TIPS % in Bond Allocation

[Alf 101]

The title of this post tells most of the story, but I'm curious as I study the role TIPS can play in a portfolio. In my situation I have about 30 years to retirement -- perhaps less if things go well as a I stay the course, perhaps more if there's something unforeseen or if work is something I very much enjoy at that point.

Over a year ago I rolled a 401K from a job of many years into a Traditional IRA at Vanguard. In setting my bond allocation, for some reason I allocated 75% of this into the TBM, and 25% into the Vanguard TIPS fund (VIPSX). I'm not saying this was my dumbest move, but I may have picked these percentages based on how much "new" money I had to allocate and what would be a close, round, number. There is a chance I had a more sophisticated rationale on top of this, and I have since forgotten it too.

To shed some light I this I decided to cross-reference the VG Target Retirement date funds. From TR 2060 to TR 2020, all bond holdings are in a total bond market fund. Only in TR 2015 do TIPS show up as 3.5% of the total portfolio (8.0% of total bond holdings). For TR 2010, the VG TIPS fund comprises 12.5% of the total portfolio (23.1% of all the bonds).

Not that I view the Target Retirement funds as an allocation guide (TR 2040, which best fits my timeline, seems a mite aggressive at 90/10). Still, and there's a good chance this has been posted earlier, I'm wondering what schools of thought exist on TIPS allocation. Specifically:

1. The ratio of TIPS (VIPSX) to Total Bond funds in a portfolio
2. How this should shift over time as retirement draws closer

There may not be a rule of thumb so simple as age in bonds, or age minus 10% or 20% in bonds, for TIPS. Or there could be. I checked today and saw, with how the market is performing thus far in 2012, that I am nearing my rebalancing band for bonds. How I divvy up my simple bond allocation though, is something I want to better consider moving forward, and I do greatly appreciate any thoughts on the matter.

[chaz]

A very personal choice.

[bertilak]

When I had a conversation with one of Vanguard's CFPs he discouraged me from holding *any* TIPS at all. His reasoning was that all bonds already are priced with the market consensus of a fair price -- including the consideration of future inflation. TIPS are a gamble for *unexpected* inflation (inflation not already priced into nominal bonds) and who are we to disagree with the market consensus on future inflation? We accept the market consensus on fair pricing of stocks, why not the same for bonds?

None the less, I have heard arguments that one should be 100% TIPS!

I don't know who to believe! So I, somewhat arbitrarily, have 1/3 of my bond allocation in TIPS. I do have a hazy justification for this -- I think of it as insurance. We don't *expect* our house to burn down but we buy fire insurance anyway. TIPS also add another dimension to the diversification of my bond holdings. (The rest is in Vanguard's Total Bond Market.)

[Taylor Larimore]

Hi Alf:

I think your 25% TIPS/75% Total Bond Market is an excellent combo for the bond part of your portfolio. Personally, we have held a 50%/50% combination of these two bond funds for over 10 years with very satisfactory results. I don't intend to change.

No one knows the perfect combination except in hindsight. When a decision is difficult it is often because the answer is unknowable or it doesn't make any difference.

Best wishes.
Taylor

[abuss368]

David Swensen of Unconventional Success, and Yale University's endowment manager, recommends a 50% allocation to TIPS (the other 50% was treasuries).

Unrelated, I am curious how bond allocations may or may not change once Vanguard launches the new Total International Bond Index fund.

[YDNAL]

The title of this post tells most of the story, but I'm curious as I study the role TIPS can play in a portfolio. In my situation I have about 30 years to retirement -- perhaps less if things go well as a I stay the course, perhaps more if there's something unforeseen or if work is something I very much enjoy at that point.

If your name was Steve Jobs and your work situation develops* like his for the next 30 years, you wouldn't need TIPS at all in your portfolio today or later.

There is lots of rhetoric (and speculation) on this subject.

* the best protection against Inflation are wages, career development, etc.

