Intermediate vs Short Term TIPS Fund

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BigJohn
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Intermediate vs Short Term TIPS Fund

Post by BigJohn » Fri May 19, 2017 7:38 pm

I'm wrestling with whether I need to add TIPS to my 3 fund portfolio to improve it's ability to weather a bout of high inflation. I'm 60 and retired two years ago. I set my AA at 35/65 based on an LMP approach. Investments are primarily in TSM/TISM and VG Intermediate Term Bond Index (VBILX) but in taxable I'm using VG Intermediate Term Tax-Exempt (VWIUX). My SWR is below 3%. Overall I don't worry much about outlasting my money but, with a high allocation to nominal bonds I feel a bit unprotected from inflation risk.

Issue one, is my worry valid? If so, how much of my bond allocation should I consider moving to TIPS (I'm considering somewhere around 50%)?

Issue two, assuming I move to TIPs, what's the best approach? I don't want to build my own TIPS ladder as that's inconsistent with my ISP to ensure I value simplicity in how I implement. So my two choices are VG Inflation-Protected fund (VAIPX, 8 year duration, 2.1% YTM) and VG Short-Term Inflation-Protected fund (VTAPX, 2.8 year duration, 1.4% YTM). My first thought was to use the IT version as the TIPS surrogate for my current IT bond fund. However, I note that VG uses the ST version in their target date funds even though they use IT for nominal bonds and I'm not sure why. Any insight into the pros/cons of these two choices would be appreciated.

grok87
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Sat May 20, 2017 8:02 am

BigJohn wrote:I'm wrestling with whether I need to add TIPS to my 3 fund portfolio to improve it's ability to weather a bout of high inflation. I'm 60 and retired two years ago. I set my AA at 35/65 based on an LMP approach. Investments are primarily in TSM/TISM and VG Intermediate Term Bond Index (VBILX) but in taxable I'm using VG Intermediate Term Tax-Exempt (VWIUX). My SWR is below 3%. Overall I don't worry much about outlasting my money but, with a high allocation to nominal bonds I feel a bit unprotected from inflation risk.

Issue one, is my worry valid? If so, how much of my bond allocation should I consider moving to TIPS (I'm considering somewhere around 50%)?

Issue two, assuming I move to TIPs, what's the best approach? I don't want to build my own TIPS ladder as that's inconsistent with my ISP to ensure I value simplicity in how I implement. So my two choices are VG Inflation-Protected fund (VAIPX, 8 year duration, 2.1% YTM) and VG Short-Term Inflation-Protected fund (VTAPX, 2.8 year duration, 1.4% YTM). My first thought was to use the IT version as the TIPS surrogate for my current IT bond fund. However, I note that VG uses the ST version in their target date funds even though they use IT for nominal bonds and I'm not sure why. Any insight into the pros/cons of these two choices would be appreciated.
Long term is my vote-LTPZ
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

dbr
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Re: Intermediate vs Short Term TIPS Fund

Post by dbr » Sat May 20, 2017 9:07 am

Intermediate TIPS is compatible with the decisions you have already made in choosing intermediate duration bonds elsewhere. You can recognize that all durations of TIPS have the same offset for inflation and also that the interest rate sensitivity is to real rates rather than to nominal rates.

I think Vanguard has some very strange reasoning behind the use of short term TIPS.

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Re: Intermediate vs Short Term TIPS Fund

Post by KyleAAA » Sat May 20, 2017 9:50 am

With such a low allocation to equities yes, I think it would be wise to inflation-protect a significant portion of your fixed-income allocation. Half of fixed income would be well within the realm of reasonable (I use half, myself). Intermediate term is consistent with what you've already chosen. I think if you go with the short term fund you should probably also go with a smaller allocation.

BigJohn
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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 20, 2017 12:11 pm

dbr/Kyle, thanks for the comments
grok87 wrote:Long term is my vote-LTPZ
grok, although a higher yield is certainly nice, I've always stayed away from long bonds because their interest rate sensitivity was just too great. Now that I've retired, I'm looking at my bonds as the liability matching part of my portfolio to cover 30 years of minimal living expenses and am even more loath to take the increased interest rate risk. I actually consider keeping my entire bond allocation in VG ST Bond Index rather than IT but decided that was too conservative and that I could'should accept the interest rate risk of IT.

With this background, would you still advocate a LT TIPS fund? If so, can you elaborate a bit on why? Thanks.

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Phineas J. Whoopee
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Re: Intermediate vs Short Term TIPS Fund

Post by Phineas J. Whoopee » Sat May 20, 2017 3:41 pm

In order to meet your financial objectives, how much risk do you need to take, including inflation risk?

Intermediate-term TIPS are protected against inflation as much as short-term TIPS, but the trade-off is the same as for any other bonds, just in real, after-inflation terms. Shorter-term TIPS can usually be expected to fluctuate in value less than intermediate-term ones, and usually can be expected to return less over time.

My suggestion, and it won't come as a surprise to long-time forum readers, is to think carefully about precisely what you're trying to accomplish, then construct a portfolio to achieve it, even though success is never guaranteed.

To what extent are you exposed to inflation risk? If one has a CPI-adjusted pension, and is looking forward to Social Security retirement benefits which are CPI-adjusted, exposure to inflation risk is much less than it would be for somebody not in those circumstances.

There is no uniform TIPS answer for everybody, although I agree with some others here that a very small percentage of one's portfolio in inflation-adjusted fixed income likely will make little difference, just as any other small allocation to any particular asset class.

