Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

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MBAkid24
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Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Thu Jan 23, 2014 9:01 pm

I've read many of the discussions weighing the merits of owning a bond fund versus laddering. Most of the time, the person wanting to build a ladder is near retirement, so the issue becomes buying bonds that mature in 1 year, 2 years, 3 years... n years as desired. My question is: what if I started now, at age 25? I could buy a 30 year TIPS contract at auction every year until I'm 54. Then, I'd have a nice pension for ages 55-85.

The big advantage I see is that my yield would be better than the yield I'm getting in my bond index funds (assuming a normal yield curve, holding only 30 year TIPS is better than holding a broad mix of TIPS).

I'm thinking hard about doing this in my Roth IRA. If I use my full contribution ($5,500) to buy a TIPS contract each year, this ladder would probably never comprise my full bond allocation. So I'd still need some TBM in my 401k; just less than I have now.

Does anyone see any issues with this? Does it sound reasonable? The idea seems like a good fit for anyone who is young and plans to max out both 401k and Roth IRA in the foreseeable future.

Laura
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Laura » Thu Jan 23, 2014 9:55 pm

The problem with this is that you are going to be too heavily weighted in bonds early in your investing lifecycle. That $5.5k will be a huge percentage of your initial savings. Later that $5.5k will represent a very small percentage. I am also not sure how this will give you a nice pension because $5.5k won't cover much in 30 years. Instead, you should invest all of your funds in that broadly diversified portfolio you mention for the rest of your holdings. You will come out ahead in the end.

Laura
The views presented are my own and not necessarily those of the Department of State or the U.S. Government.

MBAkid24
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Thu Jan 23, 2014 11:23 pm

Thanks for the reply Laura. I'm north of $100k right now in retirement accounts, so $5.5k is <5%. My savings rate is approximately $25k per year in 401k, plus the Roth IRA. So I'm talking about putting ~18% of my current savings rate into this ladder. With a target of 15% bonds in my portfolio, that's not far off.

I agree that "nice pension" may have been an overstatement. I think the math shows me that I'd be drawing about $9k per year, in today's dollars, for the duration of the drawdown phase. That's a decent supplement to Social Security - my grandmother greatly enjoys the $6k per year she gets in pension from a long-time employer.

If I fund $5,500 now, next year would be ($5,500)*(1+inflation)+(Coupon Payments Reinvested). Each ensuing year would be similar. When the ladder matures at age 55, the first year's drawdown would consist of $5,500 (real value - inflated since this is a TIPS contract) principal repayment, plus coupon payments from the still-invested 29 other years. The next year would have a slightly higher principal repayment, plus 28 years' worth of coupons. This continues for the full 30 years, so each year is roughly equal in payout (in real terms).

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Cash » Fri Jan 24, 2014 7:40 am

I'm 30 and just started doing something similar, but on a larger scale because I also have access to TIPS through our 401(k)'s and we save a lot in taxable. You will get some pushback because people will say that your expenses in retirement are unpredictable right now and that you should just go with a typical age in bonds and worry about liability matching later. My response is that I am purchasing what I currently predict to be our floor, but recognize that it is subject to future refinement (e.g., I will likely purchase more TIPS (or munis, if I am out of tax-advantaged space) for certain years on the primary or secondary market once the expenses for those years become clearer). So I think your plan can work as long as the amount of TIPS you purchase do not make your asset allocation too conservative. Of course, some might say that any amount of TIPS at their current real yield at your age would make your allocation too conservative, but I do not think that is much of a concern if you have a sufficiently high savings rate such that you are not relying on bond performance for portfolio growth/security. My goal for that portion of my portfolio is preservation of real dollars; any growth of those real dollars is just icing on the cake.

And this doesn't even get into the ladder v. bond fund debate...

linuxizer
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by linuxizer » Fri Jan 24, 2014 7:48 am

It sounds like a very expensive way to insure against a risk you don't really have to me. But if it helps you sleep at night and keeps you from panic selling stocks in the rest of your portfolio, then you should absolutely do it. There are an infinite number of strategies that are worse than this.

Just be aware that you're taking on huge interest rate sensitivity. Ask yourself: if real rates rise 1%, why would everyone else be willing to pay 25% less for the bond I now hold. 25% (assuming 25-year duration)!

You would likely be better off by adopting a Larry-like rule relating duration to the slope of the yield curve. Personally I would just buy an IT TIPS fund and be done with it.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Longtimelurker » Fri Jan 24, 2014 8:18 am

linuxizer wrote:It sounds like a very expensive way to insure against a risk you don't really have to me.


+1

You are young. Your inflation protection comes primarily in the form of your expected future earnings. As you get closer to retirement, your future expected earnings shrink while you retirement assets grow. TIPS in my mind are appropriate at some inflection point between your 30 year horizon and actual retirement. Probably more like 10 years from retirement for most affluent folks.
Stay the course. If you can't resist greed, and fear is proven to be 2x as strong, you are doomed as an investor.

MBAkid24
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 8:46 am

Thanks for the additional replies.

It sounds like a very expensive way to insure against a risk you don't really have to me. But if it helps you sleep at night and keeps you from panic selling stocks in the rest of your portfolio, then you should absolutely do it. There are an infinite number of strategies that are worse than this.

Just be aware that you're taking on huge interest rate sensitivity.


