Inflation Bonds - Convince Me - Yes or No!

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Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Sat Aug 10, 2013 3:40 pm

There are a few interesting TIPS/Inflation Bond thread up and running. I have found these threads very helpful in that they are providing advantages and disadvantages with different perspectives regarding this asset class.

Presently, we hold 0% in TIPS.

The "thing" (I won't call it a "problem") is for us, every time I read up on Inflation bonds or consider pulling the trigger on them, I can not bring myself to do it for a variety of reasons.

* The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.

* The last decade plus was a period of declining interest rates. The funds inception date was 06/29/2000 (TIPS were created in 1997 I believe). Compounded with the high duration, I would expect it is safe to assume the fund benefited from a long period of declining interest rates.

* Next to nothing in income. Our goal is to build a solid and growing income stream from dividends for retirement.

* Related to the point above, if only Vanguard's Intermediate Term fund would become an index fund like the new short term fund, and pay dividends monthly like iShares, I would probably feel better!

* We are "equal location" rather than "asset location" investors as Rick Ferri has also discussed. That is, the same funds in each account. Inflation bonds don't cut it in terms of taxes.

* Without going into policy, what happens to TIPS if floating rate bonds are issued? Would this be the same as the TSP offering of the fund that resets interest rates daily?

* What happened to TIPS in the downturn of 2008 - 2009? I was always of the impression that treasury bonds rise in a downturn and panic. I did however read a while back that the decline in the value of TIPS during this period may have been related to the collapse of Lehman. Is this correct?

* David Swensen recommend 15% of the total portfolio be allocated to TIPS in his 2005 investing book "Unconventional Success". I attended a lecture last year where he stood by the recommend portfolio in the book (i.e. no mention of the "revised" portfolio in his subsequent interview with Yale Magazine in March / April 2009). I wonder if he is of a different opinion today considering the artificially low rate environment?

* As such we invest in the Total Bond in tax advantage and Intermediate Term Tax Exempt in taxable (i.e. our only difference in our "equal location approach"). Basically as Jack Bogle has often recommended.

* Jack Bogle, in an interview with Steve Forbes (which has been posted on this forum many times), sold out of the TIPS fund many years ago and noted the bond funds above.

* Should the index for Total Bond be updated as Jack has been discussing to become the all in one stop bond option? There may be an argument for that. Perhaps TIPS, maybe High Yield, etc. should be included in the index?

Any thoughts and updated perspective would be appreciated.

Best.
Last edited by abuss368 on Sat Aug 10, 2013 3:57 pm, edited 1 time in total.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by tipswatcher » Sat Aug 10, 2013 3:53 pm

The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.
I'd agree there is risk in owning TIPS mutual funds, which have been great performers for several years but are down about 7% in 2013. Another 100 basis point swing in yield would result in a another 7% to 8% loss in the fund. I am not saying don't buy these funds, I am just saying there is risk.

My strategy is to buy and hold TIPS to maturity, building a ladder so that some issues mature every year, and I try to be a net investor in TIPS, buying more than mature. And I also buy I Bonds up to the limit each year. I add bank CDs to these and I have a super-safe allocation of about 25 to 30% of my portfolio. (Shooting for 30% but I am not there yet.)

Almost all my bond mutual fund holdings are in Vanguard Total Bond Fund, which has a duration of 5.5 years. I would be impossible for me to build a portfolio of individual bonds to match the Total Bond Fund. But with TIPS, you can buy individual issues (I buy them at auction) and let them cross a wide range of years. I view this as a very low-risk strategy. I am holding to maturity, and I don't care what the secondary market does.
TIPS: Perfect investment for imperfect times?

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Sat Aug 10, 2013 4:01 pm

tipswatcher wrote:
The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.
I'd agree there is risk in owning TIPS mutual funds, which have been great performers for several years but are down about 7% in 2013. Another 100 basis point swing in yield would result in a another 7% to 8% loss in the fund. I am not saying don't buy these funds, I am just saying there is risk.

My strategy is to buy and hold TIPS to maturity, building a ladder so that some issues mature every year, and I try to be a net investor in TIPS, buying more than mature. And I also buy I Bonds up to the limit each year. I add bank CDs to these and I have a super-safe allocation of about 25 to 30% of my portfolio. (Shooting for 30% but I am not there yet.)

Almost all my bond mutual fund holdings are in Vanguard Total Bond Fund, which has a duration of 5.5 years. I would be impossible for me to build a portfolio of individual bonds to match the Total Bond Fund. But with TIPS, you can buy individual issues (I buy them at auction) and let them cross a wide range of years. I view this as a very low-risk strategy. I am holding to maturity, and I don't care what the secondary market does.

Hi tipswatcher,

You are investing in individual TIPS presently? I would like to inquire if this is in a taxable account and thus subject to tax each year on the "phantom income". If so, how much of a burden, if any, is that?