PJW

BigJohn
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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 20, 2017 5:05 pm

Phineas J. Whoopee wrote:Intermediate-term TIPS are protected against inflation as much as short-term TIPS, but the trade-off is the same as for any other bonds
Thanks PJW. One of my key questions was whether the above statement was true. I thought it was but seeing VG choose IT nominal bonds but then ST TIPS for their target date funds had me second guessing myself.
Phineas J. Whoopee wrote:To what extent are you exposed to inflation risk? If one has a CPI-adjusted pension, and is looking forward to Social Security retirement benefits which are CPI-adjusted, exposure to inflation risk is much less than it would be for somebody not in those circumstances.
Good questions, I think I have fairly high exposure which is why I'm working on this change. No pension and planning on deferring SS until age 70 which is 10 years away. So 100% of my income is from this portfolio for the next 10 years. After that I expect SS to be somewhere around 50% of annual income so still heavily dependent on portfolio.

dbr
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Re: Intermediate vs Short Term TIPS Fund

Post by dbr » Sun May 21, 2017 8:53 am

BigJohn wrote:
Phineas J. Whoopee wrote:Intermediate-term TIPS are protected against inflation as much as short-term TIPS, but the trade-off is the same as for any other bonds
Thanks PJW. One of my key questions was whether the above statement was true. I thought it was but seeing VG choose IT nominal bonds but then ST TIPS for their target date funds had me second guessing myself.
Vanguard issued a paper in which they put forward the somewhat bizarre contention that the measure of inflation protection in an investment is getting high correlation of return with inflation. Short TIPS are better correlated with inflation than intermediate TIPS because short TIPS have less interest rate volatility on top of variability due to inflation. But that is an odd criterion because all TIPS are indexed, compensated, exactly for inflation. Longer TIPS are just more volatile, but that has nothing to do with inflation.

NiceUnparticularMan
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Re: Intermediate vs Short Term TIPS Fund

Post by NiceUnparticularMan » Sun May 21, 2017 9:19 am

Last I looked, around 5-7 years, you actually got positive yield on TIPS. I like that because I kinda hate the idea of TIPS actually losing money in real terms.

If you go out all the way to the end of the yield curve, you might get around 1%. Whoopee. With a yield curve that flat, I don't see much appeal to going beyond that 5-7 year range.

That said, my only TIPS are a small allocation I get through a Real Return fund. That's indexed to Bloomberg Barclays US Treasury Inflation
Protected Securities (TIPS) Index, which is a broad index (same index as the ETF TIP). However, it has approximately an 8.5 year weighted maturity and 7.75 year effective duration, so that's good enough for me.

grok87
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Sun May 21, 2017 8:59 pm

BigJohn wrote:dbr/Kyle, thanks for the comments
grok87 wrote:Long term is my vote-LTPZ
grok, although a higher yield is certainly nice, I've always stayed away from long bonds because their interest rate sensitivity was just too great. Now that I've retired, I'm looking at my bonds as the liability matching part of my portfolio to cover 30 years of minimal living expenses and am even more loath to take the increased interest rate risk. I actually consider keeping my entire bond allocation in VG ST Bond Index rather than IT but decided that was too conservative and that I could'should accept the interest rate risk of IT.

With this background, would you still advocate a LT TIPS fund? If so, can you elaborate a bit on why? Thanks.
so your goal is to cover 30 years of minimal living expense. so why not a 30 year tips ladder? there is no interest rate risk if you hold bonds to maturity.

back to the fund question. well a tips ladder is in a sense a bond fund- ie a bunch of bonds. for example if we ignore the coupons, a 30 year tips ladder would have an average maturity and an average duration of 15 years. once you add in the coupons it would be a bit less. by comparison LTPZ has a real duration of about 22.5. so to get down to closer to the 15 years you could do an 2:1 mix of LTPZ and I-Bonds. that would give you a real duration of 15 (since the real duration of ibonds is zero- ie they have no real interest rate risk).

the main difference if you go the ibonds/LTPZ route is that you would have to keep managing the mix of the two to get the duration you want. For example after 2 years you would need a 28 year TIPS ladder with average maturity of 14 years. in theory that would mean a 62:38 mix of LTPZ and I-bonds assuming the duration of LTPZ remains the same.

i think perhaps your concern is- what if interest rates spike just after i buy causing my LTPZ to lose value? One approach to deal with this might be to target a somewhat shorter duration than strict liability matching might suggest. For example you could do a 50/50 mix of Ibonds and LTPZ which would put your real duration at about 11.25, ie somewhat shorter than the 15 above. there are a couple of advantages of somewhat shorter duration:

1) you would lose less if real interest rates spike
2) you could live off the ibonds for quite a while (15 years) before needing to touch LTPZ.
3) in the meantime you could reinvest LTPZ's coupons in the fund which would increase the real duration of your portfolio back more toward the Liability matching target.

hope this helps
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

BigJohn
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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Mon May 22, 2017 5:55 pm

grok, thanks for taking the time to add the details. I understand your points and that may well be a very appropriate approach for some. I decided some time back that building an individual TIPS ladder isn't something I was willing to consider as one of the objectives for my retirement portfolio is additional simplicity. While simplicity may be a bit less of a worry for the LTPZ/I-Bonds mix, the purchase limit constraint makes this approach impossible to implement in the time frame I need.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Mon May 22, 2017 6:03 pm

dbr wrote:Vanguard issued a paper....
Thanks dbr, I went looking for and found the paper. Here is their summary
Our results imply that a short-term TIPS portfolio may be a more appropriate
inflation-sensitive investment than the broad TIPS market for risk-averse
investors who want their total portfolio to more closely track realized CPI
inflation over short horizons. Of course, the higher inflation correlation of shortterm
TIPS comes at a cost—a lower expected income return versus that of the
broad TIPS market. In this sense, the risk−return trade-offs of investing in a
short-maturity versus a longer-maturity TIPS portfolio parallel those involved
when selecting the interest rate exposure of any other bond portfolio.
It does indeed seem odd that their own conclusion is that the ST vs IT choice is parallel to that for nominal bonds but then they make a different choice that does not parallel using a total bond market fund.

dbr
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Re: Intermediate vs Short Term TIPS Fund

