TIPS Auction Step By Step: Read the Announcement

This is part two of the TIPS auctions series. The other posts in the series are:

• TIPS Auction Step By Step: Know the Schedule
• TIPS Auction Step By Step: Place Order
• TIPS Auction Step By Step: Read the Results

If you are interested in TIPS but you don’t want to be bothered with auctions, you can buy TIPS in a mutual fund or ETF. See Individual TIPS Or TIPS Mutual Fund.

The Treasury Department publishes auction announcements on their website. The announcement for the upcoming 10-year TIPS auction on July 10 came out today (link). It’s close enough to the auction date now. If you’ve been thinking about it, you should decide now whether you want to buy from this auction.

1. Estimate the Yield. You will not know what the yield will be until the auction is over, but you can take a guess using the current yield on existing bonds which are traded on the secondary market. I use the Daily Treasury Real Yield Curve Rates published by the Treasury Department and the yield charts by Federal Reserve Bank of St. Louis: 5-year, 10-year, and 20-year.

 

The current yield on a 10-year TIPS is 1.43%. The yield from the auction should be around that number. Remember this 1.43% number is the real yield, which is above and beyond the reported inflation number. The current real yield is below the average real yield we’ve seen in the past few years, although the reported inflation number is higher than before. You have to decide yourself whether this is a good yield for you or not. For me, I decided to skip this auction and look at the 20-year issue coming up in about two weeks. Sometimes the yields on 10-year and 20-year TIPS are close to each other (“flat yield curve”) but at this time there is a large difference (“steep yield curve”). As you can see from the chart below, the 10-year (blue line) was close to the 20-year (red line) in 2006 and most part of 2007. Lately it has dropped below the 20-year by quite a bit.

 

If you decide to buy the 10-year TIPS and you’d like to get a handle on how much money you will need, you will need some data from the announcement to do the calculation.

2. New Issue vs. Reopening. The 10-year TIPS this time is a new issue, which means it’s a brand new bond the market has never seen before. If it were a reopening, it will say so in the announcement. The next auction for a 20-year issue is going to be a reopening, which means the Treasury Department will issue additional bonds with the same terms as the existing bonds they sold before. A difference between a new issue and a reopened bond is the stated interest rate or the “coupon” rate. The coupon rate on a new issue is determined by the auction. It’s set to the nearest 0.125% below the high yield in the auction. The purchase price is also adjusted accordingly. For a reopened bond, the coupon rate is fixed. The auction will determine only the price. Another difference between a new issue and a reopened bond is the inflation adjustment. Because a reopened bond has been on the market for some time, it has accumulated some inflation adjustment. A reopened bond typically costs more in nominal dollars unless its coupon is significantly below the current market yield.

 

3. Important Dates and Index Ratio. The announcement contains many data points but only these are relevant for estimating how much a bond will cost.

• Issue Date: the date you will officially own the bond
• Maturity Date: the date they will pay you back
• Dated Date: the date from which the interest payment will be calculated
• Interest Rate (reopening only, not applicable to new issues): the coupon rate
• Index Ratio: the principal adjustment factor

 

4. Estimate Dollars Needed. Plug in the data you gathered from above together with your yield estimate into my TIPS pricing spreadsheet. You will see roughly how much you will need for each bond. By my estimate, with the yield within +/- 0.10% from 1.43%, you will need between $988.82 and $1,000 per $1,000 face value.

Next step: place order if you are going to buy it.

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