Thoughts on using an ETF for TIPS investing

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PalmQueen
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Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Wed Jul 11, 2018 6:46 pm

Greetings - Currently, the "fixed income position" in my portfolio consists of money market accounts. I'm tempted to leave it there now that interest rates are on the rise but also feel there are other options which would provide better returns which also have low risk. Hence, I'm looking at ETFs that invest in TIPS. Any experience/alternatives/opinions folks on this forum are willing to share will be most welcome and appreciated. Thanks in advance.

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grabiner
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Re: Thoughts on using an ETF for TIPS investing

Post by grabiner » Wed Jul 11, 2018 8:36 pm

Welcome to the forum!

There is no free lunch in the market. The higher the yield on your bonds, the more risk of some type you will take, so you have to decide whether taking that risk is worthwhile.

Note that I said, "in the market". Outside your IRA, you can buy I-Bonds, which are not traded in the market; unlike other bonds, they will not lose value if rates rise. If you buy an I-Bond with a 0% rate above inflation, you can cash it in at any time from 1-30 years (small penalty for less than 5 years), and get the original value plus inflation; you will pay federal but not state tax on the gains.

Inside an IRA, or if you are over the limit for I-Bond purchases ($10,000 per person per year), TIPS are a low-risk investment, but not risk-free. As with other bonds, they will lose value if their own rates rise. However, they are less risky, because increased inflation will not cause TIPS rates to rise, nor cause the real value of the bonds to fall.

So, if you are subject to inflation risk, TIPS do make sense, and a low-cost ETF is a reasonable way to hold one. Choose a fund duration which is no longer than your time horizon; for example, if you will be spending money in five years, you don't want ten-year bonds. (You can change to a shorter duration later.)

Link to list of TIPS ETFs on ETF.com Choose your duration, then look for the lowest-cost funds. I like Vanguard's VTIP for short-term (0.06% expenses), Schwab's SCHP for intermediate-term (0.05% expenses), and PIMCO's LTPZ is the only long-term choice (0.20% expenses).
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Re: Thoughts on using an ETF for TIPS investing

Post by PFInterest » Wed Jul 11, 2018 8:38 pm

PalmQueen wrote:
Wed Jul 11, 2018 6:46 pm
Greetings - Currently, the "fixed income position" in my portfolio consists of money market accounts. I'm tempted to leave it there now that interest rates are on the rise but also feel there are other options which would provide better returns which also have low risk. Hence, I'm looking at ETFs that invest in TIPS. Any experience/alternatives/opinions folks on this forum are willing to share will be most welcome and appreciated. Thanks in advance.
How long have you been in MM funds?

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FIREchief
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Re: Thoughts on using an ETF for TIPS investing

Post by FIREchief » Wed Jul 11, 2018 9:21 pm

TIPS are so easy to just buy and hold individually. Why not just do that and save a small amount of expenses?
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

averagedude
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Re: Thoughts on using an ETF for TIPS investing

Post by averagedude » Wed Jul 11, 2018 9:50 pm

I believe you should know the purpose of your fixed income investments. It isn't the same for all investors. If your purpose is inflation protection, tips should be one of your primary holdings.

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PalmQueen
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Wed Jul 11, 2018 11:34 pm

Thank you for your insights.
I'll consolidate responses to your questions -
grabiner - Thank you for your welcome. You make good points about I-Bonds. They're more attractive since there's only a small penalty if you need to cash them out. Most of these funds are what I call sideline cash, so doubt that would be necessary. (Thanks for the tip on ETF.com. I was thinking of asking the group whether their information is reliable, so thanks for already answering.)
I have a follow-up question: The main reason ETFs appeal to me rather than just buying TIPS directly is that I had the impression those shares could be bought and sold without regard to the length of terms of the TIPS held in the fund, making the funds a bit more liquid. Was I confused about that?

PFInterest - I've kept a portion of total portfolio on MMs for years and years as a safe harbor. If everything else goes South, that will be there.
I'm thinking it would be good to put it to work someplace with a bit more return yet still low risk.

FIREchief - I was originally thinking of purchasing short term TIPS individually. When I looked into the ETFs, it seemed to me that since they hold a variety of time length TIPS, they may provide a bit more return with more liquidity.

averagedude - You nailed it. I'm looking for inflation protection.

This was my first post, so apologies if the combined response isn't the best way to do it. The system seemed to default to this format.
Thank you all!

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Re: Thoughts on using an ETF for TIPS investing

Post by stlutz » Wed Jul 11, 2018 11:59 pm

PalmQueen: Since you are looking at switching from a money market fund to a TIPS fund, you should be aware that TIPS do fluctuate in value from year to year due to changes in real interest rates. Vanguard's TIPS fund was down 8.61% in 2013.