Post by dbr » Mon May 22, 2017 6:14 pm

BigJohn wrote:
dbr wrote:Vanguard issued a paper....
Thanks dbr, I went looking for and found the paper. Here is their summary
Our results imply that a short-term TIPS portfolio may be a more appropriate
inflation-sensitive investment than the broad TIPS market for risk-averse
investors who want their total portfolio to more closely track realized CPI
inflation over short horizons. Of course, the higher inflation correlation of shortterm
TIPS comes at a cost—a lower expected income return versus that of the
broad TIPS market. In this sense, the risk−return trade-offs of investing in a
short-maturity versus a longer-maturity TIPS portfolio parallel those involved
when selecting the interest rate exposure of any other bond portfolio.
It does indeed seem odd that their own conclusion is that the ST vs IT choice is parallel to that for nominal bonds but then they make a different choice that does not parallel using a total bond market fund.
Yes, their conclusion is inexplicably different. Well, actually it is explained by confusing correlation with inflation and actual compensating away of inflation risk, which compensation is equally applied to all maturities of TIPS.

grok87
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Mon May 22, 2017 7:33 pm

BigJohn wrote:grok, thanks for taking the time to add the details. I understand your points and that may well be a very appropriate approach for some. I decided some time back that building an individual TIPS ladder isn't something I was willing to consider as one of the objectives for my retirement portfolio is additional simplicity. While simplicity may be a bit less of a worry for the LTPZ/I-Bonds mix, the purchase limit constraint makes this approach impossible to implement in the time frame I need.
sure
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Angst
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Re: Intermediate vs Short Term TIPS Fund

Post by Angst » Wed May 24, 2017 12:55 pm

BigJohn wrote:My SWR is below 3%. Overall I don't worry much about outlasting my money... [snip]
Hi BigJohn,
Below 3% sounds fairly safe given your AA and I'm sure that's a comfort to you. Since you've already been in retirement for about 2 years now, how much of those "below 3%" annual withdrawals have been comprised of just dividends and interest payments? If a fairly good portion of your SWR consists of just dividends and interest, this might justify moderating a bit of your concern over the sensitivity of your fixed income to interest rates. And of course, we don't want to forget that an upside of the price variability of fixed income (especially LT FI) is its tendency to buffer some of the more dramatic drops in equity.

BigJohn
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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Wed May 24, 2017 6:33 pm

Angst wrote:....how much of those "below 3%" annual withdrawals have been comprised of just dividends and interest payments?
Interesting point Angst, never thought about that impact. In my case, more than half of my assets are in tIRAs and I'm 10 years from RMDs so until then half or less of my SWR is coming from dividends/interest. With stocks up and at high valuations, I'm selling stock funds for the other half which also helps with rebalancing. I will switch to selling bonds when there is a major market correction or to rebalance if I get too far out of range. I don't feel I need rock steady bond value and am comfortable with my IT choice but not sure I want to take on the potential volatility of going LT.

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Re: Intermediate vs Short Term TIPS Fund

Post by Angst » Wed May 24, 2017 6:55 pm

^ Understood.

One more thought. I was reading your response re: the LTPZ plus I Bonds suggestion for reducing duration of the LTPZ and I just wanted to be sure you recognize that the same goal could be accomplished by adding Vanguard's ST TIPS fund to your LTPZ holdings. Or just use Vanguard's TIPS fund and add some of their ST TIPS if you still want to go shorter.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Wed May 24, 2017 7:07 pm

Angst wrote:I just wanted to be sure you recognize that the same goal could be accomplished by adding Vanguard's ST TIPS fund to your LTPZ holdings.
Angst, is there any benefit to this vs the VG IT TIPS fund if average duration is about the same? I like simplicity and am comfortable with the risk-return trade-off of my IT nominal bond fund. The KISS approach to me is to just use an IT TIPS fund to improve my inflation protection and be done with it.

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Re: Intermediate vs Short Term TIPS Fund

Post by jalbert » Wed May 24, 2017 8:30 pm

Intermediate TIPs have generally had a high historical sample correlation with intermediate corporate bonds. TIPs maybe have too short of a history to generalize from such historical sample correlations, but the risk of simultaneous deterioration of the two asset classes during a disinflationary period is historically observable (2008/2009), not just theoretical.

Thus, replacing VBILX with a 50-50 mix of VSIGX and VAIPX would reduce inflation risk but maintain a similar profile of term risk and disinflation risk (but likely less disinflation risk overall). This is basically replacing intermediate corporates with intermediate TIPs instead of holding both on account of their historical correlation.

Short-term TIPs are useful as a source of withdrawals within a year or two of when inflation might tick up and other asset classes might still be adjusting to the changes.

If overall stock allocation is very low, then allocating fixed income to TIPs and matching the duration of the bonds to the duration of liabilities is sensible. If stock allocation is higher, say 40-60%, then I'm not sure a long duration liability matching TIPs portfolio is consistent with overall portfolio risk management, and may not adequately diversify equity risk.
Risk is not a guarantor of return.

grok87
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Thu May 25, 2017 8:57 pm

jalbert wrote:
If overall stock allocation is very low, then allocating fixed income to TIPs and matching the duration of the bonds to the duration of liabilities is sensible. If stock allocation is higher, say 40-60%, then I'm not sure a long duration liability matching TIPs portfolio is consistent with overall portfolio risk management, and may not adequately diversify equity risk.
it's a good point.

So i suppose the portfolio suggested here by William Bernstein of 75% long term tips / 25% equities would still be acceptable according to your criteria- i.e. <40% equity.

https://www.wsj.com/articles/how-to-thi ... 1417408070
"He reckons that a $750,000 portfolio of TIPS and high-quality corporate bonds yielding a real return of 1% a year, from which he will withdraw $50,000 annually before age 70 and $21,700 a year thereafter, will last him to age 98. He can put the remaining $250,000 into a globally diversified portfolio of stocks. Let’s call this $250,000 of equities his risk portfolio, or RP. "
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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Re: Intermediate vs Short Term TIPS Fund

Post by jalbert » Fri May 26, 2017 12:50 am

it's a good point.

