Why the 5-year TIPS auction saw lower investor demand

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Nov. 26 2019, Updated 12:41 a.m. ET

Five-year Treasury Inflation Protected Securities (or TIPS) auction held on August 21

TIPS are issued for five, ten, and 30-year maturities. Auctions for five-year TIPS are usually held mid-April with reopenings scheduled mid-month in August and December. Reopenings are reissues of securities that were offered previously. They’re offered at the same coupon and maturity date, but with a different purchase price.

Why invest in TIPS?

Higher inflation expectations would move bond yields higher—including Treasuries (TLT) (UST), investment-grade corporate bonds (LQD), and high-yield debt (JNK). TIPS protect the value of debt securities from eroding. The erosion is caused by inflation.

A TIPS’ principal is indexed to consumer price inflation (or CPI). The TIPS principal increases with inflation and decreases with deflation. On maturity, you would be paid the greater of the adjusted principal or the original principal amount of the TIPS.

TIPS’ coupon payments are applied to the adjusted principal. As a result, TIPS’ coupon payments provide the bondholder with a fixed amount of purchasing power. Exchange-traded funds (or ETFs) that provide exposure to TIPS include the iShares TIP Bond ETF (TIP).

Key highlights of last week’s 5-year TIPS auction: Bid-cover ratio falls

The U.S. Treasury auctioned five-year TIPS worth $16 billion on August 21—lower than the $18 billion auctioned in April. Despite lower issuance, demand for the securities was lower at 2.48x—compared to 2.70x for the April auction.

The bid-to-cover ratio is an important demand indicator for the securities. It’s the total value of bids received divided by the value of securities on offer. A higher ratio implies higher demand and vice versa.

Market demand comes in lower

The share of primary dealer bids increased to ~40%—compared to ~36% in April. Direct and indirect bids declined. An increase in primary dealer bids implies lower underlying market demand. Primary dealers are a group of 22 authorized broker-dealers who are obliged to bid at U.S. Treasury auctions.

Direct bids represent domestic demand—including bids from domestic money managers. Indirect bids include bids made by foreign governments and central banks.

Yields analysis

The high discount rate came in at -0.281%—lower than the -0.213% in April’s auction. The discount rate represents the difference between five-year Treasury yields and the expected inflation rate. Five-year TIPS yields have been negative since March 2011. This is due to two factors.

First, five-year treasury yields have stayed low. The low yields are partly due to the Fed’s accommodative monetary policy. They’re also partly due to strong overseas demand.

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Second, markets believe inflation could rise significantly in the future. The increase in inflation would be a result of excess market liquidity. This reduces real yields. It also boosts expectations that an increase in inflation would increase the principal amount to which future coupons are applied. Last week’s lower yield is due to the higher inflation figures seen lately. The Fed has also acknowledged that the risk of inflation falling persistently short of the target has “reduced somewhat.”

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