Now, that's not to scare you away--it's simply to make sure you are aware that the properties of a TIPS ETF (and individual TIPS bonds) are different from a money market fund.

Over time, TIPS are a low-risk investment and will provide a return somewhat higher than inflation. The route to get there is not perfectly smooth, however.

The money market fund offers a perfectly smooth ride, but generally gives you a return somewhat less than inflation, particularly after taxes are taken into account.

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Re: Thoughts on using an ETF for TIPS investing

Post by Phineas J. Whoopee » Thu Jul 12, 2018 5:00 pm

If I may, to help readers who aren't already familiar with bogleheads.org jargon, David is referring to Series I Savings Bonds.
PJW

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grabiner
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Re: Thoughts on using an ETF for TIPS investing

Post by grabiner » Thu Jul 12, 2018 7:48 pm

PalmQueen wrote:
Wed Jul 11, 2018 11:34 pm
I have a follow-up question: The main reason ETFs appeal to me rather than just buying TIPS directly is that I had the impression those shares could be bought and sold without regard to the length of terms of the TIPS held in the fund, making the funds a bit more liquid. Was I confused about that?
You can also buy and sell individual TIPS in your brokerage account.

The advantage of the ETF is convenience. If you have ten individual bonds, you have to keep track of all ten, and unless you want your portfolio duration to shorten, you have to sell shorter-term bonds to buy longer-term bonds. The ETF will keep its duration as it sells shorter-term bonds to buy longer-term bonds on its own; you can change duration when you want to change, by selling an intermediate-term ETF to buy a short-term ETF. (The handling of taxes is also simpler with ETFs, although this is not relevant if the TIPS ETF is held in an IRA.)

Normally, bond funds have the additional advantage over individual bonds that it is easier to get diversification with a fund. However, for TIPS funds, there is no need for diversification, as all the bonds are guaranteed by the government. (In contrast, if you wanted to hold corporate bonds, you would prefer to have a fund holding 100 different bonds so that you would only have a 1% loss if one defaulted.)
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PalmQueen
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Thu Jul 12, 2018 9:03 pm

grabiner wrote:
Thu Jul 12, 2018 7:48 pm
PalmQueen wrote:
Wed Jul 11, 2018 11:34 pm
I have a follow-up question: The main reason ETFs appeal to me rather than just buying TIPS directly is that I had the impression those shares could be bought and sold without regard to the length of terms of the TIPS held in the fund, making the funds a bit more liquid. Was I confused about that?
You can also buy and sell individual TIPS in your brokerage account.

The advantage of the ETF is convenience. If you have ten individual bonds, you have to keep track of all ten, and unless you want your portfolio duration to shorten, you have to sell shorter-term bonds to buy longer-term bonds. The ETF will keep its duration as it sells shorter-term bonds to buy longer-term bonds on its own; you can change duration when you want to change, by selling an intermediate-term ETF to buy a short-term ETF. (The handling of taxes is also simpler with ETFs, although this is not relevant if the TIPS ETF is held in an IRA.)

Normally, bond funds have the additional advantage over individual bonds that it is easier to get diversification with a fund. However, for TIPS funds, there is no need for diversification, as all the bonds are guaranteed by the government. (In contrast, if you wanted to hold corporate bonds, you would prefer to have a fund holding 100 different bonds so that you would only have a 1% loss if one defaulted.)
Thank you! I've spent (way too many) hours researching this and you're the first to explain it clearly and concisely in a way that makes sense to me. I appreciate your help.

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Re: Thoughts on using an ETF for TIPS investing

Post by galeno » Fri Jul 13, 2018 7:33 pm

15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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PalmQueen
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Mon Jul 16, 2018 12:07 am

galeno wrote:
Fri Jul 13, 2018 7:33 pm
15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
That's good to hear. Can I ask which ETF you're using? Thanks.

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FIREchief
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Re: Thoughts on using an ETF for TIPS investing

Post by FIREchief » Mon Jul 16, 2018 1:25 am

galeno wrote:
Fri Jul 13, 2018 7:33 pm
15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
So you are only 25% concerned about inflation?? :confused
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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galeno
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Re: Thoughts on using an ETF for TIPS investing

Post by galeno » Mon Jul 16, 2018 9:39 am

No. I'm 55% worried about inflation.
FIREchief wrote:
Mon Jul 16, 2018 1:25 am
galeno wrote:
Fri Jul 13, 2018 7:33 pm
15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
So you are only 25% concerned about inflation?? :confused
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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galeno
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Re: Thoughts on using an ETF for TIPS investing