So i suppose the portfolio suggested here by William Bernstein of 75% long term tips / 25% equities would still be acceptable according to your criteria- i.e. <40% equity.
I just pulled 40-60% out of the air, noting it as an estimated range-- it's not based on any analysis or research I know of.

I would be uncomfortable holding 60% equities and 40% long TIPs. Merton also recommends a liability matching TIPs portfolio combined with 25% equities. Not sure where I would draw the line.

Some efficient frontiers I've seen for a combination of US stocks and TIPs suggest one can go down to 5% stocks and 95% TIPs and still hold an efficient portfolio. 100% TIPs may be inferior to that.
Risk is not a guarantor of return.

grok87
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Fri May 26, 2017 7:11 am

jalbert wrote:
it's a good point.

So i suppose the portfolio suggested here by William Bernstein of 75% long term tips / 25% equities would still be acceptable according to your criteria- i.e. <40% equity.
I just pulled 40-60% out of the air, noting it as an estimated range-- it's not based on any analysis or research I know of.

I would be uncomfortable holding 60% equities and 40% long TIPs. Merton also recommends a liability matching TIPs portfolio combined with 25% equities. Not sure where I would draw the line.

Some efficient frontiers I've seen for a combination of US stocks and TIPs suggest one can go down to 5% stocks and 95% TIPs and still hold an efficient portfolio. 100% TIPs may be inferior to that.
thanks
yeah 25/75 stocks/long-term-tips is what the DFA target retirement fund apparently does
http://www.investmentnews.com/article/2 ... investment
where Merton is
https://en.wikipedia.org/wiki/Robert_C._Merton

[too bad about LTCM though...]
:shock:

cheers,
grok
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Fri May 26, 2017 8:03 am

grok87 wrote:yeah 25/75 stocks/long-term-tips is what the DFA target retirement fund apparently does
http://www.investmentnews.com/article/2 ... investment
cheers,
grok
No, 75% LT TIPS is not what DFA does. That doesn't make much sense financially, as it would subject the retiree to a great deal of interest rate risk.

DFA does put about 3/4s of the fund in bonds beginning from near retirement and continues that ratio thru the rest of the investor's life-cycle. Most of these bonds are a combination of ST & LT TIPS bond funds whose combined duration is matched dynamically thru time with the duration of the investor's remaining life span. This is one of the many ways that the DFA TDFs are consistent with the principles of life-cycle economics.

In order to keep the fund safe for relatively long-lived investors, I believe DFA assumes the investor will live to about age 91.

In a recent DFA report their approach to how they use TIPS funds in their TDFs was discussed.
The Application of LDI* Techniques to the DC Framework

With the focus of most retirement planning being limited to savings accumulation and growth, individuals may be more prone to the risk of unstable income in retirement. Most individual retirement funds do not take into account the liabilities of retirees, which are ongoing withdrawals from retirement assets that an individual needs to make to meet their living expenses. Focusing on savings accumulation and growth without a framework to manage the uncertainty of affordable in-retirement income may affect the approach to building the asset allocation. For instance, one of the lowest-risk assets in real-dollar terms for a portfolio that focuses on managing the uncertainty of retirement income is a portfolio of Treasury Inflation Protected Securities (TIPS) that are duration matched to the stream of income that is anticipated to be needed in retirement; not three-month treasury bills, as is the convention when managing the volatility of accumulated savings.
LDI* - liability driven investing

By mixing the ST & LT TIPS funds dynamically over time to match the TIPS duration with the duration of the liabilities over time, what DFA is doing with these TIPS funds is equivalent to holding a TIPS bond ladder. Both LDI techniques are duration matching TIPS assets to the retirees income liabilities.

BobK
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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Fri May 26, 2017 12:24 pm

bobcat2 wrote: Most of these bonds are a combination of ST & LT TIPS bond funds whose combined duration is matched dynamically thru time with the duration of the investor's remaining life span. This is one of the many ways that the DFA TDFs are consistent with the principles of life-cycle economics.
bobcat, while I understand the theoretical benefit of trying to dynamically match remaining life expectancy, is there really that much benefit in practical terms? After all, the target itself (ie life span) is a huge unknown in the base case. For the sake of simplicity, what's the downside of just using an IT TIPS fund? Sure the duration probably starts off shorter than your life expectancy so you may give up a bit of yield but that's a price I think I'm willing to pay for one fund and no rebalancing simplicity.

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Fri May 26, 2017 3:41 pm

BigJohn wrote:... while I understand the theoretical benefit of trying to dynamically match remaining life expectancy, is there really that much benefit in practical terms? After all, the target itself (ie life span) is a huge unknown in the base case. For the sake of simplicity, what's the downside of just using an IT TIPS fund? Sure the duration probably starts off shorter than your life expectancy so you may give up a bit of yield but that's a price I think I'm willing to pay for one fund and no rebalancing simplicity.
The DFA TDFs do the rebalancing for you, so that's pretty simple.

I expect to live 20 years. Is holding a boat load of TIPS bonds that all mature in 10 years essentially the same as holding a 20 year TIPS ladder? You appear to think so. I don't. :wink:

Personally I try to dynamically match the TIPS funds to age 85, and annuitize, thru longevity annuities bought over time as I get nearer to 85, that amount of income beyond age 85.

BobK
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Re: Intermediate vs Short Term TIPS Fund

Post by abuss368 » Fri May 26, 2017 4:01 pm

TIPS are not needed. Stay with the Three Fund Portfolio.
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Re: Intermediate vs Short Term TIPS Fund

Post by grok87 » Fri May 26, 2017 6:26 pm

bobcat2 wrote:
grok87 wrote:yeah 25/75 stocks/long-term-tips is what the DFA target retirement fund apparently does
http://www.investmentnews.com/article/2 ... investment
cheers,
grok
No, 75% LT TIPS is not what DFA does. That doesn't make much sense financially, as it would subject the retiree to a great deal of interest rate risk.