[SteveB3005]

When a decision is difficult it is often because the answer is unknowable or it doesn't make any difference.

This needs to be put on a plaque over the door to the place.

[Index Fan]

I personally hold 1/3 of my fixed income in TIPS, but as Taylor has said, I don't think there's any solid optimal calculation for this percentage. I'd be fine with anything between 25% and 50% of bonds in TIPS.

As far as not holding TIPS, I'd disagree with that. Since the inception of VIPSX, it's been a nice diversifier in regards to Total Bond Market Index.

VIPSX (2001-2011)

7.61
16.61
8.00
8.27
2.59
0.43
11.59
-2.85
10.80
6.17
13.24

VBMFX (2001-2011)

8.43
8.26
3.97
4.24
2.40
4.27
6.92
5.05
5.93
6.42
7.56

I like how the Target Retirement funds add more TIPS as the fund nears the retirement date. In retirement, inflation is more of a concern due to the greater amount of fixed income in a portfolio. Personally, I'd like to see the TR funds add some TIPS earlier than they do, but I don't know how important this is, really.

[abuss368]

It would be nice for Vanguard to consider adding TIPS to all the target retirement funds and a higher percentage (20% - 50% of the bond allocation).

[Valuethinker]

When I had a conversation with one of Vanguard's CFPs he discouraged me from holding *any* TIPS at all. His reasoning was that all bonds already are priced with the market consensus of a fair price -- including the consideration of future inflation. TIPS are a gamble for *unexpected* inflation (inflation not already priced into nominal bonds) and who are we to disagree with the market consensus on future inflation? We accept the market consensus on fair pricing of stocks, why not the same for bonds?

None the less, I have heard arguments that one should be 100% TIPS!

I don't know who to believe! So I, somewhat arbitrarily, have 1/3 of my bond allocation in TIPS. I do have a hazy justification for this -- I think of it as insurance. We don't *expect* our house to burn down but we buy fire insurance anyway. TIPS also add another dimension to the diversification of my bond holdings. (The rest is in Vanguard's Total Bond Market.)

Empirically, market forecasts of future prices are poor.

The yield curve also does not well forecast the future *nominal* interest rate.

I am thinking particularly of commodities futures curves.

But research I have seen, comparing 2 methods of forecasting future interest rates, future oil prices:

1. it stays the same as this period in the next period
2. it moves as the forward curve would predict

1 beats 2.

This is not to say that we have a *better* way of predicting the future inflation rate than the market. But that the market rate is just not a very good one.

So we have to think about our own *liabilities*.

My liabilities are basically real quantities (other than my mortgage) ie future consumption will be in pounds and dollars then, after inflation.

So if I neutralize inflation risk from my portfolio, I have gained something, even if the market was *wrong* about future inflation. If sometime between now and retirement inflation takes off, then I had insurance against that (in tax exempt accounts) that I just did not have in conventional bonds.

Now it's a moot point now, where bond markets are not offering protection against future *expected* inflation, RRB/ TIPS yields are so low.

So basically by investing in TIPS i normally gain something that I just don't get investing in conventional bonds. Protection of my real buying power. Now you know why Zvi Bodie has advocated 100% TIPS in retirement portfolios.

That said:

- TIPS are a lot more volatile than inflation, empirically, is. Ie they have a degree of speculation in their prices, driven by market volatility. That's OK if we buy and hold to maturity, it's less OK if we own funds. As the time to retirement gets below the duration of the TIPS, we need to think about switching more into nominal bonds, CDs, etc.

- ST bond funds have a pretty high correlation with inflation, and so offer a degree of inflation protection similar to TIPS in all but extreme cases.

If one has say 30 years to go to retirement, then I think one's fixed income should be 100% in TIPS (in an equity dominated portfolio). That said, current TIPS yields make only the 20 year+ ones remotely attractive to me (that's a market timing call, though, highly non BH).

