TIPS and other hedges against inflation

[Investor2]

I don't own any TIPS and am a novice on bond issues, but am trying to learn. I thought this article by Walter Updergrave seemed to provide a clear, simple explaination of TIPS and the role they play.

http://money.cnn.com/2013/02/01/pf/expe ... index.html

Basically, the article says that retirees need to protect against two types of inflation - expected inflation and unexpected inflation. Use stocks to hedge against expected long term inflation, TIPS to hedge against unexpected inflation spikes; but use TIPS in moderation, perhaps 25%-30% of bond portfolio (because the more you try to protect against one risk, the more you open yourself up to other risks).

The article also notes that:

Social Security already provides significant inflation protection for retirees.

REITS can provide inflation protection, but if you own a broad stock market index you already have them.

Commodities/gold are not a reliable hedge against inflation.

Do Boglehead generally agree with the above views on TIPS, and on how to protect a retirement portfolio against inflation? Any other suggestions on inflation protection?

[docneil88]

Hi Investor2, Another inflation hedge is of course a home of one's own. 42% of the CPI (Consumer Price Index) is housing (predominately rent and "owner's equivalent rent") (source: http://www.nytimes.com/interactive/2008 ... APHIC.html ).

Also, changes in the yield on cash usually correlate fairly well with changes in the inflation rate, and the average cash yield usually comes fairly close to the inflation rate. (Granted the yield on cash today is about 2% less than the inflation rate, but that is not typical.)

I wouldn't rely on intermediate or long-term TIPS for yearly returns close to the inflation rate, because if real rates spike up, that will cause a drop in TIPS value that could more than offset the 12 month increase in CPI-linked interest payments. But short-term TIPS are a good way to keep up with the inflation rate from one year to the next, e.g. PIMCO's 1-5 Year US TIPS Index ETF, symbol STPZ, with an expense ratio of 0.20%. Best, Neil

[Aptenodytes]

I'd say that summary comes pretty close to what the majority here believed up to about three years ago. Now I would guess that majority has shrunk to more of a significant minority. Many people now think the yields on TIPS are too low to make them an unequivocally good tool for this purpose -- the price they make you pay for their role in protecting against unexpected inflation is too high.

I'm still in the minority (I'm guessing it is a minority based on the tenor of discussions here) that thinks TIPS still work, largely due to the absence of clear alternatives. What docneil88 says about the interest rate risk for TIPS is a risk that can be managed by holding TIPS to maturity. I aim for them to be about 25-30% of my fixed income portfolio, in the form of 10-year notes.

I-bonds are the clear alternative you didn't mention, and I'd guess that almost everyone here thinks that investors worried about inflation should max out their I-bond holdings. But even when you do so it would be hard to get up to 25-30% of your fixed income holdings if you are in or near retirement.

Apart from the limited role of I-bonds, then, lots of people are just sucking it up and facing the risk of unexpected inflation as a lesser evil. I'm still in the accumulation phase and somewhat stock-heavy, so 25-30% of my fixed income portfolio isn't gigantic. I can tolerate the high price without much sweat. But if I were 60% bonds and retired, I would probably be much more more unhappy about TIPS. I don't expect this era of weird bond yields to last that long, though (knock wood).

[dbr]

I think the article was fine.

A point to consider is that TIPS are designed to themselves be compensated for inflation, exactly as measured by CPI, but they don't gain multiples of inflation and therefore are not a hedge that compensates an entire portfolio for inflation. What they do is reduce the sensitivity of the portfolio to inflation, diluting the effect, as it were.

The image of building some magic wall of invulnerability to inflation is a false image.

In reality a person doing financial planning for retirement needs to take account that costs will increase and that the assets needed relative to the spending planned have to take that into account. That is why, for example, there is a big difference in a withdrawal rate models between the rate at which one could take an inflation indexed withdrawal and the rate at which one can take a fixed withdrawal. That is also why funding a retirement on nominal bonds can support only minimal rates of withdrawal. Another example is to consider inflation indexed annuities and compare the payout to fixed annuities. As pointed out SS, especially delaying SS to age 70 is one of the best strategies out there.

PS Please, no one confuse the SPIA with all the other annuities.

[clacy]

I don't think there is any one particular "magic inflation hedge". Here is a good research paper that looks specifically at REIT's as an inflation hedge, but also looks at gold, commodities, tips and stocks.

http://realestate.wharton.upenn.edu/res ... ll/716.pdf

I think you have to keep in mind that not all inflation is created equal. You have everything from hyper-inflation on down to low inflation. You have rising and falling inflation rates as well. I think which asset classes perform best during inflation also has to do with growth rates or lack thereof.

