Compare TIPS vs I-BOND

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woodside
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Compare TIPS vs I-BOND

Post by woodside »

Hi

I have seen that the TIPS fund has now given a 1% real interest rate (see Vanguard Short-Term Inflation-Protected Securities ETF VTIP).

On the surface, 1% real interest TIPS seems a better deal than 0% real interest I-bond.

I understand with the real interest rate [edited] increase, the price of a TIPS fund will come down. However, when I checked the actual nominal rate of the TIPS fund VTIP, about 3-4% (say clarification below), while I-bond is about 8-9%. This indicates that a 0% real interest I-bond is a much better deal than a 1% real interest rate TIPS.

I believe both TIPS and I-bond use the same CPI-U index as the inflation adjustment.

The difference between the nominal interest rate and real interest rate for VTIP is only 2-3%, much less than the 8-9% inflation rate. Can someone explain why?

Thanks

EDITED the nominal rate for the VTIPS is compute by using all distributions for the past four quarters as the numerator, using today's price as the denominator.

EDITED 2. My nominal rate computation is very crude and is not good when the bond principal is not on par (with discount or over-priced). A better way to understand the nominal rate is the SEC yield as jeffyscott mentioned, https://www.ishares.com/us/products/239 ... s-bond-etf

EDITED 3. The SEC yield (nominal) may have a lot of variations as the TIPS is based on month-to-month non-seasonally adjusted inflation. The nominal yield (SEC yield) from TIPS has too much noise to become usable. We just have to focus on the real interest rate to compare the two products.

EDITED 4. Other than the real interest rate difference, people need to always pay attention to the difference between an individual bond and a bond fund. I-bond does enjoy the advantage of the flexibility of redeemability at any time after the first year (basically a free put option). There is no purchase limit on TIPS and TIPS can be bought from a brokerage account. There is an extensive discussion on the tax consequences between I-bond and TIPS, which is depending on the marginal interest rate and also inflation rate, see the #Cruncher's post.
Last edited by woodside on Fri Sep 23, 2022 6:58 am, edited 7 times in total.
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vineviz
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Re: Compare TIPS vs I-BOND

Post by vineviz »

woodside wrote: Wed Sep 21, 2022 9:04 am
On the surface, 1% real interest TIPS seems a better deal than 0% real interest I-bond.
That's probably true on all levels, not just the surface level. 1% is always more than 0%.
woodside wrote: Wed Sep 21, 2022 9:04 am I understand with the rate increase, the price of a TIPS fund will come down.
That's not necessarily true. If by "rate" you mean the Federal Funds rate, it has little direct impact on bond yields except for very short-term bonds. And bond yields are set by investors in a marketplaces, which means they don't only react to things: they also move in anticipation of changes. If the Fed raises its overnight rate today the real yield on TIPS could go up, go down, or stay the same.
woodside wrote: Wed Sep 21, 2022 9:04 am However, when I checked the actual nominal rate of the TIPS fund VTIP, about 3-4%, while I-bond is about 8-9%. This indicates that a 0% real interest I-bond is a much better deal than a 1% real interest rate TIPS.
Calculating a nominal yield for TIPS requires an estimate of what inflation WILL BE over the life of the bond. But the same is true of Series I savings bonds: the current rate on those is high, but if/when inflation falls that rate will also fall.

In short, when comparing TIPS with the savings bond, just focus on the real yield/rate difference because inflation will affect them equally except over very short time periods.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
billyt
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Re: Compare TIPS vs I-BOND

Post by billyt »

You are kind of comparing apples and oranges here. I bonds have a rate that is set by actual past inflation, and are not traded, so they are unaffected by rate changes, and these two factors are a big plus at the moment. You can't buy yesterdays inflation rate with a bond fund, only Ibonds. TIPS funds have already been adjusted for past inflation, but real rates have increased sharply. The returns you see reflect both those offsetting things. Looking forward, the about 1% real rate on the TIPS fund looks attractive to me, but you have to be comfortable with rising rates offsetting your NAV. Total returns will eventually benefit from rising rates.
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

Thanks vineviz. It may take me some time to digest your post.
vineviz wrote: Wed Sep 21, 2022 9:16 am
woodside wrote: Wed Sep 21, 2022 9:04 am I understand with the rate increase, the price of a TIPS fund will come down.
That's not necessarily true. If by "rate" you mean the Federal Funds rate, it has little direct impact on bond yields except for very short-term bonds. And bond yields are set by investors in a marketplaces, which means they don't only react to things: they also move in anticipation of changes. If the Fed raises its overnight rate today the real yield on TIPS could go up, go down, or stay the same.
The rate meant "real interest rate" (I edited the original post to reflect this)
vineviz wrote: Wed Sep 21, 2022 9:16 am
woodside wrote: Wed Sep 21, 2022 9:04 am However, when I checked the actual nominal rate of the TIPS fund VTIP, about 3-4%, while I-bond is about 8-9%. This indicates that a 0% real interest I-bond is a much better deal than a 1% real interest rate TIPS.
Calculating a nominal yield for TIPS requires an estimate of what inflation WILL BE over the life of the bond. But the same is true of Series I savings bonds: the current rate on those is high, but if/when inflation falls that rate will also fall.

In short, when comparing TIPS with the savings bond, just focus on the real yield/rate difference because inflation will affect them equally except over very short time periods.

We can not know the future inflation rate so there is no way to compute the nominal rate you mentioned. When I talked about the nominal yield, I am thinking about the nominal yield within the last year (using all distributions for the past four quarters as the numerator, using today's price as the denominator).
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jeffyscott
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Re: Compare TIPS vs I-BOND

Post by jeffyscott »

woodside wrote: Wed Sep 21, 2022 9:04 amHowever, when I checked the actual nominal rate of the TIPS fund VTIP, about 3-4%, while I-bond is about 8-9%.
How did you determine "the actual nominal rate of the TIPS fund VTIP"? I don't think Vanguard reports a nominal SEC yield for that fund and the nominal SEC yield would seem to be the most appropriate thing to compare to the current nominal yield of an I-bond, if you wanted to do that comparison for some reason.

