My favorite trade right now is a government bond.

I know that sounds boring coming from an options guy. For the next few months, my play is the 2-year Treasury, but the bigger opportunity is further out.

One corner of the Treasury market is paying more than 3.3% a year above inflation, backed by the U.S. government, and I think it has a shot at being the trade of the decade. Below, I’ll show you how it can pay off 2 different ways at the same time, and the one number I’d check before buying a single bond.

Start With The 2-Year

The 2-year Treasury is yielding about 4.9%, and the 5-year is around 5.1%. Of the 2, the 2-year is where I see the value.

It’s short enough that I can hold it to maturity and collect my 4.9%, no matter what rates do in the meantime. The 5-, 10- and 30-year notes pay a little more, but I’m probably not going to hold those to maturity, so a move in rates can hurt me a lot more along the way.

That’s my near-term play.

What TIPS Are

TIPS stands for Treasury Inflation-Protected Securities. They’re government bonds with one big twist: the principal rises with inflation, and the interest is paid on that bigger principal.

So when you buy a TIPS, the yield you lock in is a real yield, meaning what you earn above inflation. Right now, the 20- and 30-year TIPS are both trading at real yields over 3.3%.

To put that in perspective, when the 30-year TIPS hit 3.05% in July, it was already the highest real yield since the Treasury brought that bond back in 2010. It’s gone higher since.

2 Ways To Win

I think TIPS are going to be the trade of the year, and they might be the trade of the decade.

First, you lock in more than 3.3% a year on top of whatever inflation turns out to be, for up to 30 years. If inflation runs hot, your principal grows with it. If it cools off, you still earn your 3.3%.

Second, when interest rates start to come down and inflation eases, long-dated TIPS go up in price, just like any long-term bond. So if you ever decide to sell early, you could collect a gain on top of the income.

You’ll have 2 things working in your favor at the same time, and you don’t get that often in the bond market.

The Risk

The timing is the hard part. This morning’s economic data came in hot, and traders now see better than a 2 in 3 chance the Fed raises rates again at its next meeting in October.

I expect yields across the board to keep rising for now. If they do, long-dated TIPS will fall in price before they rise, and the only way to fully avoid that is to hold them to maturity, which for a 30-year bond is a long time.

So I’m starting with the 2-year and watching TIPS closely.

Before you buy any long-term bond, figure out what inflation the market is betting on. 

It takes about 30 seconds.

Pull up the Treasury’s Daily Treasury Par Real Yield Curve Rates page and find the 20-year TIPS yield. Then find the 20-year yield on the Daily Treasury Par Yield Curve Rates page, and subtract the TIPS yield from it.

The difference is called the breakeven inflation rate. It’s the average inflation rate the market expects over the next 20 years.

If you think inflation will run hotter than that number, TIPS win. If you think it’ll run cooler, regular Treasurys win. It’s the one number I’d check before buying either one.

Your only option,
Mark Sebastian