So gold may be a crummy inflation hedge if there is low to moderate inflation and good economic growth, but it's definitely what you want to hold if there is severe or hyper inflation. Commodities might be the best inflation hedge if there is rising growth, but not the best if you have falling growth and so on.

[Browser]

Some flaws in the article: First, TIPS by definition hedge any kind of inflation - expected or unexpected. That's what they're designed to do. They hedge inflation perfectly if they are held to maturity; they are the only asset that does so. Second, TIPS don't lose value if real interest rates increase and they are held to maturity. They have the same real value at maturity that they had when you bought them. Again, that's what they're designed to do. They can only lose value if they are held in mutual fund that trades them, or you trade them yourself. Third, Zvi Bodie would disagree that you need to diversify your TIPS holdings. They are the ideal investment to provide a known real return for retirees and a 100% allocation would be appropriate for most people. He would state that you need to secure the floor of your retirement spending needs with TIPS and I-Bonds before you invest in other assets such as stocks. Investments such as these provide an unknown, risky return and are not suitable for matching spending liabilities.

[Clive]

Any other suggestions on inflation protection?

Manorial or perpetual leases (ground rents) perhaps? Contracts can vary enormously - but some can involve low admin/effort, with ground rents being inflation uplifted.

[Investor2]

Thanks for the very thoughtful responses.

I didn’t realized what a central role real estate plays in hedging against inflation, or that, as docneil88 notes, real estate accounts for 42% of the consumer price index (CPI).

I may already be more hedged against inflation than I realized. I have an interest in an investment property, which I usually ignore when thinking about asset allocation, but, if included, makes up about 1/3 of my total assets, with the remaining 2/3 in the usual stock and bond funds. (This property will be sold in a few years, and then I’ll have to think about the best way to continue to have some real estate exposure.)

Browser, you note Zvi Bodie’s view that we should have a secure floor for essential retirement expenses consisting of TIPS and I Bonds, i.e., a liability matching portfolio. I learned about this concept fairly recently from posts on Bogleheads, and it’s now central to my retirement planning.

My floor will consist of social security (delayed until age 70), a small pension with partial inflation adjustment, and some very conservative investments to cover the SS portion until age 70 (i.e., TSP G fund, all the I Bonds l can buy in the next few years, and possibly a small amount of TIPS – but I think I’ll wait for a more opportune time to buy the TIPS). Apart from this floor, the rest will probably be in a fairly stock heavy portfolio.

clacy, I read the linked paper on REITs and other inflation hedges. It does get a bit complicated, but think I may add some REITs once I no longer have the investment property.

[clacy]

clacy, I read the linked paper on REITs and other inflation hedges. It does get a bit complicated, but think I may add some REITs once I no longer have the investment property.

Investor2, keep in mind that this study was done by a VP of NAREIT, so there is some bias. They do also point out that the best overall inflation hedge might be an energy index. Shifting some money to an energy related fund might be something to consider, although like many hard assets and inflation hedges, these have a fairly high amount of volatility.

[docneil88]

In addition to PIMCO's short term TIPS index ETF (STPZ) with a 0.20% expense ratio, there is now a Vanguard short term TIPS index ETF (VTIP http://finance.yahoo.com/q?s=vtip&ql=1 ) with a 0.10% expense ratio, and a Vanguard short term TIPS index mutual fund (VTIPX) with a 0.20% expense ratio. Here's Vanguard's summary of VTIPX: https://personal.vanguard.com/us/funds/ ... IntExt=INT . Here's

[umfundi]

Thanks for the very thoughtful responses.

I didn’t realized what a central role real estate plays in hedging against inflation, or that, as docneil88 notes, real estate accounts for 42% of the consumer price index (CPI).

I may already be more hedged against inflation than I realized. I have an interest in an investment property, which I usually ignore when thinking about asset allocation, but, if included, makes up about 1/3 of my total assets, with the remaining 2/3 in the usual stock and bond funds. (This property will be sold in a few years, and then I’ll have to think about the best way to continue to have some real estate exposure.)

Browser, you note Zvi Bodie’s view that we should have a secure floor for essential retirement expenses consisting of TIPS and I Bonds, i.e., a liability matching portfolio. I learned about this concept fairly recently from posts on Bogleheads, and it’s now central to my retirement planning.

