Buying TIPS through VBS vs. TreasuryDirect vs VIPSX

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Buying TIPS through VBS vs. TreasuryDirect vs VIPSX

Postby cb474 » Wed Aug 25, 2010 8:42 pm

I have a multipronged question about TIPS.

1) What are the advantages/disadvantages to buying TIPS through a Vanguard Brokerage Account as opposed to through TreasuryDirect?

2) Is the main advantage to VIPSX vs buying TIPS directly the convenience of an open ended mutual fund (since there's no credit risk and therefore no diversification benefit with TIPS)? And is the main disadvantage of VIPSX the volatility in the share price? I guess I'm thinking that an advantage to buying TIPS directly right now would be to protect principle. If interest rates go up, I would avoid an precipitous drop in price of VIPSX shares and the short term loss in real return that might result.

Thanks.
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Postby SSSS » Wed Aug 25, 2010 9:05 pm

If you're talking about holding TIPS in a taxable brokerage account at Vanguard, that's the same as holding them at Treasury Direct. TIPS are really annoying in a taxable account because you have to pay tax on the "phantom income" of the inflation adjustments even those gains are still locked up inside the bond.

Holding them in an IRA brokerage account at Vanguard takes care of all the tax stuff.

Yes, VIPSX will fluctuate in value based various factors such as people's opinions regarding inflation, people's opinions regarding interest rates, actual changes in interest rates, and possibly other reasons including no particular reason.
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Postby dbr » Wed Aug 25, 2010 9:09 pm

The market value of individual bonds also fluctuates but eventually comes to rest at the redemption value when the bond matures.
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Postby amh » Wed Aug 25, 2010 9:13 pm

In the scenario where you hold individual TIPS and the interest rates rise, the value of your individual TIPS holdings will decrease as well. If you hold them to maturity, their "transient" value on the secondary market is of no concern. Similarly, if you hold shares of VIPSX long enough, the fund will eventually roll over to new TIPS at the higher rate. Holding shares of the fund and building your own bond ladder are equivalent in this respect. So the NAV volatility is mainly a concern for speculators, provided you match the average fund maturity to your own timeframe.

At least, that's the argument as I understand it.
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Postby joe8d » Wed Aug 25, 2010 9:26 pm

Yes, VIPSX will fluctuate in value based various factors such as people's opinions regarding inflation, people's opinions regarding interest rates, actual changes in interest rates, and possibly other reasons including no particular reason.

So true :)
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Postby cb474 » Thu Aug 26, 2010 3:00 am

SSSS wrote:If you're talking about holding TIPS in a taxable brokerage account at Vanguard, that's the same as holding them at Treasury Direct.

So there are no extra fees or expenses associated with purchasing TIPS through VBS vs. TreasuryDirect?

dbr wrote:The market value of individual bonds also fluctuates but eventually comes to rest at the redemption value when the bond matures.

amh wrote:In the scenario where you hold individual TIPS and the interest rates rise, the value of your individual TIPS holdings will decrease as well. If you hold them to maturity, their "transient" value on the secondary market is of no concern. Similarly, if you hold shares of VIPSX long enough, the fund will eventually roll over to new TIPS at the higher rate. Holding shares of the fund and building your own bond ladder are equivalent in this respect. So the NAV volatility is mainly a concern for speculators, provided you match the average fund maturity to your own timeframe.

Yes, I probably should have specified that I was imagining holding the TIPS bonds to maturity. I that case, unlike VIPSX, a TIPS ladder of my own making would never have a negative return, right? Whereas VIPSX in short run might. I recognize that in the long run it should all be a wash. But in the short run with VIPSX I could have a negative return, including something pretty severe like in 2008. So in that sense, it seems to me like a TIPS ladder of my own making could be less volatile than VIPSX. But the downside would be that it's less convenient that just investing in VIPSX.

Or is there some downside that I'm not seeing to a TIPS ladder of my own making, where all the bonds are held until maturity? Is that how VIPSX works? Does Vanguard hold all the bonds in VIPSX to maturity?

Thanks to everyone for the responses.
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Postby Bob's not my name » Thu Aug 26, 2010 6:49 am

cb474 wrote:I was imagining holding the TIPS bonds to maturity.
But in the short run with VIPSX I could have a negative return.
Read what amh wrote again. I don't think I could improve on it. You can also read the wiki on the issue of bond fund vs. individual bonds.
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Postby dbr » Thu Aug 26, 2010 10:22 am

cb474 wrote:But in the short run with VIPSX I could have a negative return, including something pretty severe like in 2008. So in that sense, it seems to me like a TIPS ladder of my own making could be less volatile than VIPSX. But the downside would be that it's less convenient that just investing in VIPSX.