BobK
Thanks
So here is a link to the fund on morningstar

http://portfolios.morningstar.com/fund/ ... ture=en-US
Looks,like right now the bond holdings are 67.5% of the portfolio. Presumably it will build up to the 75% level over the next 3 years.

the bond holding right now are
Short term nominal bonds 3%
Intermediate tips fund (8.25 avg maturity) 36.75%
Long term tip fund (28 year avg maturity) 27.75%

I think that puts the average duration of the bonds now at 16. I'm guessing they may be targeting a 15 year duration when they get to 2020, which woul be consistent with a 30 year retirement horizon.
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Fri May 26, 2017 8:50 pm

abuss368 wrote:TIPS are not needed. Stay with the Three Fund Portfolio.
abuss, you started one of the longest discussions ever on TIPS (viewtopic.php?p=2540230). Interested in why you say TIPS are not needed. Is there more to it than just your frustration at no/low dividend payments? I know you're bothered by this but as I responded in that discussion, I think that's just the nature of the beast and the cost of inflation protection.

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Re: Intermediate vs Short Term TIPS Fund

Post by midnightrun » Sat May 27, 2017 4:36 am

Bobcat2 ... wondering if I correctly understand the details of using a blend of funds rather than individual TIPS for a LMP strategy. As a hypothetical, suppose I need 10000/year for 10 years and would like to use a mix of IBonds (duration 0 years) and VIPSX (assumed duration 8 years). I assume IBonds have a real return of 0.0%. I also assumed that VIPSX has a real return of 0.25%, recognizing that this may fluctuate up and down ... including a potential negative real return. However, for the purposes of the calculation below, I kept the rate constant. If the return is higher than expected, that would cause the blended duration to drift up, and I'd pull more from VIPSX that year. If it's less than expected, the blended duration would drift down, and I'd pull proportionally more from I Bonds that year.

|| Year || Duration || Balance in I Bonds (amount withdrawn) || Balance in VIPSX (amount withdrawn) || Real Return from VIPSX ||
1 4.5 yrs $43585 ($0) $56038 ($10000) $0
2 4 yrs $44853 ($0) $44771 ($10000) $115
3 3.5 yrs $44853 ($1212) $34886 ($8788) $87
4 3 yrs $43641 ($2466) $26185 ($7534) $65
5 2.5 yrs $41175 ($3722) $18716 ($6278) $47
6 2 yrs $37453 ($4979) $12484 ($5021) $31
7 1.5 yrs $32475 ($6236) $7494 ($3764) $19
8 1 yr $26239 ($7489) $3748 ($2511) $9
9 0.5 yrs $18750 ($8750) $1247 ($1250) $3
10 0 yr $10000 ($10000) $0


Can scale this up to longer periods by adding LTPZ. Let me know If I'm on the right track.

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 10:34 am

Hi midnightrun,

You pose an interesting question IMO and that's because I am not sure the duration of I-bonds is zero. When I googled the question, "what is the duration of I-bonds?", what came up was a heated discussion of that very topic here at Bogleheads four years ago. :D I was not aware of that discussion until today.

Here's the link - viewtopic.php?t=113274

Some argued that the duration was zero (I can understand why), while others argued that the duration of an I-bond was approximately equal to its years to redemption. I lean towards approximately equal to its years to redemption, but I have little confidence in my opinion on this matter. :(
But if that's true, calculating the duration of a combination of I-bonds and a TIPS fund doesn't appear to be a simple, straightforward proposition - at least to my meager understanding of this. :( :(

OTOH, the calculation of the duration of I-bonds when used to finance retirement spending may not be relevant. In other words, zero duration is reasonable in this context. :? :?

Personally, I thought the posts by Epsilon Delta and Market Timer on the thread were the most informative and thoughtful.

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Re: Intermediate vs Short Term TIPS Fund

Post by #Cruncher » Sat May 27, 2017 1:22 pm

bobcat2 in [url=https://www.bogleheads.org/forum/viewtopic.php?p=3383238#p3383238]this post[/url] wrote:By mixing the ST & LT TIPS funds dynamically over time to match the TIPS duration with the duration of the liabilities over time, what DFA is doing with these TIPS funds is equivalent to holding a TIPS bond ladder.
I don't see how this can be, Bob. The whole concept of using funds to match a non-rolling ladder looks flawed. To illustrate, take the hypothetical case where there are zero-coupon TIPS all with a zero real yield maturing every year over the next 30 years. If I wanted to fund 10,000 real dollar spending each year for the next 30, I could simply buy $10,000 of each of these 30 TIPS. Then every year $10,000 will mature and I'll spend the proceeds.

But assume there are also 30 TIPS funds, each holding only TIPS with the same maturity. E.g., one holds only TIPS maturing in one year, another only TIPS maturing in two years, etc., up to one fund that only holds TIPS maturing in 30 years. Each fund maintains the same maturity. E.g., when the bonds of the 1-year fund mature, the proceeds are used to buy new 1-year bonds; when the bonds of the 30-year fund are 29 years from maturity, they are sold and the proceeds used to buy new 30-year bonds. This way each fund maintains a constant maturity.

Say I invest $10,000 in each of these 30 funds. I don't see how I could handle them over the years to make them equivalent to the non-rolling ladder of 30 individual bonds. With the bond ladder each year the average maturity will decline by 1/2 year. It starts out at 15.5 ([1 + 30) / 2]). After one year, it will be 15.0 ([1 + 29] / 2), etc. If I want to match this declining average maturity with my fund holdings, every year I'll need to sell off the fund with the longest maturity.