My floor will consist of social security (delayed until age 70), a small pension with partial inflation adjustment, and some very conservative investments to cover the SS portion until age 70 (i.e., TSP G fund, all the I Bonds l can buy in the next few years, and possibly a small amount of TIPS – but I think I’ll wait for a more opportune time to buy the TIPS). Apart from this floor, the rest will probably be in a fairly stock heavy portfolio.

clacy, I read the linked paper on REITs and other inflation hedges. It does get a bit complicated, but think I may add some REITs once I no longer have the investment property.

Investor2,

I think you have a very good outlook. Zvi Bodie is (I think) somewhat conservative and absolute. For a more balanced view (in my opinion) take a look at Michael Zwecher and Jim Otar. Christine Benz of Morningstar has some online videos of how these ideas might play out.

The other thing I would caution against is searching too hard for proxies to protect against inflation. As I just said in another thread, inflation is the increase in the price of goods and services. If you want inflation protection, invest in goods and services. Unfortunately, goods and services have other risks like fluctuations in economic activity, so it's not quite that simple.

And, let me add: TIPS etc. are perfect inflation protection for only the money you have in TIPS etc.

Keith

[khh]

Would a 5-year CD ladder be a good option?

[larryswedroe]

Khh
That would give you a relatively short duration which provides a reasonable hedge against all but hyperinflation. Rates would likely rise but you'll lag by the average maturity.
Larry

[Browser]

Khh
That would give you a relatively short duration which provides a reasonable hedge against all but hyperinflation. Rates would likely rise but you'll lag by the average maturity.
Larry

Unless you redeem early (and reduce return by taking the penalty).

[larryswedroe]

Browser that is if you have that option. Some CDs do, some don't. And have to consider that cost. But yes that is true and in general banks that offer this feature are dumb, vastly underpricing the feature
Larry

[Investor2]

Khh, Larry and Browser, thanks for the discussion of 5-year CD ladders. I can see how this would allow retirees to keep a few years of cash on hand, while still retaining some protection against inflation. This is another strategy I may use. This alone probably wouldn't work for me though, as I'm hoping to retire in my late 50s and so will have have an 11-12 year period to cover before SS at 70 - never heard of anyone using an 11 or 12-year CD ladder . . .

Zvi Bodie is (I think) somewhat conservative and absolute. For a more balanced view (in my opinion) take a look at Michael Zwecher and Jim Otar. Christine Benz of Morningstar has some online videos of how these ideas might play out.

Just ordered the PDF version of Jim Otar's book - it looks excellent!

And, let me add: TIPS etc. are perfect inflation protection for only the money you have in TIPS etc.

Yes, good point.

In addition to PIMCO's short term TIPS index ETF (STPZ) with a 0.20% expense ratio, there is now a Vanguard short term TIPS index ETF (VTIP http://finance.yahoo.com/q?s=vtip&ql=1 ) with a 0.10% expense ratio, and a Vanguard short term TIPS index mutual fund (VTIPX) with a 0.20% expense ratio. Here's Vanguard's summary of VTIPX: https://personal.vanguard.com/us/funds/ ... IntExt=INT . Here's

An interesting development. As Vanguard is completely replacing the previous TIPS fund with the short term TIPS version in some of its Target Retirment Funds, I wonder if short term TIPS will soon be considered the new standard. Will be something to consider once I'm ready to buy TIPS.

[umfundi]

An interesting development. As Vanguard is completely replacing the previous TIPS fund with the short term TIPS version in some of its Target Retirment Funds, I wonder if short term TIPS will soon be considered the new standard. Will be something to consider once I'm ready to buy TIPS.

Subscribe to Mike Piper:

http://www.obliviousinvestor.com/invest ... d-changes/

Keith

[Browser]

Short term TIPS have a much higher correlation to inflation than longer term TIPS. Longer term TIPS have a lot of "tracking error" relative to the CPI. Holding short TIPS would be particularly important to people who are in the spending stage and have current spending liabilities. When first issued TIPS had a decent real yield. But as they became better understood and utilized TIPS have morphed into an asset that is essentially little more than inflation insurance, and you are paying for that insurance with near zero or negative real yields. It seems doubtful that TIPS will ever have decent real yields again in the future, except for brief events such as 2008 when there was a liquidity squeeze. Since short term TIPS are better inflation insurance than long term TIPS, you are paying a higher "premium" for that insurance with larger negative yields. Unless you need that level of coverage, paying that extra premium seems somewhat foolish. You should match the duration of TIPS to your spending liabilities.