[Valuethinker]

David Swensen of Unconventional Success, and Yale University's endowment manager, recommends a 50% allocation to TIPS (the other 50% was treasuries).

Unrelated, I am curious how bond allocations may or may not change once Vanguard launches the new Total International Bond Index fund.

if the fund is currency hedged, it will have relatively little impact on final total portfolio value. Bond yields in most developed markets have converged sharply, and of course Japan they are well below other countries (JGB market is number 2 to the USA in sovereign bond markets).

If fund is not currency hedged, then the volatility will be impressive-- you will have actually made the total portfolio more risky (for a US based investor) for many bond-equity weightings.

[PB]

As the time to retirement gets below the duration of the TIPS, we need to think about switching more into nominal bonds, CDs, etc.

Valuethinker: I'm relatively new and want to be sure I understand your POV:

Are you saying this only because of the likelihood that interest rates will rise in the relatively near future?

Or do you disagree in general with the common recommendation that retirees hold more TIPS, ala the VG Target Retirement funds, including the Target Income Fund?

Thanks.

[bertilak]

This is not to say that we have a *better* way of predicting the future inflation rate than the market. But that the market rate is just not a very good one.

Agreed. When I say we accept market pricing I'm not saying that it is especially accurate, but saying we can't really do any better. (Thus diversify.)

As the time to retirement gets below the duration of the TIPS, we need to think about switching more into nominal bonds, CDs, etc.

Perhaps this is why the Vanguard CFP recommended I stay away from TIPS as I am already retired. But, although retired, I don't expect to need to draw from my investments for a few years yet and that will be when RMDs kick in. Point being I still have about 5 years of accumulation (although no new contributions) to go. This is borderline with TBM having a duration of about 5 years. Maybe my 1/3 TIPS is about right. Maybe in a year I'll cut back some more. Maybe by then I'll have a better understanding of all this. As suggested above, maybe it doesn't really matter!

[mickeyd]

The FI part of my AA runs about 40% and of that 40%, about half sits in the TIPS fund and the other half resides in the I/T fund. This mix, for me, has been in place for around 10 years or so.

Is it the correct mix for a long-term investor? How do I know? I'll be glad to post back in 20-30 years to advise you if it worked or not.

[bling]

does the investment horizon of the investor make a difference? from the comments so far it looks like TIPS is more valuable the closer you approach retirement....so as a young investor who has a high equity allocation, you're better off with 100% bonds for your bond allocation. thoughts?

[Munir]

It would be nice for Vanguard to consider adding TIPS to all the target retirement funds and a higher percentage (20% - 50% of the bond allocation).

I have the opposite point of view. I wish that Target Retirement Income had less than 10% TIPS or none at all. 70% of its fixed income holdings are already in Total Bond Bond Index which is very heavy in treasuries and MBS. When you add the 20% TIPS, it becomes very lopsided (in my view) since I would like a 30-40% position in investment grade corporate bonds in my fixed income portfolio for their higher yield. I know many do not agree but I would like see such an option among the Vanguard income retirement funds.

[staythecourse]

does the investment horizon of the investor make a difference? from the comments so far it looks like TIPS is more valuable the closer you approach retirement....so as a young investor who has a high equity allocation, you're better off with 100% bonds for your bond allocation. thoughts?

Sounds funny to say, but I think it's the other way around. There is a great paper by Vanguard regarding inflation hedges to expected and unexpected inflation. If you read into some of the data presented in the paper it would seem TIPS has a high correlation to inflation in the short term (1 year), but not at 3 years. This is likely because unexpected inflation (both higher then expected AND lower then expected) usually resolved quickly in line with expected inflation. Likely because as new information is presented it is quickly assimilated into all pricing (EMH).

SO you are holding TIPS more for short term unexpected inflation then you are long term. The premium that one is paying with TIPS seems to be short term protection. If that is true a short time horizon would seem to be a better fit with TIPS then a long term horizon (which gives time for the unexpected inflation to be in line with expected inflation).