Expensive? If I hold to maturity, then it seems to me that I'd be making more money on 30 year TIPS than I would in an IT TIPS fund. Yield on 30 year TIPS will generally be higher than yield on 5, 10, or 20 year TIPS. This idea was actually born out of imagining ways of making more money on my bond holdings. Why hold a fund with an average duration of 5-10 years when my associated liabilities are 30+ years away?

With regard to interest rate sensitivity, I'd be holding to maturity, so I don't see an issue there. I would hope for rates to go up. If they do, my new purchases would earn more.

You are young. Your inflation protection comes primarily in the form of your expected future earnings.


Would you think differently if, instead of TIPS, I was doing this with standard 30 year treasuries? I just prefer TIPS to treasuries to protect against unexpected inflation, but their expected returns are similar, given the market's consensus expectation for future inflation. Keep in mind that this entire discussion is occurring within the context of my bond allocation, which is only 15% of my retirement portfolio.

MBAkid24
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 8:52 am

I'm 30 and just started doing something similar, but on a larger scale because I also have access to TIPS through our 401(k)'s and we save a lot in taxable. You will get some pushback because people will say that your expenses in retirement are unpredictable right now and that you should just go with a typical age in bonds and worry about liability matching later.


Very interesting. Does this ladder constitute all of your bond holdings, or just a portion? I agree that this is not sufficient to be full liability matching, but why not start somewhere? I anticipate company pension, plus social security (whatever's left of it), plus my own portfolio, which is mostly stocks tilted to small cap value at this point. But why not take the bond portion and use it to match liabilities, with the strong yields of 30-year issues?

It just makes more intuitive sense because (1) the funds mature when you need them, and (2) earnings will be higher than a typical bond fund, due to longer duration.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by linuxizer » Fri Jan 24, 2014 9:10 am

MBAkid24 wrote:Expensive? If I hold to maturity, then it seems to me that I'd be making more money on 30 year TIPS than I would in an IT TIPS fund. Yield on 30 year TIPS will generally be higher than yield on 5, 10, or 20 year TIPS. This idea was actually born out of imagining ways of making more money on my bond holdings. Why hold a fund with an average duration of 5-10 years when my associated liabilities are 30+ years away?


Would you hold Vanguard Extended Duration Treasury ETF (EDV)? Then why would you hold the same bonds outside a fund?

I urge you to look more into the math of bonds before you commit to this. Start with the Bogleheads wiki, including the page on individual bonds vs. a fund. Maybe buy one of the basic Fabozzi handbooks (cheap in the older editions used). Doing as I did and writing your own bond market simulator is probably over the top, but it really helped understand why what matters is cash flow from the underlying instruments and not where you hold them. The easier version would be to take this 30-year TIPS you're considering and run the math to understand why the market price is changing. Even if you don't mark to market, it's still a risk you are bearing in terms of opportunity cost.

Would you think differently if, instead of TIPS, I was doing this with standard 30 year treasuries?


My opinion would change for sure. Then I would say it's more than a behavioral strategy that will cost you some yield and potential for shortfall, it is a flat out bad idea. Taking risk in real dollars is just different than taking risk in nominal ones.
Last edited by linuxizer on Fri Jan 24, 2014 10:56 am, edited 1 time in total.

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JamesSFO
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by JamesSFO » Fri Jan 24, 2014 9:10 am

I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Longtimelurker » Fri Jan 24, 2014 9:30 am

JamesSFO wrote:I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.



This to me is a more acceptable strategy due to no principle risk, hence 0 implied duration. I do not like EE bonds however because the doubling period changes. So it will be impossible to have a consistent ladder that you sell upon doubling… Much better to use iBonds in my opinion for this - which I do use.
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 10:32 am

I urge you to look more into the math of bonds before you commit to this. Start with the Bogleheads wiki, including the page on individual bonds vs. a fund. Maybe buy one of the basic Fabozzi handbooks (cheap in the older editions used). Doing as I did and writing your own bond market simulator is probably over the top, but it really helped understand why what matters is cash flow from the underlying instruments and now where you hold them. The easier version would be to take this 30-year TIPS your considering and run the math to understand why the market price is changing. Even if you don't mark to market, it's still a risk you are bearing in terms of opportunity cost.


I appreciate the feedback. I wrote this post to get insight, and everyone is providing good perspective. I will take one year to learn more about fixed income before I do anything "interesting". There was probably an overconfidence bias - I have a very deep understanding of equities but my fixed income knowledge is much more sophomoric. Next year I'll enter the elective portion of my MBA and can do bond math to my heart's content if I take enough finance electives.

If I still like the idea next year, then I'll implement at age 26. If I change my mind, then I'll have saved myself some trouble.

Much better to use iBonds in my opinion for this - which I do use.


We are getting our first I-bonds with our income tax refund this year. After the 12-month lockdown period expires, they will serve as part of our emergency fund. Much better than a 0.01% savings account.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Cash » Fri Jan 24, 2014 11:38 am

MBAkid24 wrote:Very interesting. Does this ladder constitute all of your bond holdings, or just a portion?


All for now. I'm still more than 70% equities and want to stay that way. I'll probably add munis at some point.

By the way, to avoid beating a dead horse, here is a recent debate on ladders v. funds (involving linuxizer): viewtopic.php?f=10&t=130495

Edit: We also max out our I bonds yearly, so I suppose it's not our only bond holding.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by JamesSFO » Fri Jan 24, 2014 1:25 pm

Longtimelurker wrote:
JamesSFO wrote:I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.



