Sunday, July 22, 2012

Long-Term Real Interest Rates Drop Below Zero

Since 2000, the real yields on TIPS have experienced a gradual decline. This is good news for current TIPS owners to the extent that they can enjoy capital gains on the value of their holdings. But it is bad news for those wishing to purchase TIPS now to help finance long-term goals. The bad news is that financing those goals has become a lot more expensive. The following chart from the Treasury Department shows the Long-Term Real Rate Average, which they define as "the unweighted average of bid real yields on all outstanding TIPS with remaining maturities of more than 10 years and is intended as a proxy for long-term real rates." These rates dipped below zero at the start of June and then rose briefly again. But as of July 20, 2012, the average rate has fallen below zero again to its lowest level in history: -0.04%.

As this is a real yield, it can fall below zero. Investors are still locking in returns that will keep pace with inflation, which is not something that can be guaranteed with traditional Treasury instruments. While I'm not in the business of making forecasts, I certainly think it is just as likely that TIPS yields will continue to fall as they will begin to rise. Rising TIPS yields will result in capital losses for current owners, but I, for one, am still staying the course with my current allocation to TIPS mutual funds. 

For those approaching retirement, these low TIPS yields provide a valuable motivation to delay the Social Security claiming decision, and this certain speaks against the idea of claiming Social Security early with the idea in mind of investing the Social Security benefits for yourself. It will be hard to beat the implicit real rate of 2.9% provided to those who delay Social Security.


  1. Wade - Assuming that TIPS have a place in someone's portfolio, perhaps building a ladder of 10-year TIPS for future cash flow, would you buy individual TIPS today at auction? Fidelity didn't make the TIPS auction on 7/19 available to retail clients online because of the negative yield. It seems to me there isn't anything else as safe that can guarantee inflation protection, even if it is expensive. I'm still puzzling over these critters - would appreciate your thoughts.

  2. Kathy,
    It's a good question. Negative yields are not a reason to avoid then. They do offer the protection if we get a sudden bout of unexpected inflation. I'm not so optimistic that stocks will clearly perform better anyway, so I suppose I would seriously consider grudgingly going ahead with a plan to build a TIPS ladder.

  3. An alternate view is that they are not really negative yields. The TIPS par amount still increases at the inflation rate (and still makes semi-annual interest payments), but there is a fee collected at the time of purchase. You can think of this fee as a transaction fee, or as a commission, or as a "Bernanke tax". For the most recent TIPS, the fee was 7.78%, which is not insignificant. However, the fee is sort-of deductible as a capital loss when the TIPS matures.

    The advantage of a ladder, whether it is a ladder of CDs, of bonds, or of TIPS, is that it runs on "autopilot". Whenever one of the rungs reaches its maturity date, you simply roll it over into the new issue. For bonds and TIPS, you also collect semi-annual interest payments, which are added to the new issue purchase. (During the decumulation phase, you simply subtract the amount needed for spending for the next period before the new issue purchase.) With many rungs of the ladder, some are good yields, some are bad yields, some are fantastic yields, and some are terrible yields, and the hope is that overall they produce an acceptable yield. In this particular case, the coupon payments received on 7/15 from my other TIPS more than covered the Bernanke tax on this issue.

    But the real question is whether to take the safe route (even with the 7.78% fee), or try to do something that might turn out better (or, in terms of the ladder, when you see a terrible yield coming, do you take it or do something more complicated). The best 10-yr CD, with compounding, that I found was 2.25%; a 10-yr T-note was 1.5%; a 10-yr bond with FDIC insurance was 2.60%; none are attractive. All are bets on the 10-yr inflation rate, and my crystal ball is very cloudy. For five years, I see inflation very low (or even deflation), so the best TIPS alternative I saw was a 5-yr CD/bond, and plan to buy a 5-yr TIPS (or a "used" 10-yr TIPS) when it matures. Which will do better? I wish I knew. Since I don't know, my approach is to split the pot and do both (I think that's called diversification).

    Another alternative to consider is I-bonds. They are similar to TIPS, but their yield doesn't go negative. The purchase limits are their biggest detraction.

  4. Wade and Bill - thank you both for your thoughts. I do love I-Bonds, and have my clients maxing out on those where they can. As you mention, Bill, the major drawback is the purchase limitation, but since you can't buy them in IRAs, clients have to have non-retirement savings, which isn't always as likely. The other problem is that now that you can only buy them online (no more paper), some of my older clients are flummoxed by the website, which is definitely not as user friendly as say Amazon or LL Bean.

  5. I am a couple of years from retirement and currently maxing out on I-series savings bonds. I will be guaranteed to keep up with inflation, which looks like the best deal going these days. (I am also guaranteed zero real yield for bonds purchased lately.) If real yields go up, I can sell them and buy the newer issue with a penalty of only a couple months interest, which is nil anyway. Taxes are deferred. An advantage over the TIPS ladder is that if one needs extra funds, the I bonds can be sold with minimal penalty, whereas the TIPS sale may be at a capital loss. TIPS are recommended to be held in an IRA, so one cannot deduct the loss.