I ask because I would investment in the Vanguard fund in both tax advantage and taxable accounts if I pulled the trigger.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by tipswatcher » Sat Aug 10, 2013 4:18 pm

I would like to inquire if this is in a taxable account and thus subject to tax each year on the "phantom income".
I have TIPS in both taxable and tax-deferred accounts.The tax on 'phantom income' is no different than the tax you pay on any bond fund in a taxable account, where you are reinvesting dividends. Or with a bank CD where you are reinvesting interest.

I like buying TIPS at TreasuryDirect, and those TIPS are taxable. So I pay the taxes from current cash flow and when they mature, there is no tax at all on the payout. That could be a positive thing later in retirement, but yes, I know paying taxes now isn't really preferable to paying taxes later.

Here is a scholarly treatise that somewhat debunks the phantom income issue:

http://finance.ba.ttu.edu/hein/Research ... ntaged.pdf
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Sat Aug 10, 2013 4:29 pm

tipswatcher wrote:
I would like to inquire if this is in a taxable account and thus subject to tax each year on the "phantom income".
I have TIPS in both taxable and tax-deferred accounts.The tax on 'phantom income' is no different than the tax you pay on any bond fund in a taxable account, where you are reinvesting dividends. Or with a bank CD where you are reinvesting interest.

I like buying TIPS at TreasuryDirect, and those TIPS are taxable. So I pay the taxes from current cash flow and when they mature, there is no tax at all on the payout. That could be a positive thing later in retirement, but yes, I know paying taxes now isn't really preferable to paying taxes later.

Here is a scholarly treatise that somewhat debunks the phantom income issue:

http://finance.ba.ttu.edu/hein/Research ... ntaged.pdf
True.

Related to paying taxes now or at retirement, it is amazing how many clients I see are investing in Roth IRA's now instead of Traditional IRA's due to a preference to not paying taxes in retirement regardless of present or expected tax brackets.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by dbr » Sat Aug 10, 2013 4:41 pm

abuss368 wrote:There are a few interesting TIPS/Inflation Bond thread up and running. I have found these threads very helpful in that they are providing advantages and disadvantages with different perspectives regarding this asset class.

Presently, we hold 0% in TIPS.

The "thing" (I won't call it a "problem") is for us, every time I read up on Inflation bonds or consider pulling the trigger on them, I can not bring myself to do it for a variety of reasons.

* The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.

In other words you aren't interested in the solution to the problem you want to solve. A blend of short and intermediate TIPS is an option and so is buying individual bonds.

* The last decade plus was a period of declining interest rates. The funds inception date was 06/29/2000 (TIPS were created in 1997 I believe). Compounded with the high duration, I would expect it is safe to assume the fund benefited from a long period of declining interest rates.

That would be true. Certainly one does not invest in an asset based on recent returns.

* Next to nothing in income. Our goal is to build a solid and growing income stream from dividends for retirement.

Right, you can't get much of an income stream from bonds now, or maybe ever. It could be that assuming that income has to be defined by dividends paid is a mistake.

* Related to the point above, if only Vanguard's Intermediate Term fund would become an index fund like the new short term fund, and pay dividends monthly like iShares, I would probably feel better!

How often the dividends are paid is a convenience that should not be much of a factor in selecting assets.


* We are "equal location" rather than "asset location" investors as Rick Ferri has also discussed. That is, the same funds in each account. Inflation bonds don't cut it in terms of taxes.

TIPS are somewhat more tax efficient than bonds as a whole because Treasuries are state tax exempt, which may or may not affect you. There is a reason for recommending placement of bonds in tax preferred accounts. It is also true that for now the low yields on bonds reduce the tax problem. As mentioned above, the phantom income from TIPS is a phantom issue.

* Without going into policy, what happens to TIPS if floating rate bonds are issued? Would this be the same as the TSP offering of the fund that resets interest rates daily?

* What happened to TIPS in the downturn of 2008 - 2009? I was always of the impression that treasury bonds rise in a downturn and panic. I did however read a while back that the decline in the value of TIPS during this period may have been related to the collapse of Lehman. Is this correct?

I would like to understand this myself. However, it has been pointed out (by Nisi, I think, but anyone can see it) that this downturn was preceded by an unexplained upturn.

* David Swensen recommend 15% of the total portfolio be allocated to TIPS in his 2005 investing book "Unconventional Success". I attended a lecture last year where he stood by the recommend portfolio in the book (i.e. no mention of the "revised" portfolio in his subsequent interview with Yale Magazine in March / April 2009). I wonder if he is of a different opinion today considering the artificially low rate environment?

It has never made sense to me to choose asset allocations based on a generic recommendation. I take those as examples of how a person might invest rather than as a recommendation for how you, I, or Mr. Swenson ought to actually invest, all taken into account.

