I’m thinking about putting some money into Treasuries but am torn between TIPS and T-Notes.
Recent info shows 5 year TIPS paying 1.25% and 5 year T-Notes paying 3.75%
I know it’s impossible to predict what inflation will be over the next 5 years but does anyone here have any thoughts on this? Which one could be deemed the safer investment?
May be I am wrong and someone will correct it…But my understanding is:
T-Notes - Your principal is protected as long as you hold it to maturity.
TIPS - No such guarantee
According to some information on the Treasury Direct web site, the TIPS principal will vary but when it’s sold you will get no less than the original amount.
TIPS and T-notes are both debt instruments that can either be held to maturity or sold on the open market before maturity.
If held to maturity, both guarantee return of principal. If sold on the open market, both will be priced according to the prevailing interest rates. If yields fall after you buy them, they will both be worth more. If yields rise after you buy them, they will both be worth less.
The only question when making the choice between TIPS and T-notes is whether inflation will rise or fall in the future. The Federal Reserve publishes charts of the difference between TIPS and T-notes – they are the market’s expectations of future inflation. Here is the 5 year chart of the 5 year inflation breakeven rate when the yield of TIPS would be equal to the yield of T-notes.
The current breakeven yield is 2.13%. This is the collective opinion of thousands of bond investors, professional and individual.
Do you agree with them?
If you think that Macroeconomic factors will lead to lower inflation (demographics, recession, etc.) then you would buy the T-notes since the TIPS yield would fall. If you think that Macroeconomic factors will lead to higher inflation (growing government deficits, etc.) then you would buy the TIPS since their yield would rise.
Personally, I think that today’s situation resembles the 1970s and that everyone underestimates the stickiness of high inflation. That’s why I am buying TIPS and not T-notes.
Be aware that the I-Series Savings Bond is inflation-adjusted like TIPS but return of full par value is guaranteed even if it is redeemed during a period of rising yields. (Unlike TIPS whose return of principal would be less if sold during a period of rising yields.)
Please be sure to read about and fully understand these before investing.
@DoLoop wrote, “Recent info shows 5 year TIPS paying 1.25% and 5 year T-Notes paying 3.75%.” You can buy TIPS maturing in 2028 yielding over 1.75% on the secondary market at Fidelity.
Wendy
This is not correct. Both T-notes and TIPS are Treasury debt. The principal of both is protected if held to maturity.
The value of both will fluctuate if sold before maturity.
Wendy
This depends on the prevailing interest rates.
If prevailing interest rates stay the same, when the TIPS sold before maturity you will get no less than the original amount. However, if prevailing interest rates rise and you sell on the secondary market before maturity you may get less than the original amount.
Wendy
Thanks, Wendy. What you said about why you’re buying TIPS instead of T-Notes is the thoughts that I’m looking for.
And yes, I’m aware of the way I-Bonds work and am already maxed out on those. I have additional funds to do something with and that’s why I’m looking into TIPS/T-Notes.
Thanks Wendy. I think I was referring to TIPS ETF, as that is the one which is fluctuating…I had bought a TIPS ETF some time last year/ 2021 which seemed to be down most of the time - it has been a while since I looked at my portfolio…
I am guessing the TIPS sold in treasury functions very similar to the T-bills and notes with a clearly defined maturity date at 5,10,15 years…
I wonder if there is a way to know which dates the TIPS ETFs mature as otherwise I am not sure why I should be holding an TIPS ETF when I can get a better deal with the treasury direct, with the knowledge that all I have to do is wait till the maturity date.
Do you hold such TIPS ETFs?
Thanks
Charlie
No, I don’t hold any bond ETFs.
When I own an individual bond, I can choose to hold it to maturity and get my full par value. It doesn’t matter if yields rise in the meantime since I have a ladder of bonds and I hold them all to maturity.
An ETF, on the other hand, does not have a specific maturity date like a bond (when you get all your money back). The fund manager constantly adds and sells bonds to keep the fund’s target duration constant. When yields rise, the Net Asset Value (NAV) of the fund falls. The investor may not ever be able to retrieve their par value.
After being burned on this, I decided to avoid bond ETFs.
You can discover the target duration of your ETF by reading the prospectus. The longer the fund’s duration, the more the NAV will change when prevailing yields change.
Wendy
The bond market is pricing in 2.3% inflation. Downside might be 0% inflation. Upside might be 5% inflation. I consider TIPS safer for me, as there is no inflation risk and I am not worried about the lower coupon payments (cashflow). Some TIPS can lose principle value (you get back less than you paid on the secondary market) if there is deflation. Some TIPS (bought at auction) are protected from deflation. TIPS are complicated and might have lower cashflow and the same taxes (taxes are paid on the unrealized inflation accruals every year).
1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr T-notes 5.17 4.59 4.23 3.92 3.84 3.75 4.05 3.89 TIPS 2.87 2.19 1.93 1.66 1.56 1.54 1.72 1.63 difference 2.30 2.40 2.30 2.26 2.28 2.21 2.34 2.26
Annualized inflation rates for various 5-year periods:
0.8% from 1951 to 1956
1.6% from 1961 to 1966.
10.1% from 1976 to 1981.
3.1% from 1982 to 1987.
4.5% from 1986 to 1991.
2.5% from 2001 to 2006.
3.6% from 2003 to 2008.
1.2% from 2011 to 2016.
3.9% from 2018 to 2023.
Since 1947, about 27% of 5-year periods had annualized inflation less than 2%.
About 32% of 5-year periods had annualized inflation between 2% and 3%.
About 24% of 5-year periods had annualized inflation between 3% and 5%.
About 17% of 5-year periods had annualized inflation higher than 5%.
count of 5-year periods since 1947 with annualized inflation:
from to count pctTotal 0.0% 1.0% 9 1% 1.0% 2.0% 219 26% 2.0% 3.0% 273 32% 3.0% 4.0% 121 14% 4.0% 5.0% 87 10% 5.0% 6.0% 18 2% 6.0% 7.0% 30 4% 7.0% 8.0% 36 4% 8.0% 9.0% 31 4% 9.0% 10.0% 28 3% 10.0% 11.0% 4 0%
“This portfolio of TIPS investments in 2021 would pay $2,929 in coupon payments and also generate $6,088 in inflation accruals, based on inflation running at 1.8%. The $6,088 is the “phantom income” that is not paid out in the current year, but is taxable in the current year. As long the coupon payments can cover the tax on the phantom income, you will have a positive cash flow.”
It is indeed impossible to predict this, but it is possible to see the average of all bond trader’s predictions. That is literally the difference between the 5-year T-note and the 5-year TIPS. Right now the 5-year T-note is trading at 3.912% and the 5-year TIPS is trading at 1.756%, so “the market” (aka “everyone”) is expecting 5-year inflation to average about 2.156%. If you think inflation will be higher than this, buy the TIPS. If you think inflation will be lower, but the T-notes.
At this point, I-bonds are kind of ridiculous with an 0.9% fixed rate. May as well buy 30 year TIPS instead at a fixed rate of 1.624%. Yes, I know the principal value of TIPS can drop with deflation, and the I-bond will not, but that is hardly likely over 30 years.