This to me is a more acceptable strategy due to no principle risk, hence 0 implied duration. I do not like EE bonds however because the doubling period changes. So it will be impossible to have a consistent ladder that you sell upon doubling… Much better to use iBonds in my opinion for this - which I do use.


Sure, same basic concept; I am actually doing both I Bonds and EE bonds and figure if I forget about them until I'm 60-65 they will be a nice "surprise"/baseline.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by berntson » Fri Jan 24, 2014 2:32 pm

When it comes to bonds, there are the holders and the rebalancers. Most investors are rebalancers. When bonds underperform stocks, rebalancers move money from stocks to bonds. If you're a rebalancer, the present value of your bonds matters regardless of whether or not you own individual bonds and intent to hold them to maturity. The reason is that the present value of your bonds determines how much money you need to divert from equities to maintain your bond allocation. If the present value of the bonds you're holding to maturity drop in value, then you have to divert more from equities to bonds. And with less invested in equities, you can expect lower returns from your equity portfolio.

Holders don't rebalance. They buy bonds (preferably inflation-adjusted bonds) to create a known future stream of income and don't adjust their purchases according to the present value of their bond holdings. There is thus a good sense in which the present value of their bonds is just irrelevant to the holder. The present value of my bonds is down, yes, but that doesn't reduce my future expected returns, because it doesn't force me to divert funds from equities.

You can't be both a holder and a rebalancer (at least when it comes to a particular bond allocation). Either the present value of your bonds determines whether or not you divert funds from equities or it doesn't. If you're building a TIPs ladder AND you're planning to rebalance based on the present value the ladder, you're kidding yourself if you think its present value doesn't matter. It does because you're a rebalancer.

Let's suppose that you're planning to be a holder and not a closet rebalancer. The advantage of being a holder is that you can buy bonds of longer duration, thus receiving a higher rate of return on your bond portfolio. If the present value of my bonds between now and thirty years from now is irrelevant to my other portfolio decisions, then I might as well buy a thirty year inflation-adjusted bond instead of a seven year bond and get the extra ~1% expected return.

The disadvantage of being a holder is that you forgo the benefits of rebalancing. This includes a non-trivial rebalancing bonus and lower overall portfolio volatility.

So there is no free lunch here. You just have to decide whether you prefer the risks involved with being a holder or a rebalancer.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by natureexplorer » Fri Jan 24, 2014 3:00 pm

MBAkid24 wrote:I've read many of the discussions weighing the merits of owning a bond fund versus laddering. Most of the time, the person wanting to build a ladder is near retirement, so the issue becomes buying bonds that mature in 1 year, 2 years, 3 years... n years as desired. My question is: what if I started now, at age 25? I could buy a 30 year TIPS contract at auction every year until I'm 54. Then, I'd have a nice pension for ages 55-85.

The big advantage I see is that my yield would be better than the yield I'm getting in my bond index funds (assuming a normal yield curve, holding only 30 year TIPS is better than holding a broad mix of TIPS).

I'm thinking hard about doing this in my Roth IRA. If I use my full contribution ($5,500) to buy a TIPS contract each year, this ladder would probably never comprise my full bond allocation. So I'd still need some TBM in my 401k; just less than I have now.

Does anyone see any issues with this? Does it sound reasonable? The idea seems like a good fit for anyone who is young and plans to max out both 401k and Roth IRA in the foreseeable future.
Do you really want to spend you twenties and thirties managing a TIPS ladder? Particularly if the amount involved will only be a small percentage of your portfolio?

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by ogd » Fri Jan 24, 2014 3:18 pm

berntson wrote:There is thus a good sense in which the present value of their bonds is just irrelevant to the holder. The present value of my bonds is down, yes, but that doesn't reduce my future expected returns, because it doesn't force me to divert funds from equities.
...snip...
The disadvantage of being a holder is that you forgo the benefits of rebalancing. This includes a non-trivial rebalancing bonus and lower overall portfolio volatility.

The other disadvantage is that you might be blind-sided as to how little some bonds are making you. For example, this TIPS:

2016 Jul 15 2.500 109.27 109.28 + 5 -1.412

If you ignore the market value and yield, you think you are sitting on an unbeatable 2.5% real. In reality, because of the price at which you could sell, you are making a very beatable -1.4% for the remaining 1.5 years. It just seems silly to ignore the market values of securities you can trade every day at very low spreads. Market realities exist whether you acknowledge them or not and they continue changing.

As I mentioned in the recent "bonds are not riskier than ladders" thread, this exercise of planning spending 30 years ahead disregarding all the opportunities and life changes inbetween seems like a big waste of time. Or, at best, a way to have investment fun.

To the OP: the yield curve between 20 and 30 years is not very steep (1.14% vs 1.38%), so the bonus of using 30 year TIPS is minimal. Whereas the possible opportunity cost of higher yields down the road could be substantial.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by abuss368 » Fri Jan 24, 2014 3:22 pm

A couple of things:

1) You do not want your portfolio to be too conservative. There is an "insurance premium" costs of investing in TIPS. At your stage and level of wealth, I would prefer a simple bond fund such as Total Bond Index in tax advantaged accounts and/or Intermediate Term Tax Exempt in taxable.