Post by galeno » Mon Jul 16, 2018 9:44 am

We are non-USA domiciles. We use ITPS which is the Ireland domiciled equivalent to iShares TIP.
PalmQueen wrote:
Mon Jul 16, 2018 12:07 am
galeno wrote:
Fri Jul 13, 2018 7:33 pm
15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
That's good to hear. Can I ask which ETF you're using? Thanks.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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PalmQueen
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Mon Jul 16, 2018 4:17 pm

galeno wrote:
Mon Jul 16, 2018 9:44 am
We are non-USA domiciles. We use ITPS which is the Ireland domiciled equivalent to iShares TIP.
PalmQueen wrote:
Mon Jul 16, 2018 12:07 am
galeno wrote:
Fri Jul 13, 2018 7:33 pm
15% of our 40/60 portfolio is in ONE TIPS ETF. We like it just fine.

We use the TIPS ETF to protect 25% of our fixed income allocation from unexpected inflation.
That's good to hear. Can I ask which ETF you're using? Thanks.
Thanks! I'm looking at SCHP from Schwab which looks similar to iShares TIP. (At the moment they have a bit of an edge in the costs.)
While I'm looking to just buy and hold, I'm wondering what the process is when one does sell. Since it's an ETF holding bonds with varying maturities, what sort of penalty (if any) is there when you sell. I'm assuming one wouldn't have to wait until all the bonds mature as they're always adding more.

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Re: Thoughts on using an ETF for TIPS investing

Post by not4me » Tue Jul 17, 2018 12:56 pm

PalmQueen wrote:
Mon Jul 16, 2018 4:17 pm

Thanks! I'm looking at SCHP from Schwab which looks similar to iShares TIP. (At the moment they have a bit of an edge in the costs.)
While I'm looking to just buy and hold, I'm wondering what the process is when one does sell. Since it's an ETF holding bonds with varying maturities, what sort of penalty (if any) is there when you sell. I'm assuming one wouldn't have to wait until all the bonds mature as they're always adding more.
While you own the etf, there will (likely) be distributions that will affect taxes (& possibly cost basis) for the year distributed. Your broker may charge a commission to buy or sell an etf. The sale proceeds are compared to the cost basis for the shares sold & you pay capital gain tax on that gain/loss (short or long depending upon how long you own the shares sold). Does that answer or make it muddier?

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Re: Thoughts on using an ETF for TIPS investing

Post by jalbert » Tue Jul 17, 2018 1:33 pm

Greetings - Currently, the "fixed income position" in my portfolio consists of money market accounts. I'm tempted to leave it there now that interest rates are on the rise but also feel there are other options which would provide better returns which also have low risk.
Define what you mean by risk. The funds you are considering are not taking inflation risk because they are TIPS but they are intermediate-term bond funds with sensitivity to changes in interest rates (term risk). SCHP has a duration of 7.3 years. This means it will fluctuate in value with changes in interest rates, but its price will move inversely with real rates (inflation-corrected interest rates, or the amount by which interest rates exceeds inflation). You should have a holding period of at least 7-8 years to smooth out this volatility.

SCHP is likely more volatile than the bond funds you have been avoiding. That doesn't mean you should not invest in it, but it should be evaluated as part of your overall portfolio, and overall portfolio risk should be considered.

If you want an investment with stable principal that will beat inflation you should be considering series I savings bonds or i-bonds. In a taxable account, they also are more tax-efficient than TIPS. They do have liquidity restrictions so you should plan on holding them for at least 5 years.

There also are short-term TIPS funds like VTIP or STIP, which have durations less than 3 years, and are much less sensitive to changes in real rates than intermediate TIPS. Currently the spread in real yields between short-term and intermediate TIPS is unusually thin. The disadvantage of short-term TIPS is if rates fall over the next 3 years, they will incorporate the lower rates faster than intermediate TIPS (reinvestment risk), but holding cash is even more exposed to this risk.
Index fund investor since 1987.

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PalmQueen
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Tue Jul 17, 2018 4:37 pm

jalbert wrote:
Tue Jul 17, 2018 1:33 pm
Greetings - Currently, the "fixed income position" in my portfolio consists of money market accounts. I'm tempted to leave it there now that interest rates are on the rise but also feel there are other options which would provide better returns which also have low risk.
Define what you mean by risk. The funds you are considering are not taking inflation risk because they are TIPS but they are intermediate-term bond funds with sensitivity to changes in interest rates (term risk). SCHP has a duration of 7.3 years. This means it will fluctuate in value with changes in interest rates, but its price will move inversely with real rates (inflation-corrected interest rates, or the amount by which interest rates exceeds inflation). You should have a holding period of at least 7-8 years to smooth out this volatility.