Unlike Vanguard, iShares does report the nominal SEC yield of their TIPS funds. For STIP, which is similar to VTIP, the SEC yield they currently report is 7.78%.
https://www.ishares.com/us/products/239 ... s-bond-etf

Now in reality, the nominal SEC yield of a TIPS fund is not something that I would use to make any decisions regarding TIPS vs. I-bonds. But then, neither would I use the current nominal yield of an I-bond for anything other than the decision as to whether or not it is worth keeping, at least for the short term, as a nominal investment. For longer terms it is the real yield of TIPS and I-bonds that should be looked at, along with differences in the way each of them functions.
And so it goes, And so it goes, And so it goes, And so it goes, But where it's goin' no one knows
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

billyt wrote: Wed Sep 21, 2022 9:17 am You are kind of comparing apples and oranges here. I bonds have a rate that is set by actual past inflation, and are not traded, so they are unaffected by rate changes, and these two factors are a big plus at the moment. You can't buy yesterdays inflation rate with a bond fund, only Ibonds. TIPS funds have already been adjusted for past inflation, but real rates have increased sharply. The returns you see reflect both those offsetting things. Looking forward, the about 1% real rate on the TIPS fund looks attractive to me, but you have to be comfortable with rising rates offsetting your NAV. Total returns will eventually benefit from rising rates.
Yes, I agree with you that we can not buy yesterday's inflation rate, and also it's hard to predict the future inflation to compute the future return.

Yes, I-bond takes the inflation adjustment once in six months while the TIPS takes the inflation adjustment probably every month. However, the inflation rate for the past year is between 7% and 9% so this should not make much difference.

The nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator). I was focusing on the nominal return, not on the total return, which has two parts as you said (the dividend=real interest+inflation, and the price change).
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Re: Compare TIPS vs I-BOND

Post by vineviz »

woodside wrote: Wed Sep 21, 2022 9:46 am The rate meant "real interest rate" (I edited the original post to reflect this)
But which "real interest rate"? You talked about a "rate increase", so I assume you are referring to some specific rate?
vineviz wrote: Wed Sep 21, 2022 9:16 am We can not know the future inflation rate so there is no way to compute the nominal rate you mentioned.
That's basically irrelevant, though.

Whatever the future inflation rate turns out to be , that rate + 1% will be greater than that rate + 0%.

The key difference between a Series I savings bond and a TIPS is that the former will deliver its real rate (0%) over whatever period you hold it for. The TIPS will deliver its real rate over a period of time corresponding to its maturity.

Buy a 20-year TIPS and compare it to holding a Series I savings bond for that same 20-year period, and the TIPS is guaranteed to have a greater return than the savings bond.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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vineviz
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Re: Compare TIPS vs I-BOND

Post by vineviz »

woodside wrote: Wed Sep 21, 2022 9:56 am The nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator). I was focusing on the nominal return, not on the total return, which has two parts as you said (the dividend=real interest+inflation, and the price change).
Why are you comparing the nominal return on two inflation-indexed investments? It's just confusing you, I think.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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Re: Compare TIPS vs I-BOND

Post by jeffyscott »

woodside wrote: Wed Sep 21, 2022 9:56 amThe nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator).
This is a poor way to evaluate the yield of a bond fund, it's at least one reason that the SEC yield was invented.

If I do this with VBTLX, the "current nominal yield" is about 0.8%. What you are doing is sort of like comparing a HYS account with a current yield of, say, 2% to VBTLX and saying the the yield of VBTLX is only 0.8%, despite the fact that current interest rates have gone up to around 4%.
And so it goes, And so it goes, And so it goes, And so it goes, But where it's goin' no one knows
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

vineviz wrote: Wed Sep 21, 2022 10:03 am
woodside wrote: Wed Sep 21, 2022 9:56 am The nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator). I was focusing on the nominal return, not on the total return, which has two parts as you said (the dividend=real interest+inflation, and the price change).
Why are you comparing the nominal return on two inflation-indexed investments? It's just confusing you, I think.
The actual number we can see is always the nominal return. We don't know all the details on how the inflation rate was adjusted for the two inflation-indexed investments (I-bond is easier to understand, but it is much more difficult to understand the TIPS fund)?
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Re: Compare TIPS vs I-BOND

Post by dbr »

FWIW Vanguard publishes an SEC 30 day yield of 1.00% for VTIP with a note that "G - DOES NOT INCLUDE ANY INCOME ADJUSTMENT RESULTING FROM CHANGE IN INFLATION RATE" Presumably you would compare this to the 0% fixed rate on I bonds. The same datum for VAIPX is 0.78%.
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

jeffyscott wrote: Wed Sep 21, 2022 10:09 am
woodside wrote: Wed Sep 21, 2022 9:56 amThe nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator).
This is a poor way to evaluate the yield of a bond fund, it's at least one reason that the SEC yield was invented.

If I do this with VBTLX, the "current nominal yield" is about 0.8%. What you are doing is sort of like comparing a HYS account with a current yield of, say, 2% to VBTLX and saying the the yield of VBTLX is only 0.8%, despite the fact that current interest rates have gone up to around 4%.
Thanks jeffyscott for identifying the flaws of my computation. I guess my original computation is only working for the bond price on-par. When the bond price was not on par (with discounts or over-priced), the simple math is not working more. I guess we just have to stick with the SEC. Unfortunately, vanguard doesn't publish the SEC yield for the nominal. The pdf file you referred earlier is very helpful.
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Re: Compare TIPS vs I-BOND

Post by jeffyscott »

woodside wrote: Wed Sep 21, 2022 10:21 am
jeffyscott wrote: Wed Sep 21, 2022 10:09 am
woodside wrote: Wed Sep 21, 2022 9:56 amThe nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator).
This is a poor way to evaluate the yield of a bond fund, it's at least one reason that the SEC yield was invented.

