Need help understanding TIPS

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Need help understanding TIPS

Postby Bustoff » Sun Dec 30, 2012 6:04 pm

The SEC yield for VIPSX is –1.09%.

Does that negative yield mean I lose 1.09% on my investment ?
In other words, if I put money into VIPSX tomorrow, and a year later there was no change in the price, would I owe 1.09% ? I don't understand how the negative yield affects the investment.

Obviously I have no understanding of how a TIPS fund works, but I'm considering investing in the Target Retirement Income Fund which holds TIPS. Also, there seems to be a fairly large contingent of Bogleheads who are fond of TIPS so they must play an important role. Just not sure whether the role is for income in retirement or strictly as an inflation hedge.
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Re: Need help understanding TIPS

Postby jebmke » Sun Dec 30, 2012 6:23 pm

I'd start by reading this

http://www.bogleheads.org/wiki/TIPS

and then if you have specific questions, follow up on your thread.
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Re: Need help understanding TIPS

Postby Noobvestor » Sun Dec 30, 2012 6:26 pm

Bustoff wrote:The SEC yield for VIPSX is –1.09%.

Does that negative yield mean I lose 1.09% on my investment ?
In other words, if I put money into VIPSX tomorrow, and a year later there was no change in the price, would I owe 1.09% ? I don't understand how the negative yield affects the investment.

Obviously I have no understanding of how a TIPS fund works, but I'm considering investing in the Target Retirement Income Fund which holds TIPS. Also, there seems to be a fairly large contingent of Bogleheads who are fond of TIPS so they must play an important role. Just not sure whether the role is for income in retirement or strictly as an inflation hedge.


That yield is in what are called 'real dollars' - or 'inflation adjusted'. This is as opposed to 'nominal dollars' - which is what we normally think of when we're talking about money.

The short answer is: no, you will not owe them money. The longer answer might be: a lot of things have negative yields in inflation-adjusted dollars, including most savings accounts and CDs. A still longer answer can be found here: http://www.bogleheads.org/wiki/Treasury ... d_Security

The best way to think about it, in my opinion, is to just translate the 'real' yield into 'nominal' terms as best you can based on inflation estimates. So if we assume inflation to be, say, 2.5% going forward on average, then a -1% real yield = a 1.5% nominal yield, so holding -1%-yielding TIPS is analogous to holding 1.5%-yielding treasuries (with the added 'bonus' that if inflation goes up, so do your returns on inflation-protected securities - so if it ends up being 5%, then your yield will be 5% - 1% = 4%, and so forth).
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Re: Need help understanding TIPS

Postby Bustoff » Sun Dec 30, 2012 7:12 pm

jebmke wrote:I'd start by reading this

http://www.bogleheads.org/wiki/TIPS

and then if you have specific questions, follow up on your thread.


Read the wiki (and more) prior to posting the question. I realize the return on TIPS, comes not just from interest income but also from any adjustment in value as inflation rises. However, the SEC hasn't issued any guidance to fund companies on how to handle this peculiarity when they show standardized yields. Vanguard backs the inflation adjustment out of the SEC yield, producing a much smaller number often called "real yield."
That doesn't make TIPS funds less complex to me, particularly when calculating the percentage of TIPS as part of an asset allocation.
Anyone else concerned that government-reported CPI underestimates of inflation will get worse in the future.
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Re: Need help understanding TIPS

Postby livesoft » Sun Dec 30, 2012 7:34 pm

Another way to look at this is to not look at VIPSX for your fund yield, but to look at a couple of other TIPS funds to see what their reported (not SEC) yield is. A ticker to look at might be TIP
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: Need help understanding TIPS

Postby nisiprius » Sun Dec 30, 2012 8:16 pm

Bustoff wrote:Anyone else concerned that government-reported CPI underestimates of inflation will get worse in the future.
See the Bogleheads Wiki article, Accuracy of the CPI for an overview. The MIT Billion Prices project is a crude but completely independent measure of the CPI based on online prices, and it does not show any dramatic underestimate.

http://bpp.mit.edu/usa/
Image

There are certainly not underestimates of the magnitude asserted by a shadowy website that a) does not disclose its sources or its methodology, b) stated that it would have its methodology reviewed by an academic but never did so, c) has graphs that are wrong on their face because they claim to be "calculated using the methodologies in place in 1980," but which fail to show the effect of the housing crash.
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Re: Need help understanding TIPS

Postby #Cruncher » Sun Dec 30, 2012 9:20 pm

Bustoff wrote:The SEC yield for VIPSX is –1.09%. Does that negative yield mean I lose 1.09% on my investment? In other words, if I put money into VIPSX tomorrow, and a year later there was no change in the price, would I owe 1.09%?
Allow me to restate your question in a way that represents what I think you're really getting at:
If I put money into VIPSX tomorrow, and a year later there had been no CPI inflation adjustment and if TIPS yields were unchanged, would I owe 1.09%?
No, you would not owe anything. However, you would incur a loss of about 1.09%. And this loss would be manifested in the fund having a lower net asset value (NAV) per share.