2) If I wanted TIPS, I would simply invest in a mutual fund offering such as Vanguard. I personally would not want the additional account. I also like to see up to date market values when I review the portfolio.

3) Vanguard only adds TIPS to the Target funds right before retirement. The target funds are designed by their experts. That is saying something.

4) I have seen a few threads and responses on the forum recently from investors that have received a Vanguard portfolio check from a CFP. In all cases they were questioned why the large TIPS allocation and to reconsider using just Total Bond Market Index.

5) At your age how much risk from "unexpected inflation" do you have? You have income/salary adjustments and a higher equity allocation than an investor close to or in retirement. The additional account and securities may just be more complexity without making much, if any, difference.

6) I like to see the monthly dividends post form my Total Bond Market Index Fund and Intermediate Term Tax Exempt Funds. TIPS are infrequent and sometimes do not pay anything.

7) At the end of the day the most important point for an investor is to find what works for you and then stay the course. Your portfolio strategy should be one in which you will be able to stay the course in all markets.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 3:23 pm

By the way, to avoid beating a dead horse, here is a recent debate on ladders v. funds (involving linuxizer): viewtopic.php?f=10&t=130495


Nice link. This whole thread made me feel much more comfortable with the idea of the ladder, despite the constant berating of the idea. I'll probably still wait a year - it's always good to avoid rushing into things, but I'm more comfortable conceptually with the plan.

You just have to decide whether you prefer the risks involved with being a holder or a rebalancer.


I appreciate this perspective. Let's say that I'm limited to doing this in my Roth IRA, so just $5,500 per year. I built a little Excel model and it appears that the ladder would max out at ~70% of my bond portfolio in a few years, then decline over time until it is only ~25% of my bond portfolio at retirement. The remainder of bond holdings would be in TBM. So couldn't I be both a rebalancer and a holder? The worst-case scenario is a drop of >30% in equities, right when the ladder is 70% of my bond holdings. Then I would be forced to sell all my TBM, plus a portion of the ladder in order to rebalance. If this happened, I would probably do two things: first liquidate some iBonds from our emergency fund to buy equities, second redirect all new contributions to equities. I do see the quandary though...

Do you really want to spend you twenties and thirties managing a TIPS ladder? Particularly if the amount involved will only be a small percentage of your portfolio?


It really wouldn't be hard. I already have a brokerage account with Vanguard, so I'd just buy the fund at auction each year. The formula that determines how much to buy is pretty simple - scale up last year's purchase by inflation, and add the coupon payments on top of that, then round to the nearest thousand. Done :happy

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 3:30 pm

4) I have seen a few threads and responses on the forum recently from investors that have received a Vanguard portfolio check from a CFP. In all cases they were questioned why the large TIPS allocation and to reconsider using just Total Bond Market Index.

5) At your age how much risk from "unexpected inflation" do you have? You have income/salary adjustments and a higher equity allocation than an investor close to or in retirement. The additional account and securities may just be more complexity without making much, if any, difference.


Point 5 is the best counterpoint that has been made (someone mentioned it before, as well). It's a fair point and well-taken.

Point 4. This is where I might be misunderstanding something. If I buy TBM every year, I'm buying a mix of bonds all up and down the yield curve, every year. If I buy a 30 year contract every year, I'm buying the highest point on the curve that I can get at that moment in time. If I know, for sure, that I won't sell for 30+ years, why wouldn't I want the highest yield I can get?

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by ogd » Fri Jan 24, 2014 3:34 pm

MBAkid24 wrote:If I know, for sure, that I won't sell for 30+ years, why wouldn't I want the highest yield I can get?

Because if, 20 years from now, real yields at 10 years are 3%, you'll be cursing yourself for buying a 30 year instead of a 20 year for a mere 0.24% extra yield.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by bigspender » Fri Jan 24, 2014 3:40 pm

For the op, I honestly don't think it is a bad idea because of your age to have 30 year TIPS in your roth ira. I would also invest at least an equal amount of an indexed total stock market fund in your taxable account as capitol gains tax rates are low.

Just so you know, there are minimum limits with vanguard in the sense you need to buy at least 10 bonds which is 10,000 for the order, so what I do is open my roth ira with fidelity as I can order 5.5 bonds worth of 30 year tips each february.

You should check out the treasury schedules as the next 30 year TIPS is in February. And when I get a coupon payment 2 times per year, I just put it into the TIPS mutual fund. I think you need to keep a minimum of $2500 in a mutual fund at fidelity.

Now, maybe vanguard lowered their requirements for treasury holdings, but I don't remember so someone may have to chime in.

sure, interest rates can rise, but the truth of the matter is you can only buy todays yields. For example, last year my 30 year TIPS in February has a coupon of only 0.75%, so I will really have to hold onto that one foverever becasue the real yield on that bond is now about 1.4%, so it is worth almost 20% less than what I payed for it. But as long as I hold until maturity, I get all my money back. That is something you need to understand about TIPS.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 3:42 pm

Because if, 20 years from now, real yields at 10 years are 3%, you'll be cursing yourself for buying a 30 year instead of a 20 year for a mere 0.24% extra yield.


Yes, but that's just the downside. The upside is that we go into a period like Japan's, and rates are still super-low in 20 years, and I'm perfectly happy to have that extra 0.24%. And anyone who bought 30 year treasuries 20 years ago feels like a genius right now (1994 - 6-7% yield).