Or is there some downside that I'm not seeing to a TIPS ladder of my own making, where all the bonds are held until maturity? Is that how VIPSX works? Does Vanguard hold all the bonds in VIPSX to maturity?

Thanks to everyone for the responses.


The key question is why and how much do you care that VIPSX could have a negative return over some particular period of time. If you have an important reason why this is a problem, you would avoid a fund. If you don't have a good reason why this is a problem, then you don't need to worry about it.

Convenience is one reason to own a fund. Another reason is that it is simple and requires no intervention to manage things. Did I tell you about a person I know that ended up with about $500,000 in a checking account because as a result of dementia they stopped maintaining their bond ladder?
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Postby insurancerenegade » Thu Aug 26, 2010 10:24 am

There is an important difference between bond funds and holding your own ladder of bonds (TIPS or otherwise). Bond funds maintain constant maturity (and duration) and if interest rates rise shortly before you need to withdraw cash you will take a loss based on the average duration of the bonds in the fund. Individual TIPS (or other bonds) held to maturity have maturities and durations that decrease with time so that if an interest rate increase comes comes later in your planned holding period, individual bonds will perform much better than the funds.
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Postby dbr » Thu Aug 26, 2010 10:40 am

insurancerenegade wrote:There is an important difference between bond funds and holding your own ladder of bonds (TIPS or otherwise). Bond funds maintain constant maturity (and duration) and if interest rates rise shortly before you need to withdraw cash you will take a loss based on the average duration of the bonds in the fund. Individual TIPS (or other bonds) held to maturity have maturities and durations that decrease with time so that if an interest rate increase comes comes later in your planned holding period, individual bonds will perform much better than the funds.


Good comments. Remember though, a better comparison is a perpetual ladder that does indeed have a more or less constant average maturity and duration, but an opportunity to withdraw cash from maturing rather than sold bonds.

The key question is what is the purpose in holding the bonds? People seem to focus on the individual investment in terms of "getting back what I put in" without considering what they are doing with their portfolio as a whole.
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Postby Bob's not my name » Thu Aug 26, 2010 2:35 pm

I learned about bonds vs. bond funds by reading the wiki and threads on this forum, so I'm not being high and mighty here, but a common theme in such threads is the comparing of individual bonds held equanimously to maturity vs. panicked selling of a bond fund when NAV is down. These apples are delicious, while these oranges get poor mileage.
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Postby insurancerenegade » Thu Aug 26, 2010 4:24 pm

dbr wrote:The key question is what is the purpose in holding the bonds? People seem to focus on the individual investment in terms of "getting back what I put in" without considering what they are doing with their portfolio as a whole.


Great point! If you are using bonds as part of an AA structure and rebalancing peridically as you accumulate assets, the difference between bond funds and individual bonds in terms of interest rate risk is minimal. If you are actually withdrawing cash from your portfolio in retirement to pay your living expenses (not every withdrawal from a bond fund when NAV is down is panicked) then laddered bonds are vastly lower in interest rate risk than a bond fund. My 2013 through 2022 expected living expenses are all in laddered munis that I bought years ago (2011 and 2012 are in cash...I retired two years earlier than my original plan.) If instead I need to withdraw those amountseach year from my intermediate bond funds, I'd be a lot less sanguine about interest rate risk.

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Postby cb474 » Thu Aug 26, 2010 4:39 pm

I appreciate everyone's replies. I have in fact read the wiki about individual bonds vs. bond funds. And I'm reading Swedroe's book about bonds right now. And I've searched a lot of threads here looking for answers. So some responses are kind of making assumptions about why I asked the question I asked and what my reasons are and what sort of general investing advice I need, rather than responding to my question. I just wanted to check my understanding of things, to make sure I'm getting it right.

So I guess I'll just repeat what I wrote above, in the hope I might get a direct response:

Yes, I probably should have specified that I was imagining holding the TIPS bonds to maturity. I that case, unlike VIPSX, a TIPS ladder of my own making would never have a negative return, right? Whereas VIPSX in short run might. I recognize that in the long run it should all be a wash. But in the short run with VIPSX I could have a negative return, including something pretty severe like in 2008. So in that sense, it seems to me like a TIPS ladder of my own making could be less volatile than VIPSX. But the downside would be that it's less convenient that just investing in VIPSX.

Or is there some downside that I'm not seeing to a TIPS ladder of my own making, where all the bonds are held until maturity? Is that how VIPSX works? Does Vanguard hold all the bonds in VIPSX to maturity?

