bertilak wrote: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.
- 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).