in the market far more worthy of analysis.
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Re: Very high yields on 1-2 year TIPS

Post by Rodc »

RobG wrote:I've been curious about this too so I ran the numbers... it looks like a relatively small amount of deflation will bring the yield down to what you could get with money markets, etc.

The numbers (I can't say for sure that I'm doing this correctly):
For the 1/15/2009 bond with 3.875% coupon ($1.9375 ever 6 months)

The price is 98.66 + ~3 months interest = 99.62875

in three month you will get $101.9375

Your percentage gain will be (101.9375/99.62875) = 1.02317 (9.6% annualized)

HOWEVER, if the inflation is -1.54% over that period the final amount will be
(1.02317)*(1-0.0154)=1.0078, which is 3.0% return (annualized).

2% deflation will reduce the return to 1%, which is worse than you can make with money markets. Maybe 1.5-2% deflation is way out of line... I don't know, but this would certainly explain the price.

rg
Not sure I follow exactly what you are doing, but yield to maturity is independent of inflation/deflation as it is a calculation in real dollars. Unless deflation takes you below par, which you are guaranteed to get back at maturity, in which case yield goes up.

Added: Ok. You are comparing real to nominal and in deflation real yield stays the same but nominal goes down. I'm a little slow today. :)
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HueyLD
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Post by HueyLD »

Tramper Al wrote:I believe that in real terms, you will indeed receive the 3.7% to maturity, based on your purchase price. In your price, there is reflected a forecast of inflation/deflation for the relevant period.

Your issue does have the inflation factor of 1.10592, true, but you also bought it at a (unadjusted) discount to par, yes? So the price was actually something like 106.6, right? Not 110.6. I believe that the 6.6 is the maximum amount of loss of (nominal) principal that could occur between now and maturity, if in fact deflation amounted to that much or more over that period of time, yes?

In the event of deflation, I believe that your real purchasing power is actually maintained. Down to 100, however, you do not receive a bonus at maturity due to deflation. If deflation went further than that, however, I think you do begin to receive a bonus (that is more than maintain your principal's purchasing power) due to the par floor. Your principal at maturity has a nominal minimum of 100, though with falling prices that becomes more and more valuable.

Is that correct?
Al,

Your analysis makes sense to me. I have to admit that I have no first hand experience of deflation because my entire life has been inflationary of various degrees. So, naturally I have inflationary expectations.

However, the CPI's for the last few months show a declining trend and thus my concern of deflation and the TIPS inflation adjustment factor. Who knows what the future may hold. In that line of reasoning (rational or irrational), I would choese longer maturity TIPS with low inflation factors and low coupon rates. Longer maturity ones usually have lower inflation factors and lower coupon rate ones allow for less reinvestment risk.
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Post by tfb »

TIPS adjust to CPI with a 2-month lag. Right now the TIPS are still going through Aug. CPI changes. The Sept. CPI announced today will be implemented in November (no change). Then Oct. CPI in Dec. and half of Nov. CPI in Jan. until maturity on 1/15/2009. So there is only 1.5 months of unknown price adjustment.
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drjdpowell
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

richard wrote:Does anyone have a good explanation for 8.5% real yield on TIPS maturing Jan 2009 and 4% real yield on TIPS maturing Jan 2010
Just bumping this old conversation since the October CPI-U comes out tomorrow and we'll see if we get any of the 2% or so deflation needed to explain the relative yield differences of near-term TIPS versus nominal Treasuries. I note that the October PPI (Producer Price Index) was announced today: down 2.8%.

-- James
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Post by mbs »

Given the market's current reactivity, the announced 2.8% drop in the CPI should give us a few days worth of yield spikes on TIPs, no?
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

The October CPI-U came out and it was down 1.0%. In a month will know the November CPI.

-- James
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mbs
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Post by mbs »

Yeah....1% is a pretty healthy drop. Still the TIP etf was up most of the day, and finished down just $.02. Go figure.

Unless energy costs spike, I don't see how we avoid more drops in the CPI, at least through Jan. Retail sales figure to be just miserable, and I don't think anyone is asking Santa for a new Ford or Chevy.

Watch for the 4% YTM buying oppty on TIPs bonds...coming to a brokerage house near you! :wink:
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

The November CPI-U came out and it was down 1.9%. I believe one half of that drop, 0.95%, will work it's way into the final January 15 maturing TIPS.

-- James
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Re: Very high yields on 1-2 year TIPS

Post by drjdpowell »

Looking up the "Index Ratio" of the January 15 TIPS:

On October 16, when Richard first posted, the ratio was 1.33865.
The January 15 ratio will be 1.30914, a drop of 2.2% over three months, which is an annual rate of -8.5%.

So the reason for the 8.5% real yield on the Jan 2009 TIPS was presumably that deflation was expected to be about that, thus making TIPS and nominal Treasuries earn roughly the same amount.

-- James
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Re: Very high yields on 1-2 year TIPS

Post by alec »

drjdpowell wrote:Looking up the "Index Ratio" of the January 15 TIPS:

On October 16, when Richard first posted, the ratio was 1.33865.
The January 15 ratio will be 1.30914, a drop of 2.2% over three months, which is an annual rate of -8.5%.

So the reason for the 8.5% real yield on the Jan 2009 TIPS was presumably that deflation was expected to be about that, thus making TIPS and nominal Treasuries earn roughly the same amount.

-- James
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Re: Very high yields on 1-2 year TIPS

Post by Rodc »

drjdpowell wrote:Looking up the "Index Ratio" of the January 15 TIPS:

On October 16, when Richard first posted, the ratio was 1.33865.
The January 15 ratio will be 1.30914, a drop of 2.2% over three months, which is an annual rate of -8.5%.

So the reason for the 8.5% real yield on the Jan 2009 TIPS was presumably that deflation was expected to be about that, thus making TIPS and nominal Treasuries earn roughly the same amount.

-- James
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