If I do this with VBTLX, the "current nominal yield" is about 0.8%. What you are doing is sort of like comparing a HYS account with a current yield of, say, 2% to VBTLX and saying the the yield of VBTLX is only 0.8%, despite the fact that current interest rates have gone up to around 4%.
Thanks jeffyscott for identifying the flaws of my computation. I guess my original computation is only working for the bond price on-par. When the bond price was not on par (with discounts or over-priced), the simple math is not working more. I guess we just have to stick with the SEC. Unfortunately, vanguard doesn't publish the SEC yield for the nominal. The pdf file you referred earlier is very helpful.
But there are other significant problems with nominal SEC yield for TIPS funds. Since they are based on just the past 30 days distributions, they will vary wildly based on month-to-month non-seasonally adjusted inflation, because that can have wide variations. We had a month with about +1% inflation recently and then a couple with 0%. So the fund will essentially project those monthly rates as if they will continue indefinitely. This means the nominal SEC yield will go from essentially being based on about 12% annual inflation to being based on about 0% annual inflation.

You can look at the I-bond as being like a savings account, with an interest rate that is indexed to inflation, while a TIPS is a bond that is indexed to inflation, or like a (brokered) CD to stick with comparing both to bank products. This is more or less similar to what vineviz posted, here:
vineviz wrote: Wed Sep 21, 2022 10:01 am The key difference between a Series I savings bond and a TIPS is that the former will deliver its real rate (0%) over whatever period you hold it for. The TIPS will deliver its real rate over a period of time corresponding to its maturity.

Buy a 20-year TIPS and compare it to holding a Series I savings bond for that same 20-year period, and the TIPS is guaranteed to have a greater return than the savings bond.
And so it goes, And so it goes, And so it goes, And so it goes, But where it's goin' no one knows
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

vineviz wrote: Wed Sep 21, 2022 10:01 am
woodside wrote: Wed Sep 21, 2022 9:46 am The rate meant "real interest rate" (I edited the original post to reflect this)
But which "real interest rate"? You talked about a "rate increase", so I assume you are referring to some specific rate?
The real interest rate is for the TIPS fund. Say now the real interest rate for the TIPS fund is 1%. When it changes to 2%, the TIPS fund price will come down (not sure about the % though depending on the duration, the regular bond fund already has a complicated mathematical formula between the interest rate and the price, this relation is probably more complicated for the TIPS fund.

Of course, many factors may influence the real interest of the TIPS fund. e.g. If the Fed increases the short plan interest rate, then the short-term TIPS has to increase the real interest rate due to marketing conditions in the bond market.

Yes, it's always hard to know what factors may impact (edited) the real interest rate for long-term TIPS.
Last edited by woodside on Wed Sep 21, 2022 10:55 am, edited 2 times in total.
billyt
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Re: Compare TIPS vs I-BOND

Post by billyt »

The SEC yield for Vanguard TIPS funds does not include the inflation adjustment, just like the real yield of an individual bond has nothing to do with the inflation adjustment. The real yield of TIPS bonds is not hard to know, it is available in real time. It's the future nominal return that is hard to know, the real return is a contractual guarantee.
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Re: Compare TIPS vs I-BOND

Post by vineviz »

woodside wrote: Wed Sep 21, 2022 10:11 am
The actual number we can see is always the nominal return.
If you're looking backwards, you can see both nominal return and real return.

If you're looking forwards, you only "see" the real return: the nominal return can only be an expected return, and will be highly dependent on your estimate for future inflation.
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dbr
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Re: Compare TIPS vs I-BOND

Post by dbr »

jeffyscott wrote: Wed Sep 21, 2022 10:33 am
woodside wrote: Wed Sep 21, 2022 10:21 am
jeffyscott wrote: Wed Sep 21, 2022 10:09 am
woodside wrote: Wed Sep 21, 2022 9:56 amThe nominal rate for the TIPS I talked about was for the one year prior (using all distributions for the past four quarters as the numerator, using today's price as the denominator).
This is a poor way to evaluate the yield of a bond fund, it's at least one reason that the SEC yield was invented.

If I do this with VBTLX, the "current nominal yield" is about 0.8%. What you are doing is sort of like comparing a HYS account with a current yield of, say, 2% to VBTLX and saying the the yield of VBTLX is only 0.8%, despite the fact that current interest rates have gone up to around 4%.
Thanks jeffyscott for identifying the flaws of my computation. I guess my original computation is only working for the bond price on-par. When the bond price was not on par (with discounts or over-priced), the simple math is not working more. I guess we just have to stick with the SEC. Unfortunately, vanguard doesn't publish the SEC yield for the nominal. The pdf file you referred earlier is very helpful.
But there are other significant problems with nominal SEC yield for TIPS funds. Since they are based on just the past 30 days distributions, they will vary wildly based on month-to-month non-seasonally adjusted inflation, because that can have wide variations. We had a month with about +1% inflation recently and then a couple with 0%. So the fund will essentially project those monthly rates as if they will continue indefinitely. This means the nominal SEC yield will go from essentially being based on about 12% annual inflation to being based on about 0% annual inflation.

You can look at the I-bond as being like a savings account, with an interest rate that is indexed to inflation, while a TIPS is a bond that is indexed to inflation, or like a (brokered) CD to stick with comparing both to bank products. This is more or less similar to what vineviz posted, here:
vineviz wrote: Wed Sep 21, 2022 10:01 am The key difference between a Series I savings bond and a TIPS is that the former will deliver its real rate (0%) over whatever period you hold it for. The TIPS will deliver its real rate over a period of time corresponding to its maturity.

Buy a 20-year TIPS and compare it to holding a Series I savings bond for that same 20-year period, and the TIPS is guaranteed to have a greater return than the savings bond.
I quoted above the way Vanguard has done this. I hold SWRSX from Schwab and I noticed the published SEC yield has done exactly what you noted. It has been 12% and it has been 0%.