Thanks again to everyone.
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Postby natureexplorer » Thu Aug 26, 2010 5:04 pm

Why not buy individual TIPS at Fidelity? They don't charge commissions for neither buying nor selling I believe.
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Postby SSSS » Thu Aug 26, 2010 6:46 pm

cb474 wrote:
SSSS wrote:If you're talking about holding TIPS in a taxable brokerage account at Vanguard, that's the same as holding them at Treasury Direct.

So there are no extra fees or expenses associated with purchasing TIPS through VBS vs. TreasuryDirect?


I was referring to tax treatment. Buying through Vanguard, there may or may not be a brokerage fee depending on your account level (Voyager, etc) and whether it's an auction bid or a secondary market purchase; check the published fee schedules. Through Treasury Direct, you can only do auction bids (no fee), secondary market purchases are not possible, though you can sell your bonds on the market for a fee that's probably worse than Vanguard's.
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Postby Bob's not my name » Thu Aug 26, 2010 7:35 pm

cb474 wrote:I was imagining holding the TIPS bonds to maturity. I that case, unlike VIPSX, a TIPS ladder of my own making would never have a negative return, right? Whereas VIPSX in short run might. I recognize that in the long run it should all be a wash. But in the short run with VIPSX I could have a negative return, including something pretty severe like in 2008. So in that sense, it seems to me like a TIPS ladder of my own making could be less volatile than VIPSX.
wiki wrote:If you are planning to reinvest (i.e, rollover) some of the annual redemption into new individual TIPS bonds, then you have gained nothing by using a rolling ladder over a fund. Because not rolling over the whole bond at the (hypothetically) very high yield has an identical opportunity cost to selling a portion of your fund at the (hypothetically) very low NAV. Another issue with this approach is how to deal with the longevity risk if you outlive your ladder.

It has been regularly argued on the Bogleheads forum that a bond fund is risky because of NAV fluctuations. For example, the NAV for Vanguard Inflation Protected Securities fell 20.4% from peak to trough in 2008. Instead, it is said, investors should hold individual bonds, which can always be redeemed at face value by holding until maturity.

This argument is wrong because the individual bonds in a bond fund react to the market identically to the individual bonds held in a personal portfolio. You can see this by manually calculating a NAV for your own portfolio of individual bonds, and watching its daily fluctuations. The key thought is that although bond funds do have volatility, they are exactly as volatile as a rolling bond ladder with the same duration. On a Bogleheads Forum post, tfb made this explicit with the following example:

After you create your TIPS ladder, call this ladder "My TIPS Fund." Create some imaginary shares and calculate the NAV for your fund. When one bond matures, for which you receive the full guaranteed value and real yield, you take the cash, divide by the NAV at that time, and reduce the number of shares you still own in My TIPS Fund. Now, it's as if you just sold some shares from My TIPS Fund at the current NAV. Let's say the NAV is lower than the initial NAV. Did you just suffer a loss? Or did you receive the full guaranteed value and real yield from the matured bond? You see it's just a matter of framing. The substance remains exactly the same.

At any moment after buying a bond fund, you can always be assured of getting your principal back. Just as when holding an individual bond, you may have to wait some period of time if you want to be reassured the return of your principal. That period of time is the duration. Since you should always have been keeping your duration equal to or less than your investment horizon (the time after which you need the money), you will be indifferent to (if the duration equals your horizon) or happy about (if the duration is less than your horizon) interest rate increases which cause a decline in NAV. In fact, you will be slightly better off if yields change and your fund has positive convexity, as is the case with most non- MBS funds.
cb474 wrote:I have in fact read the wiki about individual bonds vs. bond funds.
Could you refine your question? Are you doing something different from the wiki example, e.g., not reinvesting?
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Postby insurancerenegade » Thu Aug 26, 2010 7:56 pm

cb474-

Actually the only time there will be a difference in the interest rate risk of VIPSX and a laddered set of TIPS that match the average maturity and duration of VIPSX is if you have to take cash out of the portfolio before the last of the bonds owed at the time of the interest rate spike matures.

Then is is much better to own the laddered TIPS.

If an interest rate spike occured and you hold your TIPs to matuity and you hold VIPSX that long as well (assuming no other interest rate changes) then you wil end up in exactly the same place, with no negative returns (unless we get deflation which is another risk of VIPSX and older secondary market TIPS.)
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Postby fishnskiguy » Thu Aug 26, 2010 8:02 pm

The main advantage of purchasing TIP at auction through VBS versus TD, is it is much easier to talk to a human being at VBS.

