Is a 5-year CD closer in behavior to TIPS or IT?

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Coato
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Is a 5-year CD closer in behavior to TIPS or IT?

Post by Coato » Thu Dec 06, 2018 10:19 am

Hello and thanks in advance for answers.

First, this is mostly mental accounting. I will only be able to hold this CD until retirement since it is in a 457b.

I really like the Fixed Income philosophy of Swensen of putting 50% of fixed income in TIPS and 50% in Intermediate Treasuries.

Through work I have access to a 5-year CD at 3.5% with a two month EWP. The alternative is to pay about 69 basis points extra to hold a Nationwide 457b that has Vanguard Sort Term Bond and the two Pimco funds (Real and Total Return). It doesn't seem worth the 69 bp plus the ERs to hold those.

I know it isn't truly either, but for the sake of mental accounting, would you think of that CD money more in the Real or Nominal section of Fixed Income?

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Ice-9
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by Ice-9 » Thu Dec 06, 2018 10:58 am

I also follow Swenson's 50/50 nominal/TIPS rule in my target asset allocation. I have self-directed brokerage window available in my workplace account, and I've purchased several CDs during the last decade at times when the yield seemed advantageous when compared to Total Bond Market's SEC yield. I consider the CDs to be on the nominal side, similar to a nominal treasury.

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nisiprius
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by nisiprius » Thu Dec 06, 2018 11:06 am

Coato wrote:
Thu Dec 06, 2018 10:19 am
...I have access to a 5-year CD at 3.5% with a two month EWP...I know it isn't truly either, but for the sake of mental accounting, would you think of that CD money more in the Real or Nominal section of Fixed Income?
I really don't understand. It seems crystal clear.

If it doesn't have "CPI" in the description, it's nominal fixed income. If you calculate interest by multiplying a number of dollars by a fixed percentage, it's nominal fixed income. I don't see why you have an instant's hesitation, or why you say "it isn't truly either."

Even if it were a 5-year CD with a 10% rate and no early withdrawal penalty, it would still be nominal fixed income, and it would lose purchasing power if inflation exceeded 10%.

Treasury bills have tended to track inflation and yield a small real return, but they are considered nominal Treasuries.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Coato
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by Coato » Thu Dec 06, 2018 11:34 am

To Nispirius,

The reason I think it could work as a TIPS is that with a 2 month EWP I think I could always just roll it into a new offering as rates rose.

Currently
The 12 month is offering 2.5%
The 36 month about 3%
The 60 month is 3.5%

So I was thinking with that small a penalty I could always try to just make sure it tracks inflation by hopping around, and since it has no principal risk it would do to protect against steady inflation above 2.5% or whatever it is now.

You are right it wouldn't track a sudden spike in inflation. It also doesn't get the spike from flight to safety/quality that a treasury would hopefully get, so I am missing on the most attractive part of each side of the FI coin.

megabad
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by megabad » Thu Dec 06, 2018 11:44 am

nisiprius wrote:
Thu Dec 06, 2018 11:06 am
Coato wrote:
Thu Dec 06, 2018 10:19 am
...I have access to a 5-year CD at 3.5% with a two month EWP...I know it isn't truly either, but for the sake of mental accounting, would you think of that CD money more in the Real or Nominal section of Fixed Income?
I really don't understand. It seems crystal clear.

If it doesn't have "CPI" in the description, it's nominal fixed income. If you calculate interest by multiplying a number of dollars by a fixed percentage, it's nominal fixed income. I don't see why you have an instant's hesitation, or why you say "it isn't truly either."

Even if it were a 5-year CD with a 10% rate and no early withdrawal penalty, it would still be nominal fixed income, and it would lose purchasing power if inflation exceeded 10%.

Treasury bills have tended to track inflation and yield a small real return, but they are considered nominal Treasuries.
+1. Inflation protection is not the same thing as duration. Very short duration nominal fixed income may have the same result (or may not), but it is not the same.

Also had to chuckle a little at "Swensen's Fixed Income philosophy". Despite his book, Swensen's actual approach has always been to essentially hold almost no fixed income. Nor does he follow many of the other points (or logic) discussed in his book in his work at Yale. I still enjoyed reading it. Now one could argue that individual retirement funds are different than endowments, but it seems a bit like Buffett's style--do as I say not as I do.

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happymob
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by happymob » Thu Dec 06, 2018 12:02 pm

Coato wrote:
Thu Dec 06, 2018 11:34 am
The reason I think it could work as a TIPS is that with a 2 month EWP I think I could always just roll it into a new offering as rates rose.
But that's not inflation protection. That's some (delayed) protection as rates rise, but that's not the same thing.

lyrictulip
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Re: Is a 5-year CD closer in behavior to TIPS or IT?

Post by lyrictulip » Fri Dec 07, 2018 8:52 am

So the reason this may not work is that prevailing CD rates may, or *may not* exceed inflation. Whereas a TIPS is guaranteed to. In practice a strategy like what you're describing has tended to work historically, but there is in principle no reason why it must continue to work.

The other thing I'll say, as Nisiprius is fond of pointing out, is that most CDs, if you read the fine print, are not actually *required to give you your money back before the maturity date. And in particular, they will be more tempted to refuse in the event of some period of rapid inflation.
Coato wrote:
Thu Dec 06, 2018 11:34 am
So I was thinking with that small a penalty I could always try to just make sure it tracks inflation by hopping around, and since it has no principal risk it would do to protect against steady inflation above 2.5% or whatever it is now.

You are right it wouldn't track a sudden spike in inflation. It also doesn't get the spike from flight to safety/quality that a treasury would hopefully get, so I am missing on the most attractive part of each side of the FI coin.

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