After one year I'll need to sell off the 30-year fund, and a year later the 29-year fund, etc. But this subjects me to tremendous interest rate risk. Suppose the first year interest rates rise from 0% to 1% for all maturities. My initial $10,000 investment in the 30-year fund will have declined to about $7,500 (10000 / 1.01 ^ 29). If I sell this fund to match the reduced duration of the ladder, I'll fall $2,500 short of my $10,000 spending requirement.

I could avoid the interest rate risk if I instead sell off the 1-year fund. However, I'll no longer match the duration of the ladder. After one year the ladder's average maturity will be 15 ([1 + 29] / 2], while that of the funds will be 16 ([(2 + 30) / 2].

I believe the problem would also exist with a combination of real world funds, albeit possibly not as extreme. Say I hold a short term and long term fund in such proportions to initially have the same 15.5 average maturity of the ladder. To match the 15.0 average maturity of the ladder one year later, I'd need to sell off part of the long term fund and thereby be subject to significant interest rate risk.
midnightrun in [url=https://www.bogleheads.org/forum/viewtopic.php?p=3384350#p3384350]this post[/url] wrote:As a hypothetical, suppose I need 10000/year for 10 years and would like to use a mix of IBonds (duration 0 years) and VIPSX (assumed duration 8 years). ... Let me know If I'm on the right track.
I don't have an opinion on your specific proposal, midnightrun. But I've re-formatted your table to make it easier for others to comment on:

Code: Select all

                  ----- I Bonds -----     --------- VIPSX -----------
Year  Duration    Balance   Withdrawn     Balance   Withdrasn  Return
----  --------    -------   ---------     -------   ---------  ------
  1    4.5 yrs    $43,585        ($0)     $56,038   ($10,000)      $0
  2    4 yrs      $44,853        ($0)     $44,771   ($10,000)    $115
  3    3.5 yrs    $44,853    ($1,212)     $34,886    ($8,788)     $87
  4    3 yrs      $43,641    ($2,466)     $26,185    ($7,534)     $65
  5    2.5 yrs    $41,175    ($3,722)     $18,716    ($6,278)     $47
  6    2 yrs      $37,453    ($4,979)     $12,484    ($5,021)     $31
  7    1.5 yrs    $32,475    ($6,236)      $7,494    ($3,764)     $19
  8    1 yr       $26,239    ($7,489)      $3,748    ($2,511)      $9
  9    0.5 yrs    $18,750    ($8,750)      $1,247    ($1,250)      $3
 10    0 yr       $10,000   ($10,000)          $0

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 1:53 pm

Hi #Cruncher,

You are rebalancing the funds at higher frequency than annually. I suggest a frequency of at least a quarterly or trimester basis. The higher frequency the better, but you have to trade off the efficiency of near continual re-balancing with the trading costs, both in dollars and time and effort of re-balancing, on a monthly or higher frequency trading basis. As an aside, I believe DFA TDFs rebalance the TIPS funds on a monthly basis.

I would add that in none of these duration matching strategies, and that includes TIPS bond ladders, are we going to achieve perfect immunization against changes in interest rates. We are aiming for a relative safe retirement income stream, not perfect protection against interest rate movements.

It seems to me that if trading were costless and you knew the duration and convexity of the bond funds at every point in time, then continuous time trading would provide nearly perfect immunization against changing interest rates. That is not practical for real world applications. :D

Fortunately, all these strategies provide much safer retirement income than, for example, the 3 fund portfolio of US stock fund, international stock fund, and US total indexed bond fund.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 27, 2017 2:52 pm

bobcat2 wrote:I would add that in none of these duration matching strategies, and that includes TIPS bond ladders, are we going to achieve perfect immunization against changes in interest rates. We are aiming for a relative safe retirement income stream, not perfect protection against interest rate movements

It seems to me that if trading were costless and you knew the duration and convexity of the bond funds at every point in time, then continuous time trading would provide nearly perfect immunization against changing interest rates. That is not practical for real world applications.

Fortunately, all these strategies provide much safer retirement income than, for example, the 3 fund portfolio of US stock fund, international stock fund, and US total indexed bond fund.
bobcat, thanks for these comments. Although not directed at my question about whether an IT TIPS fund was "good enough" it actually helps with my decision. As with lots of questions with investing, there are always trade-offs. I don't need perfect protection, just a directional improvement in inflation protection over the 3 fund portfolio.

Input from you and others this discussion has convinced me that adding TIPS is a good idea and that using an IT TIPS fund is a practical/reasonable approach to doing so. My thanks to all.

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 3:05 pm

Hi BigJohn,
I was referring to the different duration matching strategies. Holding an intermediate term TIPS fund is far removed from any of the duration matching strategies. For safe income over retirement there is little difference between holding an intermediate nominal bond fund and an intermediate TIPS fund. Neither provides a retiree with safe income. You are only kidding yourself, if you think otherwise.

The duration of VIPSX is usually around 8. If real interest rates move 200 basis points, as they do sometimes, and the duration of the income liability is above 14, then that duration mismatch between the fund and the income liability makes the TIPS fund a risky investment.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 27, 2017 5:28 pm

bobcat2 wrote:For safe income over retirement there is little difference between holding an intermediate nominal bond fund and an intermediate TIPS fund. Neither provides a retiree with safe income. You are only kidding yourself, if you think otherwise.
Well, I'm really not sure I understand this statement and it is certainly very different from the perspective of many on this forum as well as VG's conclusion. Sure seems like a healthy dose of an IT TIPS fund would be better than all nominals if we get into a stagflation situation were nominals are losing value and stocks aren't helping keep up with inflation in the near/medium term. There is no free lunch and anything can/will lose value at some point. I'm not planning to live exclusively off TIP, just looking for balance between stocks, nominal bonds and TIPS to get the most robust portfolio possible. I'm sure at some point I'll sell something at a loss but will have options on which fund has the lowest loss.

I'm no bond expert so is there a relatively simple explanation for why you see little difference between nominal bonds and TIPS?