It's easier to understand this, I believe, if you first understood what would happen to a single TIPS bond under the same circumstances. For example consider the 5 year 0.125% TIPS first issued last April 30 and which will mature April 15, 2017. The results of the issue's auction were that buyers had to pay $106.16 for each $100 of principal. This corresponded to a yield of -1.08%. (See the auction results PDF file for details.)

Assume you had purchased $100 principal of this bond at the auction. Also assume over the next year the CPI stayed the same so there was no inflation adjustment to principal or interest. Also assume that the yield remained at -1.08%. This would mean that the price one year later would be $104.89. (1) During the year you would have received $0.125 in interest. But with the price falling $1.27 from $106.16 to $104.89., overall you'd have lost $1.145 or about 1.08% of the $106.16 purchase price. Thus the way one "pays" the negative 1.08% yield is thru the net effect of interest payments received and a reduction in price.

The NAV of a bond mutual fund is the overall value of the bonds it holds. So what happens to this one TIPS would happen to a TIPS fund NAV if the CPI were unchanged and the interest rate stayed the same on all of its holdings.

1) I used the bond calculator at http://www.ficalc.com to calculate this price using a settlement date of 4/30/2013.
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Re: Need help understanding TIPS

Postby Bustoff » Sun Dec 30, 2012 10:02 pm

Thank you #Cruncher for that great explanation.
Not sure I'm comfortable investing in an asset that is so difficult to understand. I suppose I could throw all caution to the wind and simply put a portion into the VIPSX, but then I wouldn't really understand if I was making a good or bad investment.
Thanks again.
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Re: Need help understanding TIPS

Postby FNK » Sun Dec 30, 2012 10:54 pm

Another, somewhat less painful way to look at the negative TIPS yield, is this: think of it as an insurance premium.

Consider the $106.16 example that Cruncher provided. In five years you'll collect $0.625 (inflation adjusted) in interest, lose $5.535 (inflation adjusted) and collect the $100 (inflation adjusted) principal. You will have paid the $5.535 premium to make sure the $100 is inflation adjusted no matter what the inflation is.

With the Fed targeting 2% inflation, the 1.5% nominal yield of Total bond Market is only -0.5% real. If the Fed over-eases and inflation goes higher than 2.5%, TIPS will have been better - the insurance will have paid off.
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Re: Need help understanding TIPS

Postby dbr » Mon Dec 31, 2012 12:34 pm

Bustoff wrote:Thank you #Cruncher for that great explanation.
Not sure I'm comfortable investing in an asset that is so difficult to understand. I suppose I could throw all caution to the wind and simply put a portion into the VIPSX, but then I wouldn't really understand if I was making a good or bad investment.
Thanks again.


I would be concerned that a larger issue here is what constitutes a "good" or "bad" investment.

The first question is what is the overall investment plan. Unless this is a special situation, one would be like almost everyone else in holding a balanced portfolio of stocks and bonds. Bonds are held to dilute the volatility of the portfolio at the cost of less expected return. TIPS are chosen out of bonds because it is a way to insure against inflation (and being able to go a little longer on the yield curve as a consequence). Thus a low cost diverse selection of TIPS in any easy to use TIPS fund can be one of the building blocks of a portfolio.

What the prospective returns of a portfolio conditional on any point in time will be is not under the investor's control by and large. History hands us what we are going to get. In that sense current poor returns on bonds are a fact of life, but not one that makes bonds any more a "good" or "bad" investment than they are under any other forward looking circumstance.
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Re: Need help understanding TIPS

Postby Phineas J. Whoopee » Mon Dec 31, 2012 4:32 pm

Bustoff wrote:Thank you #Cruncher for that great explanation.
Not sure I'm comfortable investing in an asset that is so difficult to understand. I suppose I could throw all caution to the wind and simply put a portion into the VIPSX, but then I wouldn't really understand if I was making a good or bad investment.
Thanks again.

Hi Bustoff,

More than one Boglehead wrote to tell me they found this explanation of TIPS useful:

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=105365#p1530754

Hope that helps.

PJW
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Re: Need help understanding TIPS

Postby abuss368 » Mon Dec 31, 2012 6:04 pm

Bustoff wrote:The SEC yield for VIPSX is –1.09%.

Does that negative yield mean I lose 1.09% on my investment ?
In other words, if I put money into VIPSX tomorrow, and a year later there was no change in the price, would I owe 1.09% ? I don't understand how the negative yield affects the investment.

Obviously I have no understanding of how a TIPS fund works, but I'm considering investing in the Target Retirement Income Fund which holds TIPS. Also, there seems to be a fairly large contingent of Bogleheads who are fond of TIPS so they must play an important role. Just not sure whether the role is for income in retirement or strictly as an inflation hedge.


This was an excellent post that I enjoyed reading the entire thread.

The second part of your question related to "whether the role is for income in retirement or strictly as an inflation hedge" does not appear to have been answered. I am curious of fellow Bogleheads thoughts regarding this.
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Re: Need help understanding TIPS

Postby BrandonBogle » Fri Feb 01, 2013 4:29 am

Wow, this thread and the link to the detailed explanation were very informative.

