jalbert in previous post wrote:
... TIAA-CREF published an article ... explaining the model they used to value a TIP. They see four contributors to return:
- the income/coupon stream;
- the regular adjustment to principal based on (the variation of) CPI;
- changes in principal due to fluctuations in interest rates; and
- market perception of expected inflation.
I disagree. There are no more than three contributors to TIPS return. Number 4
, expected inflation, only affects the yield of nominal
bonds, not inflation-indexed bonds. If one is only concerned about bond returns in real terms, then there are only two, since number 2
, the inflation-indexing of principal, doesn't affect the real return. And if one holds individual TIPS to maturity, then there is only one, since number 3
, fluctuations in interest rates can be ignored. However, for a bond fund
-- which this thread is about -- number 3 as well as number 1 would be a contributor. (But technically fluctuations in interest rates affect the price
, not the principal
, of a bond.)
jalbert in previous post wrote:I think the best way to choose duration of TIPs is to look at the role for them you've identified in your portfolio, rather than trying to analyze which has ... the more attractive yield-duration tradeoff, which I believe is an exercise in futility due to the complexity.
I agree, jalbert, that one needs to consider the role one wants for a TIPS fund in order to choose one with the appropriate duration. For example, I wouldn't use any fund longer than a 1-5 year TIPS fund for savings earmarked to pay college expenses in five years.
But I think one should also look at the yield-duration tradeoff. As I try to explain above, the analysis is not so complex to make it futile. (It is actually simpler than it would be for a nominal bond fund, since one can ignore changes in the CPI.) Even if one plans on holding TIPS for a long time, one might want to use a short term fund if one thinks a)
long term TIPS rates are unusually low today and b)
the yield increment from going to a longer term is too small. I fall in this category and am therefore keeping my average TIPS duration about 6 - 7 years. But if long term TIPS yields were 1.5% points higher, I'd probably increase that to 10-15 years.