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Postby alec » Thu Aug 26, 2010 8:09 pm

fishnskiguy wrote:The main advantage of purchasing TIP at auction through VBS versus TD, is it is much easier to talk to a human being at VBS.

Chris


not too mention you don't need a gazillion passwords and a secret decoder sheet to log into VBS. :shock:
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Postby SSSS » Thu Aug 26, 2010 8:15 pm

alec wrote:not too mention you don't need a gazillion passwords and a secret decoder sheet to log into VBS. :shock:


Although you do have to have third-party cookies enabled to get into the Vanguard Bond Desk, or add cookie exceptions for vanguard.com and bonddesk.com. So that's kind of a pain if you use multiple computers & always disable third-party cookies. I can't decide if it's more or less annoying than the TD card.
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Postby cb474 » Fri Aug 27, 2010 4:28 am

Thanks to everyone again for all the responses.

Bob's not my name and insurancerenegade, I'm having a little trouble reconciling your two posts.

I'd already read the section from the wiki that Bob's not my name cited. But now I think I'm understanding it a little differently. The point seems to be that if I hold VIPSX for a period of time equal to the duration, I will get my principle back and negative fluctations in return (due to interest rate spikes) won't effect me. So this is not different from having a ladder of individual TIPS, because I would have to wait for the bonds to mature anyway, before getting my principle. Or, conversely, if I did not wait and sold a bond on the secondary market, I would suffer the same consequences of a loss in value due to an interest rate spike that I would suffer in VIPSX.

Is that right?

On the other hand, insurancerenegade wrote:
Actually the only time there will be a difference in the interest rate risk of VIPSX and a laddered set of TIPS that match the average maturity and duration of VIPSX is if you have to take cash out of the portfolio before the last of the bonds owed at the time of the interest rate spike matures.

Then is is much better to own the laddered TIPS.

I'm not sure I actually follow this and perhaps need it spelled out for me more. But superficially this seems to contradict the wiki's claim that there are no differences between a laddered portfolio of TIPS and a fund like VIPSX, in terms of interest rate risk. At least in some limited circumstances the TIPS ladder has an advantage.

So I'm a little confused.
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Postby livesoft » Fri Aug 27, 2010 7:51 am

Every time interest rates go up by X% it will take X% times the duration for a bond fund to recover. Thus if you are holding VIPSX and interest rates go up by 1% today, then it will take your VIPSX 3.5 years to recover. But if during that 3.5 years, interest rates go up by another 1%, then you got to factor that in as well.

So you are tooling along in VIPSX for a few years and need the money in year 8. Then in year 7, what happens if interest rates go up by 2%? If the duration is the same, then it will take another 7 years to recover. The duration of VIPSX changes, but does not get ever shorter like the duration of an individual bond would.

Also consider if interest rates go down.
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Postby insurancerenegade » Sun Aug 29, 2010 9:28 am

cb474-
Sorry for the confusion. Maybe an example will help me explain. Imagine you are planning on spending $100k per year for the next 20 years, withdrawing the money from your investment portfolio. You own a set of laddered zero coupon bonds, with $100k maturing each of the next 20 years. Interest rates are currently 3% across the yield curve, so the market value of the bond ladder is a little over $1.5 million. You no longer care what happens to interest rates (relative to this part of your portfolio) because you will get $100k per year for the next 20 years, no matter what.
Suppose you sell the bond portolio and invest the proceeds in the InsRen bond fund which buys 20 year bond fund ladders maintaining a constant average maturity and average duration identical to your old bond ladder. If interest rates go up 200 basis points to 5% the day after you purchase the bond fund, the market value will drop to about $1.3 million, but because the yield is now 5%, you can withdraw your $100k per year from the Ins Ren bond fund for each of the next 20 years and it will come out exactly the same as if you had held on to the laddered bonds. This is what the wiki and Bob's not my name are describing.

However , if the interest rate spike occurs 5 years after you have been drawing down your InsRen fund instead of the day after you purchase it, you will run out of money-you'll be about $88k short in you last year of withdrawals which you will have to make up from your other investments. You end up short because the duration of your "liabilities" (future withrawals) shortened as you moved further into your withdrawal plan, but the bond fund kept its original average duration. Your original laddered bond portolio would have shortened in duration with time, matching the shortening of your expected withrawals.

The advantage of laddered bonds over bond funds is not the ability to "hold to maturity", but the fact that individual bonds have constantly declining maturity and duration , while bond funds have constant maturity and duration.
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