The use of TIPS
Nominal bond yields rise due to higher inflation expectations. Treasury Inflation-Protected Securities, or TIPS, protect the value of debt securities from eroding due to inflation. A TIPS principal is indexed to the CPI (consumer price index). The TIPS principal increases with inflation and decreases with deflation.
Upon maturity, an investor is paid the greater of the adjusted principal or the TIPS original principal amount. The coupon payments on TIPS are applied to the adjusted principal. As a result, the coupon payments on TIPS provide the bondholder with a fixed amount of purchasing power. ETFs that provide exposure to TIPS include the iShares TIPS Bond ETF (TIP).
Changes in inflation and inflation expectations would affect the returns on fixed income ETFs including the Vanguard Total Bond Market ETF (BND), the Core Total US Bond Market ETF (AGG), and the ProShares Ultra 7–10 Year Treasury ETF (UST).
Ten-year TIPS auction on May 21
The US Treasury auctioned ten-year TIPS worth $13 billion on May 21. The amount was the same as it was at the March 19 auction. Even with the same amount on offer, demand for the securities fell from the previous auction, with the bid-to-cover ratio at 2.33x versus 2.43x at the March auction.
Market demand falls
Market demand for the securities fell in May compared with demand at the March auction, led by a fall in indirect bids. Indirect bids include bids from foreign governments. They fell from 75.7% in March to 67.1% in May. Direct bids include bids from domestic money managers like State Street (STT) and Invesco (IVZ). They rose from 1.1% to 4.5% of the total competitive accepted bids.
Due to lower market demand, primary dealer uptake rose from 23.2% in March to 28.3% in May. An increase in primary dealer bids implies lower underlying market demand. Primary dealers are a group of 22 authorized broker-dealers. They’re required to bid at US Department of the Treasury auctions. They include firms like JPMorgan Securities (JPM) and Goldman Sachs & Co. (GS). Both firms are part of the iShares Core S&P 500 ETF (IVV).
The high discount rate rose to 0.358%—up from 0.2% at March’s auction and its highest level since November 2014. The discount rate represents the difference between ten-year Treasury yields and the expected inflation rate. With the FOMC (Federal Open Market Committee) remaining accommodative in its April 2015 statement, inflation has space to move higher yet.