Question on short term TIPS fund

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Willmunny
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Question on short term TIPS fund

Post by Willmunny » Tue Jun 04, 2019 6:16 am

I am thinking of adding some TIPS to my fixed income portion. I like the short term funds better than the long term currently. So, it is between building a 5 year ladder or buying a low cost fund like STIP or Vanguard's short term TIPS fund. I am leaning towards the fund for convenience. I have one question:

I understand that TIPS can lose principal in a deflationary period if bought after it's price is adjusted upward and/or if sold before maturity. I understand TIPS will at least return principal invested if bought at issue and held to maturity. How do the funds handle this risk? Do they frquently buy well after issue date and/or sell before maturity date?

Thanks!

Will

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Dialectical Investor
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Re: Question on short term TIPS fund

Post by Dialectical Investor » Tue Jun 04, 2019 7:26 am

I don't manage any of those funds, so I don't know, but it would not make sense for the fund to buy TIPS well after the issue date to handle this "risk" because older issues have more room to fall before they reach the deflation floor since inflation is the norm. A fund may sell before the maturity date to reinvest proceeds in higher-yielding issues, or to follow its investment objective of targeting specific maturity dates and/or duration, but I doubt this issue registers high in order of importance. The market is aware of this behavior and ought to price a TIPS that has been outstanding longer at a discount to an otherwise equivalent TIPS that was outstanding for a shorter period of time. There also is the question of the degree to which a negative adjustment is really a problem or if it truly is a risk--you signed up for a real return (positive usually, sometimes negative in the past), and you still get that, and possibly then some.

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Re: Question on short term TIPS fund

Post by Valuethinker » Tue Jun 04, 2019 7:54 am

Willmunny wrote:
Tue Jun 04, 2019 6:16 am
I am thinking of adding some TIPS to my fixed income portion. I like the short term funds better than the long term currently. So, it is between building a 5 year ladder or buying a low cost fund like STIP or Vanguard's short term TIPS fund. I am leaning towards the fund for convenience. I have one question:

I understand that TIPS can lose principal in a deflationary period if bought after it's price is adjusted upward and/or if sold before maturity. I understand TIPS will at least return principal invested if bought at issue and held to maturity. How do the funds handle this risk? Do they frquently buy well after issue date and/or sell before maturity date?

Thanks!

Will
So the distinguishing characteristic of TIPS (vs other inflation linked bonds) is that they redeem at par, $100 per $100 face value, always. Thus if deflation would cause the price to fall to $90, say, you still get the $100.

But say one bought at $130 and there was 10% deflation post buying it - one would lose that $10 difference because at redemption one would only get the rise in CPI over the life of the bond (i.e. taking the price from $100 to $120).

Because of this risk that a TIPS bond could fall towards maturity in price (due to deflation in prices from time of purchase at a premium to $100) it turns out that the TIPS bonds that are closer to issue price (less price adjustment upwards) have slightly higher yields than those which are trading at a greater premium. Larry Swedroe covers this, I believe. Bonds trading at a greater premium to $100 face value are thus "cheaper" (higher yield).

A passive fund just holds the TIPS index in the weightings by the value of those bonds. So there's no decision for a fund manager to take.

An active manager can take a view that the likelihood of deflation is greater than the market is forecasting and so alter the portfolio to favour those bonds with prices closer to $100. More likely, and I think this is what Larry Swedroe said his firm does for clients, is buy the one with the higher price (but also a higher yield) because the risk is so small.

I am assume the Vanguard TIPS fund is the former, so they just "do nothing". In investing, that often turns out to have been the best strategy (if done at low cost).

On short term TIPS this is probably not something to worry about too much. Unless we revisit 2008-09, the actual amounts of deflation should be quite small.