People are correct that the real comparison is that I bonds are like real yield cash and TIPS funds are like bond funds (amazingly because they are bond funds). To the extent real yields on TIPS are positive the long run expected return on TIPS funds will be positive, but a marketable bond is a marketable bond and a fund of marketable bonds is a fund of marketable bonds and has a duration but not a maturity. There is no advantage in the inflation indexing between TIPS and I bonds other than some short run nuances in when the adjustments are made.
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Re: Compare TIPS vs I-BOND

Post by vineviz »

woodside wrote: Wed Sep 21, 2022 10:36 am The real interest rate is for the TIPS fund. Say now the real interest rate for the TIPS fund is 1%. When it changes to 2%, the TIPS fund price will come down ....
You mean IF it changes to 2%: we have no way of reliably predicting future changes in bond yields.

But saying that the price of a bond goes down when its yield goes up is a tautology, so I'm still not sure about what your actual question is.
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

jeffyscott wrote: Wed Sep 21, 2022 10:33 am
But there are other significant problems with nominal SEC yield for TIPS funds. Since they are based on just the past 30 days distributions, they will vary wildly based on month-to-month non-seasonally adjusted inflation, because that can have wide variations. We had a month with about +1% inflation recently and then a couple with 0%. So the fund will essentially project those monthly rates as if they will continue indefinitely. This means the nominal SEC yield will go from essentially being based on about 12% annual inflation to being based on about 0% annual inflation.

You can look at the I-bond as being like a savings account, with an interest rate that is indexed to inflation, while a TIPS is a bond that is indexed to inflation, or like a (brokered) CD to stick with comparing both to bank products. This is more or less similar to what vineviz posted, here:
vineviz wrote: Wed Sep 21, 2022 10:01 am The key difference between a Series I savings bond and a TIPS is that the former will deliver its real rate (0%) over whatever period you hold it for. The TIPS will deliver its real rate over a period of time corresponding to its maturity.

Buy a 20-year TIPS and compare it to holding a Series I savings bond for that same 20-year period, and the TIPS is guaranteed to have a greater return than the savings bond.
Thanks jeffyscott. It's good to know that TIPS is based on month-to-month non-seasonally adjusted inflation so it can have wide variations. The nominal yield (SEC yield) from TIPS has too much noise to become usable. We just have to focus on the real interest rate.
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Re: Compare TIPS vs I-BOND

Post by acegolfer »

2 big differences between the 2.

1. TIPS is a marketable security but i-bond is not. So you will see TIPS price changes every day, which is reflected in return calculation. For example, even if inflation increases, if the market interest rate increases, one can have a negative return. otoh, there's no market price for i-bond. You only see the i-bond account balance, similar to a bank savings account.

2. Effect of inflation rate are different. When inflation rate changes, it affects TIPS face value but not interest rate. otoh, inflation rate affects i-bonds interest rate. And then time lags in the inflation effect on these 2 are different.
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Re: Compare TIPS vs I-BOND

Post by woodside »

woodside wrote: Wed Sep 21, 2022 10:36 am
vineviz wrote: Wed Sep 21, 2022 10:01 am
woodside wrote: Wed Sep 21, 2022 9:46 am The rate meant "real interest rate" (I edited the original post to reflect this)
But which "real interest rate"? You talked about a "rate increase", so I assume you are referring to some specific rate?
The real interest rate is for the TIPS fund. Say now the real interest rate for the TIPS fund is 1%. When it changes to 2%, the TIPS fund price will come down (not sure about the % though depending on the duration, the regular bond fund already has a complicated mathematical formula between the interest rate and the price, this relation is probably more complicated for the TIPS fund.

Of course, many factors may influence the real interest of the TIPS fund. e.g. If the Fed increases the short plan interest rate, then the short-term TIPS has to increase the real interest rate due to marketing conditions in the bond market.

Yes, it's always hard to know what factors may impact(edited) the real interest rate for long-term TIPS.
Last edited by woodside on Wed Sep 21, 2022 10:54 am, edited 1 time in total.
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Re: Compare TIPS vs I-BOND

Post by woodside »

billyt wrote: Wed Sep 21, 2022 10:38 am The SEC yield for Vanguard TIPS funds does not include the inflation adjustment, just like the real yield of an individual bond has nothing to do with the inflation adjustment. The real yield of TIPS bonds is not hard to know, it is available in real time. It's the future nominal return that is hard to know, the real return is a contractual guarantee.
My last post has a typo, I meant "it's always hard to know what factors may impact (edited) the real interest rate for long-term TIPS."
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Re: Compare TIPS vs I-BOND

Post by billyt »

Yes, the rates are set by the market, and you can only try to collect what the market offers as efficiently as possible.
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

vineviz wrote: Wed Sep 21, 2022 10:44 am
woodside wrote: Wed Sep 21, 2022 10:36 am The real interest rate is for the TIPS fund. Say now the real interest rate for the TIPS fund is 1%. When it changes to 2%, the TIPS fund price will come down ....
You mean IF it changes to 2%: we have no way of reliably predicting future changes in bond yields.

But saying that the price of a bond goes down when its yield goes up is a tautology, so I'm still not sure about what your actual question is.
Yes, the relation between the interest rate and the bond price is a little tautology. What the market can see is that the price is down, this is equivalent to that the interest is up. The reason why the price is down is that other bond product provides a higher interest rate.

I believe jeffyscott and you have clarified some of my misunderstandings on how the TIPS fund work and especially on the inflation adjustment part, so the conclusion is that it is just very difficult to get the future nominal yield for the TIPS, so we just need to focus on the real interest rate to compare TIPS and I-Bond.
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woodside
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Re: Compare TIPS vs I-BOND

Post by woodside »

acegolfer wrote: Wed Sep 21, 2022 10:47 am 2 big differences between the 2.

1. TIPS is a marketable security but i-bond is not. So you will see TIPS price changes every day, which is reflected in return calculation. For example, even if inflation increases, if the market interest rate increases, one can have a negative return. otoh, there's no market price for i-bond. You only see the i-bond account balance, similar to a bank savings account.