I think my contention is not that every year's purchase will win out, but that, on average, over the next 60 years a portfolio of individual 30 year TIPS would outperform TBM. I could easily be wrong, but the idea makes sense intuitively to me.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 3:43 pm

Just so you know, there are minimum limits with vanguard in the sense you need to buy at least 10 bonds which is 10,000 for the order


Nice to know, thanks. I'll check into that.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by linuxizer » Fri Jan 24, 2014 3:52 pm

The real cost of being a "holder" is behavioral--these bonds are "safe," so you don't have to worry about interest rate risk.

Again, would you recommend a 25-year-old buy the Vanguard Extended Duration TIPS fund? If not, then why is it ok to hold the same bonds outside the fund.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by ogd » Fri Jan 24, 2014 4:00 pm

MBAkid24 wrote:Yes, but that's just the downside. The upside is that we go into a period like Japan's, and rates are still super-low in 20 years, and I'm perfectly happy to have that extra 0.24%. And anyone who bought 30 year treasuries 20 years ago feels like a genius right now (1994 - 6-7% yield).

You asked what the downside was, and I gave it to you. 20% underperformance is nothing to sneeze at. Also, TIPS will fare badly in Japan-style deflation.

MBAkid24 wrote:I think my contention is not that every year's purchase will win out, but that, on average, over the next 60 years a portfolio of individual 30 year TIPS would outperform TBM. I could easily be wrong, but the idea makes sense intuitively to me.

There are three major components here:
1) Credit worthiness: TBM is more risky than TIPS
2) Inflation risk: same
3) Interest rate risk: the long TIPS are more risky
Going by "we expect risk to be rewarded", the components resolve to: 1) underperform, 2) underperform, 3) outperform. How they add up is unknown, but it's not a slam dunk that 3) will dominate.

To me, the yield bonus from 20 to 30 years simply doesn't look rewarding enough, and I think you're in different waters in that area (long-term liabilities for retirees and institutions), where someone your age shouldn't be swimming.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by tcjbum » Fri Jan 24, 2014 4:07 pm

I'm new to this, so this is a genuine, uninformed question.

Are you sure this is the best use of your Roth space from a tax perspective? I'm about your age. My preference is to load my Roth with equities since I think they'll have relatively high returns by the time I retire - and I won't be taxed on those returns.

TIPS seem like a very conservative use for such valuable (tax free) space.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 4:14 pm

would you recommend a 25-year-old buy the Vanguard Extended Duration TIPS fund? If not, then why is it ok to hold the same bonds outside the fund.


There are three major components here:
1) Credit worthiness: TBM is more risky than TIPS
2) Inflation risk: same
3) Interest rate risk: the long TIPS are more risky
Going by "we expect risk to be rewarded", the components resolve to: 1) underperform, 2) underperform, 3) outperform. How they add up is unknown, but it's not a slam dunk that 3) will dominate.


I think this does get to the heart of the issue. If we disregard the ladder vs. fund question for a moment, and also disregard TIPS vs. other fixed income, let me ask a new question. If the time horizon is very long, why not buy extended duration bonds, instead of TBM? The expected return is higher for someone who will be in the game for 30 years.

EDIT: adding numbers. Vanguard Long Term Bond Index has 10 year returns of 6.25%, versus 4.42% for TBM. This represents reward for term risk, right? If my horizon is really long, can't I bear this risk without much hesitation? The "since inception" numbers are similar although they didn't start at the exact same time.
Last edited by MBAkid24 on Fri Jan 24, 2014 4:18 pm, edited 1 time in total.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 4:16 pm

Are you sure this is the best use of your Roth space from a tax perspective?


Bonds are pretty tax-inefficient, so I believe it's common to keep them all in a tax-advantaged space. For me personally, all of my retirement funds are in either my 401k or Roth IRA, so I don't have the "problem" of having to put something in a taxable account. :happy

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by linuxizer » Fri Jan 24, 2014 4:26 pm

MBAkid24 wrote:I think this does get to the heart of the issue. If we disregard the ladder vs. fund question for a moment, and also disregard TIPS vs. other fixed income, let me ask a new question. If the time horizon is very long, why not buy extended duration bonds, instead of TBM? The expected return is higher for someone who will be in the game for 30 years.


Larry Swedroe's bond book shows some evidence that the additional risk of LT over IT bonds has historically not been rewarded.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by ogd » Fri Jan 24, 2014 4:28 pm

MBAkid24 wrote:I think this does get to the heart of the issue. If we disregard the ladder vs. fund question for a moment, and also disregard TIPS vs. other fixed income, let me ask a new question. If the time horizon is very long, why not buy extended duration bonds, instead of TBM? The expected return is higher for someone who will be in the game for 30 years.

This is a good question, but you shouldn't underestimate the effects of volatility on your risk-adjusted returns. Larry Swedroe has a paper (which I don't have time to track down) which indicates that long bonds are the best counterpart to an equity-heavy portfolio (say, 80%), where the volatility of stocks dominates. For larged FI allocations, the volatility of long bonds themselves begins to show its teeth and intermediates work best.

This suggests a slight mispricing occurs at the long end of the curve, where (I speculate) the certainty of long-term bonds is very valuable to certain large players like pension funds but is overvalued for everyone else. You can say you don't care about volatility, but it does make for a less efficient portfolio. If you have access to cheap leverage you could make more returns with the same risk, which is what ties risk and returns together.