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Re: Question on short term TIPS fund

Post by #Cruncher » Wed Jun 05, 2019 12:41 pm

Willmunny wrote:
Tue Jun 04, 2019 6:16 am
I understand that TIPS can lose principal in a deflationary period if bought after it's price is adjusted upward and/or if sold before maturity.
When discussing TIPS it's important to distinguish "principal" and "price". The "principal" amount of a TIPS is its face value adjusted for inflation. "Price" is how much one pays for that principal. For example if the CPI has increased 10% since original issue [1], a $1,000 face value TIPS will have a principal value of $1,100. If, because TIPS' interest rates have fallen since the original issue, one has to pay $1,210 for that bond, the price is 110% (1,210 / 1,100) [2].
Willmunny in same post wrote:I understand TIPS will at least return principal invested if bought at issue and held to maturity.
Not sure what you mean by "principal invested", Willmunny. Consider the 0.125% April 15, 2018 TIPS. If you'd purchased $1,000 face value at the initial auction in April 2013 you'd have gotten $1,004.08 in principal [3] for a cost of $1,078.21 [4]. If by maturity the CPI had declined, you'd have received the initial "principal" [5], but you wouldn't have gotten back the entire $1,078.21 "investment".
Willmunny in same post wrote:How do the funds handle this risk? Do they frquently buy well after issue date and/or sell before maturity date?
First off, I agree with Dialectical Investor above that this isn't really a "risk". Even without the deflation floor, if a TIPS purchaser holds to maturity, he is guaranteed to get the real yield-to-maturiy at the time of his purchase regardless of whether the CPI rises or falls. If the CPI index were to be less than 1.0 at maturity, he'd get a higher real yield. So "deflation bonus" is a better term than "deflation risk".

As to what funds do, the two you mention, Vanguard VTAPX and iShares STIP, are both 0-5 year index funds. This means they have no choice but to own all the TIPS that mature within the next five years. So for example, about January 2020, they will have to purchase the 2.375% January 15 2025 TIPS issued 15 years ago and currently having an index ratio of about 1.35. For the "deflation bonus" to kick in on this bond, the CPI would have to fall about 25% between now and January 2025.

However, I would not lose any sleep over buying old TIPS that have a large accumulated inflation adjustment. In my opinion, the chances of any TIPS -- including newly issued ones -- getting a "deflation bonus" is tiny. For a newly issued 5-year TIPS to do so, the CPI would have to fall over five years. The last time this happened was January 1932 - January 1937. (See my CPI-U since 1913 spreadsheet.)

As ValueThinker says above, if the market thinks there is a chance of a deflation bonus for a more recently issued TIPS, this will be reflected in the yield. I.e., if you choose a TIPS with higher index ratio, you'll be rewarded with a slightly higher yield. For example according to the WSJ TIPS Quotes 6/4/2019 the 2.5% Jan 15 2029 TIPS (issued ten years ago and now having a 1.18 index ratio) was yielding 0.374%, while the 0.875% Jan 15 2029 TIPS (issued this year and now with a 1.01 index ratio) was yielding 0.362%, only 0.012% points less. Apparently the market doesn't think there is much chance of the CPI falling over the next ten years.

  1. Technically the increase in the CPI is computed from a TIPS' "Dated Date" which is six months before its first interest payment. This is usually a couple of weeks before the first issue date. E.g., the 0.5% April 15, 2024 TIPS first auctioned last April has a "Dated Date" of 4/15/2019 and an Original Issue Date of 4/30/2019. By the latter date, the CPI based index had already increased to 1.00211 (see footnote 2).
  2. Sometimes, by "price" people will mean the cost divided by the face value rather than by the principal value. To distinguish the two meanings of "price", the former is often called the "adjusted price" (121% in the example) and the latter is called the "unadjusted price" (110% in the example). This may be confusing since the divisor used to compute the adjusted pricer is before inflation adjustment while the divisor used to compute the unadjusted price is after inflation adjustment!
  3. This is because the CPI index increased from 1.0 on the 4/15/2013 Dated Date to 1.00408 on the 4/30/2013 Original Issue Date.
  4. The 107.38% price (1078.21 / 1004.08) arose because the yield-to-maturity was negative (-1.311%). Since Treasury Notes & Bonds (including TIPS) have a minimum 0.125% coupon, this negative yield caused the price to be well above 100%. (If the yield to maturity determined at an initial TIPS auction is 0.125% or more, the price will never be above 100%.)
  5. I'm unsure whether the Treasury would pay back $1,004.08 or only $1,000. TreasuryDirect's FAQ, What happens to TIPS if deflation occurs?, seems to imply the former:
    You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.

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