[dbr]

Short term TIPS have a much higher correlation to inflation than longer term TIPS. Longer term TIPS have a lot of "tracking error" relative to the CPI. Holding short TIPS would be particularly important to people who are in the spending stage and have current spending liabilities. When first issued TIPS had a decent real yield. But as they became better understood and utilized TIPS have morphed into an asset that is essentially little more than inflation insurance, and you are paying for that insurance with near zero or negative real yields. It seems doubtful that TIPS will ever have decent real yields again in the future, except for brief events such as 2008 when there was a liquidity squeeze. Since short term TIPS are better inflation insurance than long term TIPS, you are paying a higher "premium" for that insurance with larger negative yields. Unless you need that level of coverage, paying that extra premium seems somewhat foolish. You should match the duration of TIPS to your spending liabilities.

Inflation "insurance" and correlation with inflation are two completely different things.

[umfundi]

The title of this thread:

TIPS and other hedges against inflation

Why do you call TIPS a "hedge"? Sure, they are sort of "protected" against inflation, but to me "hedge" implies some kind of leverage, which they do not have.

Keith

[Phineas J. Whoopee]

Hi Browser,

I'm afraid there are several misconceptions in the post.

Short term TIPS have a much higher correlation to inflation than longer term TIPS.

They have a higher correlation to inflation year-to-year, but there's no reason to think they will be more (or less) correlated to long term inflation than longer-term TIPS. Of course funds roll their bonds, so short- or long-term, the inflation protection will be ongoing.

Longer term TIPS have a lot of "tracking error" relative to the CPI.

While I think I get what you mean, TIPS are not designed to "track" CPI over short periods of time.

Holding short TIPS would be particularly important to people who are in the spending stage and have current spending liabilities.

The behavior of a single component of a portfolio is not important; the total return is. For some investors' portfolios short-term TIPS can add desirable characteristics. For others', the reverse may be true.

When first issued TIPS had a decent real yield. But as they became better understood and utilized TIPS have morphed into an asset that is essentially little more than inflation insurance, and you are paying for that insurance with near zero or negative real yields. It seems doubtful that TIPS will ever have decent real yields again in the future, except for brief events such as 2008 when there was a liquidity squeeze.

It sounds as if you're saying their behavior up to 2007 will never happen again, and what's occurring now will continue without end. Is that what you meant?

Since short term TIPS are better inflation insurance than long term TIPS, you are paying a higher "premium" for that insurance with larger negative yields.

Short- and long-term TIPS receive the same inflation adjustments, thus are equally protected against inflation. They are not equally exposed to interest rate risk, and therefore have different expected returns.

Unless you need that level of coverage, paying that extra premium seems somewhat foolish.

The premise, as shown above, is incorrect, therefore this statement does not follow.

You should match the duration of TIPS to your spending liabilities.

Despite the rest, this is pretty good. It's just like any bond fund in that as long as you intend to hold beyond the average duration, changes in NAV due to interest rates will be cancelled out by changes in yield as long as you reinvest dividends. It's worth noting that in funds the inflation protection is paid out as a dividend, so if spent the portfolio component will not keep up with the compounding of inflation.

On a wider note, this is the fourth time in recent days a post has said X-term TIPS are better inflation protection than Y-term TIPS. I wonder why it's coming up now, in a cluster.

Thanks Browser for giving me the opportunity to expound on these points.

PJW

[Browser]

PJW - Take a look at this article from Vanguard. It is relevant to some of your points.

https://personal.vanguard.com/us/insights/article/inflation-TIPS-012013

PJW:

While I think I get what you mean, TIPS are not designed to "track" CPI over short periods of time

Vanguard:

So when we think back to the reasons for including inflation sensitive assets in a portfolio, there's a tradeoff between short-term TIPS and long-term TIPS. Short-term TIPS offer better inflation tracking properties.

PJW:

The behavior of a single component of a portfolio is not important; the total return is.

Vanguard:

There are really two ways an investor can address the risk of inflation when they're choosing investments and designing a strategic asset allocation. One avenue to take—and this is perhaps a more traditional approach—is to go about choosing assets that you expect to have a higher return, offer a higher risk premium than that inflation expectation over the long run.