Personally, at 60% stocks I stay intermediate, though I've dipped my toes into longer durations on occasion, either as a result of tax loss harvesting or because the availability of very good deals on the short end (CDs, savings accounts) every now and then makes a barbell duration that averages to intermediate a better proposal.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by abuss368 » Fri Jan 24, 2014 4:38 pm

What about the opposite? Environments where rates are high and then are reduced by the Fed and the market, however bond funds are still holding bonds that are paying the higher rates over inflation. An investor should look at it from both directions.

I think based on above it is becoming clear you have made up your mind and are looking for confirmation. I would go ahead and open a account following the strategy you outlined as long as it passes your "sleep test".

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MBAkid24 » Fri Jan 24, 2014 4:42 pm

Very interesting, thanks again for the responses. I'll read Swedroe's bond book. As I mentioned, I'll spend a year learning up on bonds before I do anything that deviates from TBM. With my current bond allocation barely in the five-digit range, I've got a while before it begins to actually matter.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by abuss368 » Fri Jan 24, 2014 4:46 pm

MBAkid24 wrote:Very interesting, thanks again for the responses. I'll read Swedroe's bond book. As I mentioned, I'll spend a year learning up on bonds before I do anything that deviates from TBM. With my current bond allocation barely in the five-digit range, I've got a while before it begins to actually matter.


I think that is a good plan.

Another book you may want to consider reading "The Bond Book."

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by linuxizer » Fri Jan 24, 2014 4:52 pm

If you want to know the actual bond math, I will give my oft-repeated recommendation for a used copy of Fabozzi's bond handbook.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by 500Kaiser » Fri Jan 24, 2014 6:49 pm

This column by Wade Pfau goes over setting up a 30 year TIPS ladder. The comments section at the end of the article has some outstanding material as well. http://wpfau.blogspot.ie/2013/12/how-do ... r-for.html
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Angst » Sat Jan 25, 2014 12:30 am

MBAkid24 wrote:
Just so you know, there are minimum limits with vanguard in the sense you need to buy at least 10 bonds which is 10,000 for the order

Nice to know, thanks. I'll check into that.

No! This is incorrect. At Vanguard brokerage you can purchase as little as $1,000 of TIPS at a time. It used to be $10,000 but it's now $1,000. It's been that way for maybe a year now.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by berntson » Sat Jan 25, 2014 12:50 pm

MBAkid24 wrote:
You just have to decide whether you prefer the risks involved with being a holder or a rebalancer.


I appreciate this perspective. Let's say that I'm limited to doing this in my Roth IRA, so just $5,500 per year. I built a little Excel model and it appears that the ladder would max out at ~70% of my bond portfolio in a few years, then decline over time until it is only ~25% of my bond portfolio at retirement. The remainder of bond holdings would be in TBM. So couldn't I be both a rebalancer and a holder? The worst-case scenario is a drop of >30% in equities, right when the ladder is 70% of my bond holdings. Then I would be forced to sell all my TBM, plus a portion of the ladder in order to rebalance. If this happened, I would probably do two things: first liquidate some iBonds from our emergency fund to buy equities, second redirect all new contributions to equities. I do see the quandary though...


Let's take a simple example. At the beginning of January, you have $85,000 in stocks, $5,000 in nominal bonds, and $10,000 in tips. By July, your TIPs have lost 20% and you now have $85,000 in stocks, $5,000 in nominal bonds, and $8,000 in TIPs.

You now have two choices. Do you sell equities and buy more nominal bonds to maintain your 15% total bond allocation? If you do, you're a rebalancer. You have to sell stocks to pay for the present losses in your ladder. So those present losses matter. It's irrelevant whether or not the loss in TIPs causes you to buy more TIPs. It matters that your loss in TIPs makes you sell stocks and buy bonds. If you don't rebalance, you're a holder (at least when it comes your TIPs...you may treat your nominal bonds differently if they were to drop in price).

It doesn't matter whether or not you're forced to buy or sell TIPs. What matters is whether the performance of your TIPs ladder forces you to buy or sell bonds, in your TIPs ladder or elsewhere.

MBAkid24 wrote:I think this does get to the heart of the issue. If we disregard the ladder vs. fund question for a moment, and also disregard TIPS vs. other fixed income, let me ask a new question. If the time horizon is very long, why not buy extended duration bonds, instead of TBM? The expected return is higher for someone who will be in the game for 30 years.


My own thought is: You buy bonds to reduce portfolio volatility. You can increase returns by increasing duration, yes, but at some point, it's more effective (from a mean variance perspective) to just hold a smaller bond position and add equities. Most people think that point is somewhere around the duration of intermediate bonds. Many (like DFA) think that it's even shorter than that.

Now maybe you don't care that much about mean variance. Suppose you mostly care about holding bonds as risk insurance for the next crash. Then you likely want long-term nominals.
Last edited by berntson on Sat Jan 25, 2014 1:06 pm, edited 1 time in total.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by dbr » Sat Jan 25, 2014 1:02 pm

berntson wrote:
It doesn't matter whether or not you're forced to buy or sell TIPs. What matters is whether the performance of your TIPs ladder forces you to buy or sell bonds, in your TIPs ladder or elsewhere.