2. Effect of inflation rate are different. When inflation rate changes, it affects TIPS face value but not interest rate. otoh, inflation rate affects i-bonds interest rate. And then time lags in the inflation effect on these 2 are different.
Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
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Re: Compare TIPS vs I-BOND

Post by acegolfer »

woodside wrote: Wed Sep 21, 2022 11:10 am Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
FYI, the coupon amount of TIPS is calculated by fixed interest rate * increased face value. So when face value increases, coupon amount also increases.
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Re: Compare TIPS vs I-BOND

Post by woodside »

dbr wrote: Wed Sep 21, 2022 10:43 am
jeffyscott wrote: Wed Sep 21, 2022 10:33 am But there are other significant problems with nominal SEC yield for TIPS funds. Since they are based on just the past 30 days distributions, they will vary wildly based on month-to-month non-seasonally adjusted inflation, because that can have wide variations. We had a month with about +1% inflation recently and then a couple with 0%. So the fund will essentially project those monthly rates as if they will continue indefinitely. This means the nominal SEC yield will go from essentially being based on about 12% annual inflation to being based on about 0% annual inflation.
I quoted above the way Vanguard has done this. I hold SWRSX from Schwab and I noticed the published SEC yield has done exactly what you noted. It has been 12% and it has been 0%.
Thanks Dbr for the confirmation that SEC yield (nominal) for the TIPS is very noisy.
Last edited by woodside on Wed Sep 21, 2022 11:40 am, edited 1 time in total.
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Re: Compare TIPS vs I-BOND

Post by woodside »

acegolfer wrote: Wed Sep 21, 2022 11:18 am
woodside wrote: Wed Sep 21, 2022 11:10 am Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
FYI, the coupon amount of TIPS is calculated by fixed interest rate * increased face value. So when face value increases, coupon amount also increases.
Thanks acegolfer for the clarification. The coupon increase will become very significant for long-duration TIPS when the face value becomes much higher.
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Re: Compare TIPS vs I-BOND

Post by PA_Boglehead »

Does it ever make sense to hold TIPS in taxable?

Lets say you don't have an ability to purchase a TIPS in a tax deferred space, how would one compare I-Bonds which pay a composite rate that is tax deferred but ultimately have a real yield of 0% versus a 5-year TIPS in taxable that has a real yield of >1% but will suffer from significant tax drag?
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Re: Compare TIPS vs I-BOND

Post by dbr »

PA_Boglehead wrote: Wed Sep 21, 2022 2:29 pm Does it ever make sense to hold TIPS in taxable?

Lets say you don't have an ability to purchase a TIPS in a tax deferred space, how would one compare I-Bonds which pay a composite rate that is tax deferred but ultimately have a real yield of 0% versus a 5-year TIPS in taxable that has a real yield of >1% but will suffer from significant tax drag?
I bonds don't have an after tax real yield of 0%. It is less than that because deferred tax still has to be paid. You have to pay when you redeem the bond or you have to pay it at the end of 30 years. It could be zero if your tax brackets are low enough when those things happen. It could be a lot if the 30 year period or redemption ends in a high income year for you. An option for someone who might have that happen is to pay I bond taxes as you go.

If you want to compute a comparison you are going to have to estimate your income tax returns for the rest of your life and also the real returns on TIPS and see what comes out. The key is to know what your tax rate on bond interest is going to be now and into the future. A good thing about I bonds is that the purchase limit makes it difficult for a large tranch of I bonds to all come due in the same year pushing you into a higher tax bracket at the time.
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Re: Compare TIPS vs I-BOND

Post by PA_Boglehead »

Hey dbr,

I'm aware that I-Bonds don't have a an after tax real yield of 0%, that's my fault for clumsily wording the post. Instead, is the tax deferment of I-Bonds at the expense of any positive real yield ever worth more than giving up a (pre-tax) real 1% yield on a TIPS subject to the drag of taxes in a taxable brokerage?
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Re: Compare TIPS vs I-BOND

Post by jeffyscott »

dbr wrote: Wed Sep 21, 2022 3:09 pm If you want to compute a comparison you are going to have to estimate your income tax returns for the rest of your life and also the real returns on TIPS and see what comes out. The key is to know what your tax rate on bond interest is going to be now and into the future.
I think You would need to assume an inflation rate, too.

If you have a TIPS earning 1% real and there is 2.5% inflation, you would be paying tax on about 3.5% gains per year. Compared to 0% I-bond, the TIPS is clearly better as long as you are not losing 1% to taxes, even if you can withdraw the I-bond money at 0%. So unless your federal tax rate is above 28%, I think the TIPS in taxable are certain to beat the tax-deferred I-bonds. But if inflation is 3%, then that rate becomes 25%, at 3.5% that tax rate would be ~22%, etc.

So that could be one step, figure out what inflation rate would correspond to TIPS being better even with no tax on the I-bonds. For the 12% bracket its about 7.3% inflation, so that's an easy one. And even for the 22% bracket, seems likely that you should probably favor TIPS, since it's unlikely you will actually pay 0% on the I-bond withdrawals, so the break-even inflation rate is likely to be somewhat higher than 3.5%.
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Re: Compare TIPS vs I-BOND

Post by patrick »

There are a couple of advantages to the I bond beyond the real rate.

They have a 0% floor in nominal returns, so the nominal value won't go down in case there is a 6-month period of deflation. I don't think this is worth enough to make up for a whole 1% in yield difference, but probably is worth a little bit.

You can redeem at full value any time from 5 to 30 years out, without interest rate risk. Investors sometimes attempt to build liability matching portfolios with bonds, but most cannot reliably predict expenditures years in advance, and even estimates of their duration are quite uncertain. Only I bonds are able to match liabilities whose timing is unknown.

If purchased before November 2022, they have a nominal yield of 9.62% for the first 6 months based on a backward-looking inflation measurement. Assuming that future inflation will likely be less than 9.62% (I certainly hope so!) this makes I bonds purchased now a better investment during their first 6 months. This wouldn't make up for lower returns over the full 30 years, but could be useful if you plan to sell them sooner.
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Re: Compare TIPS vs I-BOND

Post by squirrel1963 »

woodside wrote: Wed Sep 21, 2022 9:04 am Hi

I have seen that the TIPS fund has now given a 1% real interest rate (see Vanguard Short-Term Inflation-Protected Securities ETF VTIP).