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 6:03 pm

When you want to turn assets in bond funds into safe income in retirement - there are two principal risks
1) inflation risk
2) interest rate risk

Holding any bond fund with a duration of 8 does not protect you against interest rate risk, except for the point in time that the corresponding liability has a duration of 8 years. When the duration of your bond holdings matches the duration of your intended withdrawals over time, you are protected against interest rate risk. (In this case the withdrawals are the liability.)

Here's an example. Supposing you are putting off taking SS for 4 years. You need to cover safely for the next 4 years that missing SS income of $26,000/year. You invest what you think is the right amount of money in the IT Vanguard TIPS fund. That fund has a duration of 8 years. Real interest rates spike 2% in the second year, which means the fund has lost 16% of its value. You now don't have enough money in the fund to cover the lost income for the last two years of delaying your SS benefits. That's because you have a duration mismatch between the bond assets and the remaining two years of income withdrawals. If the duration of the bond assets and the withdrawals had been matched thru time, that shortfall wouldn't have happened. When the duration of the asset and the liability are matched, it doesn't matter how interest rates move. However they move, you will have the right amount of assets to cover the liability.

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Re: Intermediate vs Short Term TIPS Fund

Post by midnightrun » Sat May 27, 2017 8:29 pm

bobcat - thanks for the link to the discussion of I Bonds duration. Sounds like no clear consensus but it is reasonable to use I Bonds or a Short term TIPS funds as your minimal duration component if attempting to implement a TIPS fund strategy rather than a ladder.

Based on my understanding of the subject, it appears that a TIPS ladder has the benefit of providing a definite amount of real income planned in advance at set points in the future. This can provide certainty for the retiree. However, it has the downside of giving up liquidity and the hassle of constructing a ladder (whether or not the hassle of putting together a TIPS ladder is overblown is unclear to me as I haven't attempted it, but given the general sentiment among bogleheads ... it seems to be a real issue). Moreover, one has guaranteed a definite amount of real income but there is no guarantee that the real expense needs in the future will match the real income.

In contrast, blending duration of TIPS funds allows reasonable liquidity, an approximation of a real income stream, and the flexibility to adjust the amount of withdrawals on the fly to match real expenses. The downside is fund expenses, need to dynamically track blended fund duration, and the small but real risk of such an extended period of declining fund value that it impacts the funds available to match liabilities.

Personally, I am leaning toward using a blend of funds for a LMP in early retirement, but anticipate having a large risk portfolio that is 80/20 so assume I can make up any shortfalls due to rising rates from excess stock returns. The mental accounting of splitting out a LMP provides more peace of mind in ER. If I were someone skating by with a large LMP relative to a small Risk Portfolio, I'd probably feel that the certainty of a definite income amount each year is paramount.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 27, 2017 8:57 pm

BobK, thanks for the answer and example. I understand the concept of interest rate risk and the fact that it's the same for TIPS and nominal bond. I've put together a 3 fund portfolio that I'm comfortable with handling interest rate risks using an IT nominal bond fund. I understand there are pros/cons to laddering vs this approach when I made these decisions several years ago.

The risk I'm trying to address right now is not interest rate risk, it's inflation risk. Change your example above to an unexpected spike in inflation by 2%. Wouldn't having your bonds in a TIPS fund address this risk scenario better than if it were in a nominal bond fund regardless of the duration?

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 10:17 pm

BigJohn wrote: I've put together a 3 fund portfolio that I'm comfortable with handling interest rate risks using an IT nominal bond fund.
If you understand interest rate risk to your withdrawals, then you understand that an IT bond fund does not handle the risk. For your withdrawals from the portfolio to provide safe retirement income, the income from the bonds must be safe against both interest rate risk and inflation risk.

Using an IT TIPS bond fund to provide safe income is like thinking your car seat is safe when you have air bags but no seat restraint.

My advice is to follow grok's advice early in this thread, but instead of I-bonds mix instead the Vanguard ST TIPS fund with the LT TIPS fund from Pimco.

I realize duration matching is not that easy to do and, for that matter, the concept is not very intuitive to most people. I had to think about for for quite a while before I grasped the importance. Nonetheless, unless that's what you do, you will not have safe income in retirement from withdrawals from your portfolio. I realize that's not what many people want to hear.

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sat May 27, 2017 11:18 pm

bobcat, thanks again for all your help/advice but I think we have different definition of what "handle the risk" means. I did not mean to imply that my approach was immune to the risk but I'm confident that I can survive without undue hardship. With a normal SWR below 3% and the possibility to go close to 2% if both stocks and bonds perform badly at the same time, I have flexibility that others might not have. I choose to use that flexibility to simplify things for personal reasons I won't get into in this discussion. If things were tighter and I was at 4+% SWR, my flexibility to manage some decrease in my bond fund output would be much more limited and your approach might be more necessary.

So putting interest rate risk aside I come back to my initial question, won't the addition of an IT TIPS fund improve the ability of my portfolio to handle a spike in inflation?

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Re: Intermediate vs Short Term TIPS Fund

Post by bobcat2 » Sat May 27, 2017 11:49 pm

BigJohn wrote:bobcat, thanks again for all your help/advice but I think we have different definition of what "handle the risk" means. I did not mean to imply that my approach was immune to the risk but I'm confident that I can survive without undue hardship. With a normal SWR below 3% and the possibility to go close to 2% if both stocks and bonds perform badly at the same time, I have flexibility that others might not have. I choose to use that flexibility to simplify things for personal reasons I won't get into in this discussion. If things were tighter and I was at 4+% SWR, my flexibility to manage some decrease in my bond fund output would be much more limited and your approach might be more necessary.

So putting interest rate risk aside I come back to my initial question, won't the addition of an IT TIPS fund improve the ability of my portfolio to handle a spike in inflation?
Hardly at all. You are protecting retirement income, not a small portion of your portfolio from inflation. You can't protect your retirement income by simply adding the Vanguard IT TIPS fund to your portfolio. Unfortunately, finance doesn't work that way. You can ask this as many ways as you want. This is ineffective!