Good luck.

[CyberBob]

If you own Total Bond, which holds things by market weight, shouldn't TIPS also be held by market weight?

Let's see, the outstanding marketable treasury securites held by the public is $10,048,852,000,000, and the amount of that in TIPS is $745,457,000,000, or roughly 7%.

And according to Vanguard, the Total Bond Market Index Fund is 43.1% Treasury/Agency (not all treasury, but close enough for a rough estimate), so that would mean that if TIPS were included in the Total Bond Index Fund in their actual market weight, that they would be a bit over 3% of the fund. So, 97% Total Bond and 3% TIPS?

Bob

[TheEternalVortex]

Now it's a moot point now, where bond markets are not offering protection against future *expected* inflation, RRB/ TIPS yields are so low.

Well, so are Treasuries. You have to move out to riskier bonds to beat expected inflation.

[staythecourse]

If you own Total Bond, which holds things by market weight, shouldn't TIPS also be held by market weight?

Let's see, the outstanding marketable treasury securites held by the public is $10,048,852,000,000, and the amount of that in TIPS is $745,457,000,000, or roughly 7%.

And according to Vanguard, the Total Bond Market Index Fund is 43.1% Treasury/Agency (not all treasury, but close enough for a rough estimate), so that would mean that if TIPS were included in the Total Bond Index Fund in their actual market weight, that they would be a bit over 3% of the fund. So, 97% Total Bond and 3% TIPS?

Bob

This is the reason I make fun of some of the "market weight" folks on this site. NO ONE holds the market weight. The amount of TIPS to total bonds for the market weighters is good evidence of that.

Good luck.

[Valuethinker]

If you own Total Bond, which holds things by market weight, shouldn't TIPS also be held by market weight?

Let's see, the outstanding marketable treasury securites held by the public is $10,048,852,000,000, and the amount of that in TIPS is $745,457,000,000, or roughly 7%.

And according to Vanguard, the Total Bond Market Index Fund is 43.1% Treasury/Agency (not all treasury, but close enough for a rough estimate), so that would mean that if TIPS were included in the Total Bond Index Fund in their actual market weight, that they would be a bit over 3% of the fund. So, 97% Total Bond and 3% TIPS?

Bob

Bob

Then you are a victim of US Treasury policy.

Consider: the UK government is 25% index-linked gilts (by value outstanding).

So a UKian gets more inflation protection than a USian? That's rational based on their needs?

[Valuethinker]

Now it's a moot point now, where bond markets are not offering protection against future *expected* inflation, RRB/ TIPS yields are so low.

Well, so are Treasuries. You have to move out to riskier bonds to beat expected inflation.

Or you move to relatively short term bonds and CDs.

[Valuethinker]

As the time to retirement gets below the duration of the TIPS, we need to think about switching more into nominal bonds, CDs, etc.

Valuethinker: I'm relatively new and want to be sure I understand your POV:

Are you saying this only because of the likelihood that interest rates will rise in the relatively near future?

Or do you disagree in general with the common recommendation that retirees hold more TIPS, ala the VG Target Retirement funds, including the Target Income Fund?

Thanks.

Generally you should hold fixed income instruments with maturities at or below your need for cash. you can proxy that with the duration (in years) of the bond. Albeit TIPS have real duration, which is harder to make meaningful.

Retirees should hold TIPS in proportion to their prospective cash needs (above Social Security and Medicare, which are inflation linked) in similar durations to those needs.

[TheEternalVortex]

Now it's a moot point now, where bond markets are not offering protection against future *expected* inflation, RRB/ TIPS yields are so low.

Well, so are Treasuries. You have to move out to riskier bonds to beat expected inflation.

Or you move to relatively short term bonds and CDs.

Yes, you can do better with CDs. If you go out to 7 years you can get 2.7%. But short-term CDs don't offer such high rates, you'll get more like 1% which is below expected inflation.