I would think that the entire concept of this ladder is to lock in a future income stream, mostly from return of capital. As such it is not useful as an asset at all and would have no effect on the rest of the asset allocation no matter what its market value might be at some moment in time.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by berntson » Sat Jan 25, 2014 1:08 pm

dbr wrote:
berntson wrote:
It doesn't matter whether or not you're forced to buy or sell TIPs. What matters is whether the performance of your TIPs ladder forces you to buy or sell bonds, in your TIPs ladder or elsewhere.


I would think that the entire concept of this ladder is to lock in a future income stream, mostly from return of capital. As such it is not useful as an asset at all and would have no effect on the rest of the asset allocation no matter what its market value might be at some moment in time.


Right. You would think that someone with a ladder would be a holder (would ignore the TIPs ladder for the purposes of rebalancing). But then they're giving up on the benefits of being a rebalancer (at least when it comes to that chunk of the portfolio).

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by MooreBonds » Sat Jan 25, 2014 4:28 pm

MBAkid24 wrote:I'm thinking hard about doing this in my Roth IRA. If I use my full contribution ($5,500) to buy a TIPS contract each year, this ladder would probably never comprise my full bond allocation. So I'd still need some TBM in my 401k; just less than I have now.

Does anyone see any issues with this? Does it sound reasonable? The idea seems like a good fit for anyone who is young and plans to max out both 401k and Roth IRA in the foreseeable future.


Kudos on putting it in a tax-efficient account.

As a 37 year young investor, I could think of many worse things for you to be doing at 25. As you noted, this is only about 15% of your contributions....and 15% of a 25 year old's portfolio in bonds (mostly in 30year TIPS), while a little more than I would personally do if I had to do it all over again, is far from outlandish or foolish. Provided that your other 85% is adequately diversified in a good selection of stocks (IMO, including a good exposure to International and Emerging Markets).

Others have commented that the premium between 20/30 year TIPS isn't enough to them to justify going an extra 10 years out....but to me, that's a 21% difference in your real return component! (1.38% vs 1.14% with current numbers) And if you do this ever year, then it won't really matter as much if in 20 years the 10 year TIPS are at 3% again, because your new $5,500 purchase in 20 years will go into another 30 year TIP, who's real return will presumably be, again, higher than a 10-year TIP. And in the meantime, your $5,500 has been earning 0.24% more every year for 20 years Along with the accumulated interest payments that your older bonds have been spinning out.

To round out your bond holdings, since you'd have a large chunk in TIPS, perhaps put the other bond holdings in more risky bonds - like maybe some in a Vanguard High Yield bond fund?

At 37, I also have roughly 15% in fixed income, but have a big chunk of that (~8%) in preferred stocks, a few percent in muni Closed End Funds, and the remainder (~5%) in I-bonds. So I'm somewhat doing what you're doing, albeit in a slightly different manner. I lucked out and have I-bonds with fixed rates averaging 3.3%, so if I were starting today, I wouldn't necessarily aim for the same allocation that I currently have - but it would simply depend on what the rates were at that particular point in time. If for some reason I bonds have bigger fixed real returns than 30 year TIPS in some years, I'd buy some I-bonds, and you can use your ROTH contribution that year to buy other tax-inefficient investments.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by ogd » Sun Jan 26, 2014 12:55 pm

MooreBonds wrote:Others have commented that the premium between 20/30 year TIPS isn't enough to them to justify going an extra 10 years out....but to me, that's a 21% difference in your real return component! (1.38% vs 1.14% with current numbers)

When the numbers are this small, it's misleading to talk about % differences. For example, I could talk about how the yield in normal times is 100% higher (as recently as 2006) and likely to return there, but that enormous difference is still only 1.3% in absolute terms.

MooreBonds wrote:And if you do this ever year, then it won't really matter as much if in 20 years the 10 year TIPS are at 3% again, because your new $5,500 purchase in 20 years will go into another 30 year TIP, who's real return will presumably be, again, higher than a 10-year TIP.

Not really. Again looking at 2006 and other times of high yields, the TIPS curve was almost perfectly flat. It's much more the norm than the current steepness.

MooreBonds wrote:And in the meantime, your $5,500 has been earning 0.24% more every year for 20 years Along with the accumulated interest payments that your older bonds have been spinning out.

4.8%, say rounded to 5%, is not nearly enough to compensate for the 15% or so of underperformance in the years 20-30 if yields merely return to 2006 levels. If the numbers were different, I'd understand taking that extra risk. Or if the reliability of the yield, i.e. it not decreasing, was as important to you as it is to the pension fund that has to pay out fixed inflation-adjusted amounts. At age 25 (aiming for the 45-55 period), I just don't get it.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by billfromct » Sun Jan 26, 2014 6:38 pm

Why would someone with 35-40 years until retirement want to lock in the lowest interest rates (adjusted for inflation) in decades for their retirement portfolio?.

What would 30 year TIPS return, 3%-4%/year compared to a 6%-7% annual return for stocks over the next 35-40 years? Of course the returns on stocks aren't guaranteed.. That additional 3%-4% compounded rate of return/year will do wonders over 35-40 years.

If you think technology will improve productivity, the standard of living and economic growth over time, the only place to be is the stock market, at least for the next 25-30 years anyway.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Cash » Sun Jan 26, 2014 7:05 pm

billfromct wrote: What would 30 year TIPS return, 3%-4%/year compared to a 6%-7% annual return for stocks over the next 35-40 years? Of course the returns on stocks aren't guaranteed.. That additional 3%-4% compounded rate of return/year will do wonders over 35-40 years.
l


By your logic, one should not hold bonds at all.