SCHP is likely more volatile than the bond funds you have been avoiding. That doesn't mean you should not invest in it, but it should be evaluated as part of your overall portfolio, and overall portfolio risk should be considered.

If you want an investment with stable principal that will beat inflation you should be considering series I savings bonds or i-bonds. In a taxable account, they also are more tax-efficient than TIPS. They do have liquidity restrictions so you should plan on holding them for at least 5 years.

There also are short-term TIPS funds like VTIP or STIP, which have durations less than 3 years, and are much less sensitive to changes in real rates than intermediate TIPS. Currently the spread in real yields between short-term and intermediate TIPS is unusually thin. The disadvantage of short-term TIPS is if rates fall over the next 3 years, they will incorporate the lower rates faster than intermediate TIPS (reinvestment risk), but holding cash is even more exposed to this risk.
Thanks for the clarification. These funds are in a taxable account so your points about short term TIPS funds or I-bonds are relevant.

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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Tue Jul 17, 2018 4:38 pm

not4me wrote:
Tue Jul 17, 2018 12:56 pm
PalmQueen wrote:
Mon Jul 16, 2018 4:17 pm

Thanks! I'm looking at SCHP from Schwab which looks similar to iShares TIP. (At the moment they have a bit of an edge in the costs.)
While I'm looking to just buy and hold, I'm wondering what the process is when one does sell. Since it's an ETF holding bonds with varying maturities, what sort of penalty (if any) is there when you sell. I'm assuming one wouldn't have to wait until all the bonds mature as they're always adding more.
While you own the etf, there will (likely) be distributions that will affect taxes (& possibly cost basis) for the year distributed. Your broker may charge a commission to buy or sell an etf. The sale proceeds are compared to the cost basis for the shares sold & you pay capital gain tax on that gain/loss (short or long depending upon how long you own the shares sold). Does that answer or make it muddier?
Thanks. This explanation makes this muddy (for me) topic a lot clearer.

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Re: Thoughts on using an ETF for TIPS investing

Post by jalbert » Tue Jul 17, 2018 5:29 pm

In a taxable account the interest and principal correction from inflation for I-bonds and TIPS is state-tax-free. If you hold individual TIPS you will have to pay Federal tax on the interest and principal correction of each bond annually, but you only will receive any principal correction when you sell the bond or it matures. This is considered a defect of holding individual TIPS in a taxable account. TIPS mutual funds and ETFs distribute the interest and principal correction, so ou receive the income, can use it to pay the Federal tax and reinvest the rest of desired.

If you reinvest all distributions from a TIPS fund, it is equivalent to holding an individual TIPS in terms of paying the tax on income you don’t realize.

Capital gains distributions from a TIPS fund or individual TIPS you sell are taxed by states with income tax assuming they tax capital gains, which most do as regular income.

The real interest rate on a current issue I-bond currently is .3% vs an SEC-yield of .57% for VTIP so it is unclear that the tax benefits of an I-bond currently are enough to compensate for their lower yield and reduced liquidity.
Index fund investor since 1987.

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Re: Thoughts on using an ETF for TIPS investing

Post by grabiner » Tue Jul 17, 2018 7:42 pm

jalbert wrote:
Tue Jul 17, 2018 5:29 pm
Capital gains distributions from a TIPS fund or individual TIPS you sell are taxed by states with income tax assuming they tax capital gains, which most do as regular income.
Check with your own state tax authority. In NJ, for example, capital gains on Treasury bonds and Treasury funds are not taxable.
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Re: Thoughts on using an ETF for TIPS investing

Post by PalmQueen » Tue Jul 17, 2018 10:49 pm

jalbert wrote:
Tue Jul 17, 2018 5:29 pm
In a taxable account the interest and principal correction from inflation for I-bonds and TIPS is state-tax-free. If you hold individual TIPS you will have to pay Federal tax on the interest and principal correction of each bond annually, but you only will receive any principal correction when you sell the bond or it matures. This is considered a defect of holding individual TIPS in a taxable account. TIPS mutual funds and ETFs distribute the interest and principal correction, so ou receive the income, can use it to pay the Federal tax and reinvest the rest of desired.

If you reinvest all distributions from a TIPS fund, it is equivalent to holding an individual TIPS in terms of paying the tax on income you don’t realize.

Capital gains distributions from a TIPS fund or individual TIPS you sell are taxed by states with income tax assuming they tax capital gains, which most do as regular income.

The real interest rate on a current issue I-bond currently is .3% vs an SEC-yield of .57% for VTIP so it is unclear that the tax benefits of an I-bond currently are enough to compensate for their lower yield and reduced liquidity.
Good point on difference in yield between I-bonds and VTIP.

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