On the surface, 1% real interest TIPS seems a better deal than 0% real interest I-bond.

I understand with the real interest rate [edited] increase, the price of a TIPS fund will come down. However, when I checked the actual nominal rate of the TIPS fund VTIP, about 3-4% (say clarification below), while I-bond is about 8-9%. This indicates that a 0% real interest I-bond is a much better deal than a 1% real interest rate TIPS.

I believe both TIPS and I-bond use the same CPI-U index as the inflation adjustment.

The difference between the nominal interest rate and real interest rate for VTIP is only 2-3%, much less than the 8-9% inflation rate. Can someone explain why?

Thanks

EDITED the nominal rate for the VTIPS is compute by using all distributions for the past four quarters as the numerator, using today's price as the denominator.

EDITED 2. My nominal rate computation is very crude and is not good when the bond principal is not on par (with discount or over-priced). A better way to understand the nominal rate is the SEC yield as jeffyscott mentioned, https://www.ishares.com/us/products/239 ... s-bond-etf

EDITED 3. The SEC yield (nominal) may have a lot of variations as the TIPS is based on month-to-month non-seasonally adjusted inflation. The nominal yield (SEC yield) from TIPS has too much noise to become usable. We just have to focus on the real interest rate to compare the two products.
All things being equal I would prefer long TIPS in tax deferred because of the better yield , but after running out of space in tax deferred we started buying I-bonds. The one definite advantage of I-bonds is that you can redeem any time after 1 year at par value.
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Re: Compare TIPS vs I-BOND

Post by #Cruncher »

PA_Boglehead wrote: Wed Sep 21, 2022 2:29 pmDoes it ever make sense to hold TIPS in taxable? ... how would one compare I-Bonds which pay a composite rate that is tax deferred ... versus a 5-year TIPS in taxable that has a real yield of >1% but will suffer from significant tax drag?
The I Bond tax deferral isn't worth much over just five years. As shown in cell D7 below, even with a 28% tax rate, 15.75% inflation would be required for a 0% fixed rate I Bond to equal the after-tax performance of a TIPS yielding 1%. [1]

Code: Select all

Row                  Col A     Col B     Col C     Col D   Formula in Col B
  2             Investment     1,000
  3                  Years         5
  4      I Bond fixed rate      0.0%
  5             TIPS yield      1.0%
  6               Tax rate       12%       22%       28%
  7              Inflation   28.399%   18.493%   15.751%
  8  I Bond pre tax growth   28.399%   18.493%   15.751%  =(1+$B4)*(1+B7)-1
  9  TIPS after tax growth   26.121%   15.349%   12.174%  =((1+$B5)*(1+B7)-1)*(1-B6)
 10        I Bond grows to     3,490     2,336     2,078  =$B2*(1+B8)^$B3
 11       I Bond after tax     3,191     2,042     1,776  =B10-B6*(B10-$B2)
 12          TIPS grows to     3,191     2,042     1,776  =$B2*(1+B9)^$B3
 13         TIPS vs I Bond         0         0         0  =B12-B11
However, over 30 years the tax deferral is more beneficial. As shown below, with a 28% tax rate, the I Bond would break even versus the TIPS with just 6.04% inflation. [2]

Code: Select all

Row                  Col A     Col B     Col C     Col D   Formula in Col B
  2             Investment     1,000
  3                  Years        30
  4      I Bond fixed rate      0.0%
  5             TIPS yield      1.0%
  6               Tax rate       12%       22%       28%
  7              Inflation   12.048%    7.283%    6.042%
  8  I Bond pre tax growth   12.048%    7.283%    6.042%  =(1+$B4)*(1+B7)-1
  9  TIPS after tax growth   11.588%    6.517%    5.113%  =((1+$B5)*(1+B7)-1)*(1-B6)
 10        I Bond grows to    30,349     8,240     5,811  =$B2*(1+B8)^$B3
 11       I Bond after tax    26,827     6,647     4,464  =B10-B6*(B10-$B2)
 12          TIPS grows to    26,827     6,647     4,464  =$B2*(1+B9)^$B3
 13         TIPS vs I Bond         0         0         0  =B12-B11
You can do the calculation with other assumptions by following these steps:
  • Select All, Copy, and Paste [3] the following at cell A1 of a blank Excel sheet.

    Code: Select all

    Col A	Col B	Col C	Col D
    Investment	1000
    Term	30
    I Bond fixed rate	0
    TIPS yield	0.01
    Tax rate	0.12	0.22	0.28
    Inflation	0.120482018766852	0.0728280678748116	0.0604150144938128
    I Bond pre tax growth	=(1+$B4)*(1+B7)-1
    TIPS after tax growth	=((1+$B5)*(1+B7)-1)*(1-B6)
    I Bond grows to	=$B2*(1+B8)^$B3
    I Bond after tax	=B10-B6*(B10-$B2)
    TIPS grows to	=$B2*(1+B9)^$B3
    TIPS vs I Bond	=B12-B11
  • Copy cells B8:B13 right to column D.
  • Format for readability.
  • Modify assumptions as desired in cells B2:B5 and B6:D7.
  • To find the break-even inflation rate, you can either use trial-and-error or the Excel Goal Seek tool. For example, here is how I did it to get the 6.042% breakeven inflation in cell D7 of the second table:

    Code: Select all

    Set cell         D13
    To value           0
    By changing cell  D7
  1. To simplify things I'm ignoring the different lag in applying the CPI to I Bonds and TIPS. I'm also ignoring the boost I Bonds would get from their 0% floor on the composite rate should the CPI decline over any 6 months March-September or September-March.
  2. I'm sticking with a 1% yield for the TIPS to show the effect of longer tax deferral. However, 30-year TIPS are currently yielding about 1.25% according to Wednesday's WSJ TIPS Quotes.
  3. If you have trouble pasting, try "Paste Special" and "Text".
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Re: Compare TIPS vs I-BOND

Post by Mel Lindauer »

^^^#Cruncher to the rescue once again! Thank you for your numerous valuable contributions to the forum community. You're a real ace and we hope you'll continue to contribute your skills for a very long time.
Best Regards - Mel | | Semper Fi
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Re: Compare TIPS vs I-BOND

Post by PA_Boglehead »

Cruncher,

Thank you, great work and contribution. Cheers.

