Interest Rate Watch: Regular Treasury vs. TIPS vs. Breakeven Inflation Rates

There continues to be a lot of interest rate movement in savings accounts, CDs, and other cash equivalents. I find the most interesting corner right now to be the rise of real yields on TIPS (Treasury Inflation-Protected Securities) and their relationship with traditional Treasury bonds. Roughly 1/3rd of my bond allocation is to TIPS.

TIPS can be a bit complicated, but basically they are priced based on their real yield. As of 9/26/22, the closing real yield on a 5-year TIPS was 1.82%. This is the highest real yield since the 2008 Financial Crisis, and we’ve had negative yields for much of the last decade. (Source: FRED)

(As an inflation-linked bond, a TIPS with a 1.82% real yield means that if the CPI-U inflation is 3%, then your total yield will be 4.82%. “Real” means after adjusting for inflation. TIPS thus “protect” you from unexpectedly high inflation. If inflation ends up being 10%, you’ll get 11.82%. However, if inflation is very low, your yield will also be affected the other way.)

As of 9/26/22, the closing nominal yield on a regular 5-year Treasury was 4.15%. That means the 5-year “breakeven” inflation rate was 2.33%. If you bought equal amounts of both the 5-year Treasury and 5-year TIPS today, the winner after 5 years will depend on whether the future inflation rate ends up being higher or lower than 2.33% over the next 5 years. This creates a market-based estimate of future inflation rates. Here’s the historical 5-year breakeven inflation rate for the last 10 years:

Looking back, TIPS underperformed regular Treasuries for 11 out of the 16 10-year periods ending 2013-2021, as inflation was usually lower than the breakeven rate. Image credit to TIPSWatch.

At this moment, there are 5-year brokered CDs at 4.20% (non-callable) and the 5-year Treasury at 4.15%. Purely my opinion, but I would consider the 5-year TIPS over both of those options as I like the combination of a decent 1.83% real rate and a modest 2.33% breakeven rate. I would take the risk of underperforming regular Treasuries by a little bit in exchange for the insurance against high inflation. This is why I usually hold mix of TIPs and Treasuries for the bond allocation of my portfolio.

Note that current Savings I Bonds only have a 0% real rate and we’ll see how much they raise it in November (my bet: not nearly as high as the 5-year TIPS). So TIPS would even beat savings bonds right now in my book (as a long-term bond holding). However, the situation is changing daily and I don’t know what the rates will look like when I actually have significant cash available to re-invest.