Looking forward to reading more. As to the previous question of whether TIPS would be a hedge against inflation, it sounds like the answer is yes based on the reading. But I'm a newb, so hopefully others will chime in.
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Re: Need help understanding TIPS

Postby dbr » Fri Feb 01, 2013 9:59 am

BrandonBogle wrote:Wow, this thread and the link to the detailed explanation were very informative.

Looking forward to reading more. As to the previous question of whether TIPS would be a hedge against inflation, it sounds like the answer is yes based on the reading. But I'm a newb, so hopefully others will chime in.


TIPS are "hedged" for inflation in and of themselves but are not a hedge for other investments. To hedge a portfolio for inflation one would have to have an investment that gains in multiples of inflation to offset losses in other investments. The only investment that does that but very imperfectly is equities which promise to outrun inflation but do not deliver on that promise in detail. In fact TIPS are not perfectly correlated with inflation as inflation may be accompanies by rises in real interest rates that depress TIPS values. A more accurate statement might be that TIPS are "insured" against inflation which means adding them to a portfolio reduces the overall sensitivity of the portfolio to inflation by an amount. Also by eliminating inflation risk, a TIPS investor might choose to take more term risk by buying longer bonds.
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Re: Need help understanding TIPS

Postby dbr » Fri Feb 01, 2013 10:03 am

abuss368 wrote:
The second part of your question related to "whether the role is for income in retirement or strictly as an inflation hedge" does not appear to have been answered. I am curious of fellow Bogleheads thoughts regarding this.


Portfolios should not be designed for income; they should be designed for return. To focus only on income is to not pay attention to the whole picture in investing.

The role of TIPS is the same as the role of any bond in the most general sense, including cash equivalents. That role is to dilute the risk of the portfolio by allocating appropriately between risky and not risky assets. TIPS are an alternative among bonds in that using them reduces the sensitivity of the portfolio to inflation. TIPS hardly hedge a whole portfolio against inflation, of course.
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Re: Need help understanding TIPS

Postby FoolStreet » Fri Feb 01, 2013 10:59 am

What helps me understand TIPS are the sec yields of comparative investments, especially ibonds, as follows:

6 mo CPI: 0.88 (annualized at 1.76)
I bond: zero real, +1.76 inflation. Net +1.76 nominal growth
ING Savings Account: 0.8% nominal, meaning a loss of 0.96% purchasing power
TIPS: -1.06 real [plus 1.76 inflation, gives net +.7 NOMINAL yield]
TBM Index: SEC is 1.6 nominal, so loss of 0.16% purchasing power


If at CPI goes up in may, the i-bond holder would get a higher nominal yield due to the higher CPI. So would a TIP holder - except - presumably, as soon as the May CPI number is published, the market forces would reprice the real yield of the fund to even it out. I-bond rates are published every 6 mo. Presumably TIP rates use a CPI published weekly. I-bonds real rates can't go below zero. TIPS real rates can go wherever Mr. Market takes them.

i-bonds are like a better TIP except you can only buy 10k per year. Oh, by the way, vanguard charges a (not unreasonable) .25% frnt-end load to buy their tips fund.

If you want your bonds inflation-adjusted, TIPS aren't that bad, but compared to TBM, or even any similar bond fund, you get a little less return because of the clean peg to inflation given a lot of folks on the street are worried about inflation.


Did I get that right?
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Re: Need help understanding TIPS

Postby stevewolfe » Fri Feb 01, 2013 11:50 am

The 0.25% purchase fee applies only to the Vanguard Short term inflation protected fund (VTAPX) not to the Vanguard Inflation Protected fund which is intermediate term (VIPSX).
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Re: Need help understanding TIPS

Postby gkaplan » Fri Feb 01, 2013 4:26 pm

FoolStreet wrote:Oh, by the way, vanguard charges a (not unreasonable) .25% frnt-end load to buy their tips fund.


It's not a load. It's a purchase fee. There's a difference.
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Re: Need help understanding TIPS

Postby abuss368 » Sat Feb 02, 2013 12:34 pm

Perhaps someday Vanguard will have an intermediate TIPS fund that is indexed.
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Re: Need help understanding TIPS

Postby Angst » Sat Feb 02, 2013 1:07 pm

Bustoff wrote:Thank you #Cruncher for that great explanation.
Not sure I'm comfortable investing in an asset that is so difficult to understand. I suppose I could throw all caution to the wind and simply put a portion into the VIPSX, but then I wouldn't really understand if I was making a good or bad investment.
Thanks again.

I look at the "asset" you're investing in as "bonds", not either nominal or inflation protected bonds. My point is that if you really don't understand TIPs, you can't fully understand nominal bonds either. All bonds entail effects of inflation. Hang in there - don't give up on understanding TIPs! It doesn't mean you have to include them in your bond allocation, but you'll have more confidence in and justification for how you eventually set it.
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