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by billfromct » Sun Jan 26, 2014 8:10 pm

Of course one should hold bonds, CDs, etc that will be used in 3-5 maybe 7 years in taxable accounts and as he/she gets closer to retirement start to transfer retirement accounts (401K, Roth's, etc) stocks to debt instruments 15-20 years before retirement (of course depending on your risk tolerance).

The 25 year old poster won't be able to get his Roth earnings out for 34 years without penalties kicking in.

If you want to double your money 18-24 years, 30 year TIPS are the way to go.

I want to double my money in 7-10 years and am willing to take the risk.

Going into retirement, I will have 5-7 years of annual retirement withdrawals (roughly my present annual salary) in short term bond funds, CDs, bond ladder, etc and will keep that 5-7 year withdrawal amount in these short term debt instruments throughout retirement.

bill

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Iorek » Sun Jan 26, 2014 9:22 pm

Longtimelurker wrote:
JamesSFO wrote:I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.



This to me is a more acceptable strategy due to no principle risk, hence 0 implied duration. I do not like EE bonds however because the doubling period changes. So it will be impossible to have a consistent ladder that you sell upon doubling… Much better to use iBonds in my opinion for this - which I do use.


But an EE bond that is redeemed early will almost certainly earn less than inflation, so it doesn't seem entirely right to say has no implied duration (or principal risk)?

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by berntson » Tue Jan 28, 2014 12:45 am

billfromct wrote: I want to double my money in 7-10 years and am willing to take the risk.


Adjusted for inflation, the market has returned ~6.2% a year. Heavily tilting the portfolio without holding bonds could get you up to 7.6%, a rate at which it could be expected to double in ten years. But by most estimates, we won't even get historic rates of return going forward. Plan on it doubling every 15 years and be pleasantly surprised if you get lucky. :beer

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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by RyeWhiskey » Tue Jan 28, 2014 1:06 am

MBAkid24 wrote:I've read many of the discussions weighing the merits of owning a bond fund versus laddering. Most of the time, the person wanting to build a ladder is near retirement, so the issue becomes buying bonds that mature in 1 year, 2 years, 3 years... n years as desired. My question is: what if I started now, at age 25? I could buy a 30 year TIPS contract at auction every year until I'm 54. Then, I'd have a nice pension for ages 55-85.

The big advantage I see is that my yield would be better than the yield I'm getting in my bond index funds (assuming a normal yield curve, holding only 30 year TIPS is better than holding a broad mix of TIPS).

I'm thinking hard about doing this in my Roth IRA. If I use my full contribution ($5,500) to buy a TIPS contract each year, this ladder would probably never comprise my full bond allocation. So I'd still need some TBM in my 401k; just less than I have now.

Does anyone see any issues with this? Does it sound reasonable? The idea seems like a good fit for anyone who is young and plans to max out both 401k and Roth IRA in the foreseeable future.


In all honesty, your plan sounds fine. That said, I encourage you to use this year to study up on bonds and the mechanisms of yields, etc... I recommend "The Bond Book" as well as the others mentioned in this thread. The truth is, so long as you hold to maturity and do not deviate from your plan, your plan will serve you well as it is simple and coherent. Nonetheless, more information won't harm you at this point - do your research before you make your commitment. :beer
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Longtimelurker » Tue Jan 28, 2014 8:57 am

Iorek wrote:
Longtimelurker wrote:
JamesSFO wrote:I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.



This to me is a more acceptable strategy due to no principle risk, hence 0 implied duration. I do not like EE bonds however because the doubling period changes. So it will be impossible to have a consistent ladder that you sell upon doubling… Much better to use iBonds in my opinion for this - which I do use.


But an EE bond that is redeemed early will almost certainly earn less than inflation, so it doesn't seem entirely right to say has no implied duration (or principal risk)?


From a risk perspective, duration impacts principle. The principle cannot go down with EE bonds or iBonds. Therefore the duration is 0. Inflation is another risk entirely.
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Re: Starting a 30 Year TIPS Ladder at Age 25 (Roth IRA)

Post by Iorek » Tue Jan 28, 2014 9:54 am

Longtimelurker wrote:
Iorek wrote:
Longtimelurker wrote:
JamesSFO wrote:I thought Mel's strategy of buying $10K (or $20K) of EE bonds/year to create a baseline was a more appealing idea. It has the advantage of guaranteed doubling and has a goal of providing $20 (or $40K) of (nominal) income a year 20 years out which is not supposed to solve 100% of the retirement problem, but does create a nice baseline with social security.



This to me is a more acceptable strategy due to no principle risk, hence 0 implied duration. I do not like EE bonds however because the doubling period changes. So it will be impossible to have a consistent ladder that you sell upon doubling… Much better to use iBonds in my opinion for this - which I do use.


But an EE bond that is redeemed early will almost certainly earn less than inflation, so it doesn't seem entirely right to say has no implied duration (or principal risk)?


From a risk perspective, duration impacts principle. The principle cannot go down with EE bonds or iBonds. Therefore the duration is 0. Inflation is another risk entirely.


As you can tell I am not very well versed on this stuff and am trying to understand it better. How is an EE bond different from a Treasury bond in this way? The principal of a Treasury cannot go down either, but I don't think people consider the 30 year Treasury to have a duration of 0, or do they?

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