Putting interest rate risk aside is like asking, aside from my prognosis of terminal pancreatic cancer, can't I be expected to live a long life?

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Re: Intermediate vs Short Term TIPS Fund

Post by BigJohn » Sun May 28, 2017 7:09 am

OK Bob, I'll quite asking you then, thanks

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Re: Intermediate vs Short Term TIPS Fund

Post by abuss368 » Sun May 28, 2017 11:32 am

BigJohn wrote:
abuss368 wrote:TIPS are not needed. Stay with the Three Fund Portfolio.
abuss, you started one of the longest discussions ever on TIPS (viewtopic.php?p=2540230). Interested in why you say TIPS are not needed. Is there more to it than just your frustration at no/low dividend payments? I know you're bothered by this but as I responded in that discussion, I think that's just the nature of the beast and the cost of inflation protection.
Wasn't that an amazing thread? Exceeded my expectations! I found the responses very educational and informative.
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Re: Intermediate vs Short Term TIPS Fund

Post by abuss368 » Sun May 28, 2017 11:35 am

BigJohn wrote:
abuss368 wrote:TIPS are not needed. Stay with the Three Fund Portfolio.
abuss, you started one of the longest discussions ever on TIPS (viewtopic.php?p=2540230). Interested in why you say TIPS are not needed. Is there more to it than just your frustration at no/low dividend payments? I know you're bothered by this but as I responded in that discussion, I think that's just the nature of the beast and the cost of inflation protection.
TIPS definitely can have a place in an investment portfolio. The question is if there is a need or greater than normal risk of inflation.
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Re: Intermediate vs Short Term TIPS Fund

Post by #Cruncher » Mon May 29, 2017 4:42 pm

bobcat2 in [url=https://www.bogleheads.org/forum/viewtopic.php?p=3384765#p3384765]this post[/url] wrote:... in none of these duration matching strategies, and that includes TIPS bond ladders, are we going to achieve perfect immunization against changes in interest rates. (underline added)
I disagree. A non-rolling ladder does immunize perfectly against changes in interest rates. Since each rung of the ladder is a bond that will be held to maturity, the proceeds are not subject to changes in interest rates. Please explain why you think this is not so, Bob.
bobcat2 in same post wrote:... if trading were costless and you knew the duration and convexity of the bond funds at every point in time, then continuous time trading would provide nearly perfect immunization against changing interest rates.
The frequency of trading and its cost doesn't eliminate interest rate risk for a bond fund used to fund future spending. To illustrate, assume one needs $10,000 (in real terms) per year for the next 12 years 2018 - 2029. Ignoring coupons and yield one could accomplish this by buying $10,000 each of 12 TIPS maturing in these years. Regardless of changes in interest rates one is guaranteed to have $10,000 to spend each year.

But assume instead one attempts to duplicate the ladder of individual bonds with a "duration matched" combination of two mutual funds: the Vanguard Inflation-Protected Securities Fund (VIPSX) which has a duration of 8.0 and the Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIPX) which has a duration of 2.8. One splits $120,000 between them so as to have a weighted average duration of 6.5 ([1 + 12] / 2). [1] [2] This is shown in the first row of the table below.

Code: Select all

         ----- % Allocation ----   Avg   ------- $ Value -------
          VIPSX   VTIPX   Total    Dur    VIPSX   VTIPX   Total
         ------  ------  -------   ---   ------  ------  -------
2017     71.15%  28.85%  100.00%   6.5   85,400  34,600  120,000
          -8.0%   -2.8%                  78,600  33,600  112,200
2018     61.54%  38.46%  100.00%   6.0   62,900  39,300  102,200
Trade                                   (15,700)  5,700  (10,000)
Assume that immediately after making the initial purchases, interest rates rise 1% point for all TIPS and that (following the rule of thumb), VIPSX falls 8.0% and VTIPX 2.8%. The lower values are shown on the second row. Now move forward one year when one needs to take out $10,000 for the first year's spending. The third row shows what the values in each fund need to be to produce the $10,000 and also produce an average duration of 6.0 ([1 + 11] / 2). [3] The last row shows the amount of VIPSX that needs to be sold and the amount of VTIPX that needs to be purchased to do this.

After withdrawing the $10,000, the value of one's holdings has fallen to about $102,000. If interest rates hadn't risen and the value of the funds remained the same, the value would be $110,000 after withdrawing one year's proceeds. Thus rising interest rates caused a loss of $8,000. [4] I don't see how how the frequency of trading would significantly affect this result. Please explain how you think it would, Bob.
  1. For simplicity, I'm calculating average duration as average maturity.
  2. 6.5 = 71.15% * 8.0 + 28.85% * 2.8
  3. 6.0 = 61.54% * 8.0 + 38.46% * 2.8
  4. What's more, the need to "duration match" has forced one to sell the fund with the bigger loss (VIPSX) and buy the fund with the smaller loss (VTIPX). This is the opposite of standard "re-balancing".

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Re: Intermediate vs Short Term TIPS Fund

Post by jalbert » Tue May 30, 2017 11:09 pm

If overall stock allocation is very low, then allocating fixed income to TIPs and matching the duration of the bonds to the duration of liabilities is sensible. If stock allocation is higher, say 40-60%, then I'm not sure a long duration liability matching TIPs portfolio is consistent with overall portfolio risk management, and may not adequately diversify equity risk.
I think more accurate would be to say holding fixed income as a liability matching TIPs portfolio is only sensible if it is large enough to fully or nearly fully fund the liabilities (in real terms). If a very high net worth individual can do that at 90% stocks and 10% TIPs then the equity risk is not as important.

If partially dependent on the equity allocation to cover expenses, then managing the equity risk matters, and a fixed income allocation that is exclusively TIPs likely won't manage portfolio risk adequately.
Risk is not a guarantor of return.

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