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Re: Compare TIPS vs I-BOND

Post by BigJohn »

woodside wrote: Wed Sep 21, 2022 11:10 am
acegolfer wrote: Wed Sep 21, 2022 10:47 am 2 big differences between the 2.

1. TIPS is a marketable security but i-bond is not. So you will see TIPS price changes every day, which is reflected in return calculation. For example, even if inflation increases, if the market interest rate increases, one can have a negative return. otoh, there's no market price for i-bond. You only see the i-bond account balance, similar to a bank savings account.

2. Effect of inflation rate are different. When inflation rate changes, it affects TIPS face value but not interest rate. otoh, inflation rate affects i-bonds interest rate. And then time lags in the inflation effect on these 2 are different.
Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
This is not correct for a TIPS fund. They distribute the entire inflation adjustment at least annually. Individual TIPS work differently. For those none of the inflation adjustment is distributed. You get the cumulative inflation adjustment at maturity.
"The greatest enemy of a good plan is the dream of a perfect plan" - Carl Von Clausewitz
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Re: Compare TIPS vs I-BOND

Post by woodside »

BigJohn wrote: Fri Sep 23, 2022 3:23 am
woodside wrote: Wed Sep 21, 2022 11:10 am
acegolfer wrote: Wed Sep 21, 2022 10:47 am 2 big differences between the 2.

1. TIPS is a marketable security but i-bond is not. So you will see TIPS price changes every day, which is reflected in return calculation. For example, even if inflation increases, if the market interest rate increases, one can have a negative return. otoh, there's no market price for i-bond. You only see the i-bond account balance, similar to a bank savings account.

2. Effect of inflation rate are different. When inflation rate changes, it affects TIPS face value but not interest rate. otoh, inflation rate affects i-bonds interest rate. And then time lags in the inflation effect on these 2 are different.
Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
This is not correct for a TIPS fund. They distribute the entire inflation adjustment at least annually. Individual TIPS work differently. For those none of the inflation adjustment is distributed. You get the cumulative inflation adjustment at maturity.
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
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Re: Compare TIPS vs I-BOND

Post by woodside »

#Cruncher wrote: Thu Sep 22, 2022 9:14 am
PA_Boglehead wrote: Wed Sep 21, 2022 2:29 pmDoes it ever make sense to hold TIPS in taxable? ... how would one compare I-Bonds which pay a composite rate that is tax deferred ... versus a 5-year TIPS in taxable that has a real yield of >1% but will suffer from significant tax drag?
The I Bond tax deferral isn't worth much over just five years. As shown in cell D7 below, even with a 28% tax rate, 15.75% inflation would be required for a 0% fixed rate I Bond to equal the after-tax performance of a TIPS yielding 1%. [1]

Code: Select all

Row                  Col A     Col B     Col C     Col D   Formula in Col B
  2             Investment     1,000
  3                  Years         5
  4      I Bond fixed rate      0.0%
  5             TIPS yield      1.0%
  6               Tax rate       12%       22%       28%
  7              Inflation   28.399%   18.493%   15.751%
  8  I Bond pre tax growth   28.399%   18.493%   15.751%  =(1+$B4)*(1+B7)-1
  9  TIPS after tax growth   26.121%   15.349%   12.174%  =((1+$B5)*(1+B7)-1)*(1-B6)
 10        I Bond grows to     3,490     2,336     2,078  =$B2*(1+B8)^$B3
 11       I Bond after tax     3,191     2,042     1,776  =B10-B6*(B10-$B2)
 12          TIPS grows to     3,191     2,042     1,776  =$B2*(1+B9)^$B3
 13         TIPS vs I Bond         0         0         0  =B12-B11
However, over 30 years the tax deferral is more beneficial. As shown below, with a 28% tax rate, the I Bond would break even versus the TIPS with just 6.04% inflation. [2]

Code: Select all

Row                  Col A     Col B     Col C     Col D   Formula in Col B
  2             Investment     1,000
  3                  Years        30
  4      I Bond fixed rate      0.0%
  5             TIPS yield      1.0%
  6               Tax rate       12%       22%       28%
  7              Inflation   12.048%    7.283%    6.042%
  8  I Bond pre tax growth   12.048%    7.283%    6.042%  =(1+$B4)*(1+B7)-1
  9  TIPS after tax growth   11.588%    6.517%    5.113%  =((1+$B5)*(1+B7)-1)*(1-B6)
 10        I Bond grows to    30,349     8,240     5,811  =$B2*(1+B8)^$B3
 11       I Bond after tax    26,827     6,647     4,464  =B10-B6*(B10-$B2)
 12          TIPS grows to    26,827     6,647     4,464  =$B2*(1+B9)^$B3
 13         TIPS vs I Bond         0         0         0  =B12-B11
You can do the calculation with other assumptions by following these steps:
  • Select All, Copy, and Paste [3] the following at cell A1 of a blank Excel sheet.