The second way to address inflation in portfolio construction is where you choose assets that are highly correlated with inflation over a short time horizon. Now, TIPS fit this description quite nicely. They have an indexation mechanism where their principal is indexed to the Consumer Price Index. So, the principal rises and coupon payments rise with inflation over time. So, in some sense, they're the ideal asset for this kind of inflation-tracking strategy because their income is directly derived from movements in inflation.

[dbr]

PJW - Take a look at this article from Vanguard. It is relevant to some of your points.

https://personal.vanguard.com/us/insights/article/inflation-TIPS-012013

PJW:

While I think I get what you mean, TIPS are not designed to "track" CPI over short periods of time

Vanguard:

So when we think back to the reasons for including inflation sensitive assets in a portfolio, there's a tradeoff between short-term TIPS and long-term TIPS. Short-term TIPS offer better inflation tracking properties.

PJW:

The behavior of a single component of a portfolio is not important; the total return is.

Vanguard:

There are really two ways an investor can address the risk of inflation when they're choosing investments and designing a strategic asset allocation. One avenue to take—and this is perhaps a more traditional approach—is to go about choosing assets that you expect to have a higher return, offer a higher risk premium than that inflation expectation over the long run.

The second way to address inflation in portfolio construction is where you choose assets that are highly correlated with inflation over a short time horizon. Now, TIPS fit this description quite nicely. They have an indexation mechanism where their principal is indexed to the Consumer Price Index. So, the principal rises and coupon payments rise with inflation over time. So, in some sense, they're the ideal asset for this kind of inflation-tracking strategy because their income is directly derived from movements in inflation.

I think the statements quoted from Vanguard above are garbage. I don't know why they write articles like that.

PS Smart people say dumb things sometimes. That does not apply to me because I am not that smart about this stuff.

[umfundi]

PS Smart people say dumb things sometimes. That does not apply to me because I am not that smart about this stuff.

Ah, The Forrest Gump of Bogleheads.

Keith

[Phineas J. Whoopee]

PJW - Take a look at this article from Vanguard. It is relevant to some of your points.

https://personal.vanguard.com/us/insights/article/inflation-TIPS-012013

PJW:

While I think I get what you mean, TIPS are not designed to "track" CPI over short periods of time

Vanguard:

So when we think back to the reasons for including inflation sensitive assets in a portfolio, there's a tradeoff between short-term TIPS and long-term TIPS. Short-term TIPS offer better inflation tracking properties.

You've left out the context immediately above what you quoted. If I may:

Short term TIPS have a much higher correlation to inflation than longer term TIPS.

They have a higher correlation to inflation year-to-year, but there's no reason to think they will be more (or less) correlated to long term inflation than longer-term TIPS. Of course funds roll their bonds, so short- or long-term, the inflation protection will be ongoing.

In the article (thank you for the link) when Thomas says inflation he seems always to mean over the short term. It would have been better if that were made explicit. Long term inflation, of course, is the result of compounding short-term inflation.

PJW:

The behavior of a single component of a portfolio is not important; the total return is.

Vanguard:

There are really two ways an investor can address the risk of inflation when they're choosing investments and designing a strategic asset allocation. One avenue to take—and this is perhaps a more traditional approach—is to go about choosing assets that you expect to have a higher return, offer a higher risk premium than that inflation expectation over the long run.

The second way to address inflation in portfolio construction is where you choose assets that are highly correlated with inflation over a short time horizon. Now, TIPS fit this description quite nicely. They have an indexation mechanism where their principal is indexed to the Consumer Price Index. So, the principal rises and coupon payments rise with inflation over time. So, in some sense, they're the ideal asset for this kind of inflation-tracking strategy because their income is directly derived from movements in inflation.

Thank you for silently eliding the last two thirds of my paragraph. In full it reads:

The behavior of a single component of a portfolio is not important; the total return is. For some investors' portfolios short-term TIPS can add desirable characteristics. For others', the reverse may be true.

I see no contradiction between what I wrote (in full) and the part of Thomas's interview you quoted.

I welcome and learn from discussion, but if rebuttals to what I wrote could be based on what I actually wrote, I would be grateful.

PJW

[Browser]

I'd respond but I don't think the discrepancies are worth haggling about. Short term bonds behave differently from long term bonds, whether they are TIPS or nominals because of shorter durations. If you want bonds whose returns more closely track inflation expectations, whether TIPS or nominals, then you want shorter duration bonds. If you want bonds with higher expected returns, whether TIPS or nominals, you want longer term bonds if you are willing to accept the term risk. You don't get to have both.