    Code: Select all

    Col A	Col B	Col C	Col D
    Investment	1000
    Term	30
    I Bond fixed rate	0
    TIPS yield	0.01
    Tax rate	0.12	0.22	0.28
    Inflation	0.120482018766852	0.0728280678748116	0.0604150144938128
    I Bond pre tax growth	=(1+$B4)*(1+B7)-1
    TIPS after tax growth	=((1+$B5)*(1+B7)-1)*(1-B6)
    I Bond grows to	=$B2*(1+B8)^$B3
    I Bond after tax	=B10-B6*(B10-$B2)
    TIPS grows to	=$B2*(1+B9)^$B3
    TIPS vs I Bond	=B12-B11
  • Copy cells B8:B13 right to column D.
  • Format for readability.
  • Modify assumptions as desired in cells B2:B5 and B6:D7.
  • To find the break-even inflation rate, you can either use trial-and-error or the Excel Goal Seek tool. For example, here is how I did it to get the 6.042% breakeven inflation in cell D7 of the second table:

    Code: Select all

    Set cell         D13
    To value           0
    By changing cell  D7
  1. To simplify things I'm ignoring the different lag in applying the CPI to I Bonds and TIPS. I'm also ignoring the boost I Bonds would get from their 0% floor on the composite rate should the CPI decline over any 6 months March-September or September-March.
  2. I'm sticking with a 1% yield for the TIPS to show the effect of longer tax deferral. However, 30-year TIPS are currently yielding about 1.25% according to Wednesday's WSJ TIPS Quotes.
  3. If you have trouble pasting, try "Paste Special" and "Text".
There is a lot of discussion on the tax difference to compare the two funds. I don't have the time and energy to digest the details. I will update the original post to get people's attention on this discussion.
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Re: Compare TIPS vs I-BOND

Post by BigJohn »

woodside wrote: Fri Sep 23, 2022 6:46 am
BigJohn wrote: Fri Sep 23, 2022 3:23 am
woodside wrote: Wed Sep 21, 2022 11:10 am
acegolfer wrote: Wed Sep 21, 2022 10:47 am 2 big differences between the 2.

1. TIPS is a marketable security but i-bond is not. So you will see TIPS price changes every day, which is reflected in return calculation. For example, even if inflation increases, if the market interest rate increases, one can have a negative return. otoh, there's no market price for i-bond. You only see the i-bond account balance, similar to a bank savings account.

2. Effect of inflation rate are different. When inflation rate changes, it affects TIPS face value but not interest rate. otoh, inflation rate affects i-bonds interest rate. And then time lags in the inflation effect on these 2 are different.
Number 2 probably partially explains why the dividends of the TIPS (for VTIP particular) fund are lower than expected as the increase of the face value is probably not distributed.
This is not correct for a TIPS fund. They distribute the entire inflation adjustment at least annually. Individual TIPS work differently. For those none of the inflation adjustment is distributed. You get the cumulative inflation adjustment at maturity.
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
Yes, the mechanics of the two are different but the outcome should be the same as long as the inflation adjustment pay out is reinvested. Others may know more but I think your guesses on how they generate the cash are correct, probably a bit of both depending on circumstances.
"The greatest enemy of a good plan is the dream of a perfect plan" - Carl Von Clausewitz
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Re: Compare TIPS vs I-BOND

Post by jeffyscott »

BigJohn wrote: Fri Sep 23, 2022 6:59 am
woodside wrote: Fri Sep 23, 2022 6:46 am The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
Yes, the mechanics of the two are different but the outcome should be the same as long as the inflation adjustment pay out is reinvested. Others may know more but I think your guesses on how they generate the cash are correct, probably a bit of both depending on circumstances.
To the extent that fund investors are reinvesting dividends, the fund would not need to generate any actual cash and the pay out of the inflation adjustment becomes just an accounting exercise (more shares, lower share price).
And so it goes, And so it goes, And so it goes, And so it goes, But where it's goin' no one knows
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Re: Compare TIPS vs I-BOND

Post by dbr »

woodside wrote: Fri Sep 23, 2022 6:46 am
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
Let's not forget to note that tax deferral on the gains of an after tax investment is not the same thing as a tax deferred pre-tax investment. I bonds can't be held in an IRA or 401k. The OP is about TIPS in taxable but for an investor taxes include what assets are chosen over other assets and include how assets are distributed to before tax and after tax investing and then what assets are chosen in those different cases. There are also after tax, tax exempt Roths, which don't accept I bonds, and tax exempt bonds in taxable to choose among. Not to be ignored is that choosing equities instead can allow indefinite deferral of capital gains, tax avoidance by basis step-up, and tax loss harvesting.
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Re: Compare TIPS vs I-BOND

Post by exodusNH »

woodside wrote: Fri Sep 23, 2022 6:46 am
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
The funds also need to manage their duration. They are selling the maturing-soon (for the definition of "soon" that makes sense based on the fund's target duration) bonds and buying replacements. That's also a source of cash.
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Re: Compare TIPS vs I-BOND

Post by vineviz »

exodusNH wrote: Fri Sep 23, 2022 8:31 am
woodside wrote: Fri Sep 23, 2022 6:46 am
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
The funds also need to manage their duration. They are selling the maturing-soon (for the definition of "soon" that makes sense based on the fund's target duration) bonds and buying replacements. That's also a source of cash.
Virtually no mutual funds have a "target" duration, especially index funds. They typically own a defined range of maturities without regard to duration.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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Re: Compare TIPS vs I-BOND

Post by exodusNH »

vineviz wrote: Fri Sep 23, 2022 8:51 am
exodusNH wrote: Fri Sep 23, 2022 8:31 am
woodside wrote: Fri Sep 23, 2022 6:46 am
The individual bond and the bond fund are always like two different beasts even though their long-term return should be more or less the same. If the TIPS fund also distributes the adjustment of the face money, where is the money coming from? My naive guess is that it is from the new money who purchases the fund or by selling a small proportion of individual TIPS bonds?
The funds also need to manage their duration. They are selling the maturing-soon (for the definition of "soon" that makes sense based on the fund's target duration) bonds and buying replacements. That's also a source of cash.
Virtually no mutual funds have a "target" duration, especially index funds. They typically own a defined range of maturities without regard to duration.
The shortcut I was taking was using the "average effective maturity" as the target maturity. Perhaps that's not a valid heuristic.

The idea I was trying to get across was that to maintain whatever is listed in the prospectus as the range of maturities held (e.g. 1-5 year), the fund needs to sell holdings periodically to match the index. In general, they're not holding everything to maturity; those transactions are another source of cash.
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