* As such we invest in the Total Bond in tax advantage and Intermediate Term Tax Exempt in taxable (i.e. our only difference in our "equal location approach"). Basically as Jack Bogle has often recommended.

Then you could hold some TIPS in tax advantaged.


* Jack Bogle, in an interview with Steve Forbes (which has been posted on this forum many times), sold out of the TIPS fund many years ago and noted the bond funds above.

If you want your investments to follow what Mr. Bogle might suggest, it is certainly possible to do so. I have long since given up on understanding why Mr. Bogle might or might not recommend specifics at that level. But . . . who am I to differ?

* Should the index for Total Bond be updated as Jack has been discussing to become the all in one stop bond option? There may be an argument for that. Perhaps TIPS, maybe High Yield, etc. should be included in the index?

Any thoughts and updated perspective would be appreciated.

Sure. You invest in TIPS rather than nominal bonds because you want for some reason some assets to not have inflation risk. Usually people who would want to do that are retirees who want conservative portfolios without a lot of stock volatility but who also recognize that inflation is a serious risk to their livelihood. It seems to me that if one is such an investor then most of one's fixed income should be in TIPS. How it can be helpful to allocate minor allocations to TIPS is beyond me. Other than that interest rate risk and tax costs are similar to all bonds, except that interest rate sensitivity is to real rather than nominal rates.

I suppose a possible alternative to TIPS for some retirees would be an inflation indexed SPIA, if they do not already have a secure inflation indexed pension, including SS.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by chicagobear » Sat Aug 10, 2013 4:55 pm

I wouldn't buy TIPS. The tax treatment is terrible and you can lose money if real rates go up. I own online savings accounts for liquidity and gold bullion for inflation protection.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by grabiner » Sat Aug 10, 2013 5:12 pm

abuss368 wrote:* The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.
However, the interest-rate risk is probably somewhat less; TIPS yields change when real interest rates change, and real interest rates are less volatile than nominal rates. (In particular, if expected inflation increases, nominal interest rates will rise, but TIPS won't be affected.)
* Next to nothing in income. Our goal is to build a solid and growing income stream from dividends for retirement.
You'll actually receive a fair amount of income from the fund, as the inflation adjustment is paid out by TIPS funds (and taxable) but is not counted in the yield. If you hold individual TIPS, you don't receive the inflation adjustment as cash, but you still owe tax on it.
* We are "equal location" rather than "asset location" investors as Rick Ferri has also discussed. That is, the same funds in each account. Inflation bonds don't cut it in terms of taxes.
If you hold bonds in your taxable accounts, you should use I-Bonds in preference to TIPS (or most other bonds, for that matter); the interest is deferred for up to 30 years and you can cash in the bonds without penalty after 5 years if rates rise.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by nisiprius » Sat Aug 10, 2013 5:42 pm

Speaking as a big fan of TIPS myself, I don't see any reason to try to convince you. It's not a great big hairy deal, it's not going to make a lot of difference one way or another. I also think that unless one's stock allocation is virtually zero, it hardly matters what's in the bond allocation, provided it's high-grade bonds--the fluctuation of the stocks is going to dominate the portfolio to such an overwhelming extent that you aren't even going to see what the bonds are doing.

If you just don't like TIPS, you don't need 'em. Just ignore them.

I admit I'm fighting the last war--I remember circa-1980 well enough that I want some insurance against that specific, precise scenario, and I don't see any huge dangers in opting for TIPS; so, TIPS for me and I'm willing to forgive their being suboptimal if it turns out they're suboptimal. But of course the last thing that's likely to happen is a close repetition of circa-1980.

(BTW TIPS are a negligible part of the total bond market. I keep looking it up and forgetting the answer, but they constitute maybe 3% of all Treasuries?; if they were in the Barclay's index they'd be an insignificant part of it).

I assume the market for high-grade bonds is efficient. My working assumption is that you shouldn't expect there to be anything but a risk/reward tradeoff, i.e. TIPS shouldn't be intrinsically better or worse. Here's the odd part: I'd have thought that TIPS were less risky, because they have one less risk factor than nominal bonds--inflation--and that, therefore, they should have less return. What's actually happened in the Vanguard TIPS fund has been just the other way around, noticeably riskier and noticeably more reward.

However, Morningstar is showing the 10-year Sharpe ratio as being 0.60 for VIPSX and 0.86 for Total Bond (VBMFX), so, hey, overall VIPSX hasn't done as well.

Doing what I always like to do, an eyeball chart--comparing VIPSX not to Total Bond, but to Intermediate-Term Investment-Grade because it's a closer comparison--and then throwing in Total Stock for perspective--it's hard to believe there's going to be any huge, important difference between a mix of Total Stock (green) and VIPSX (blue) versus the same mix of Total Stock and Intermediate-Term Investment-Grade (orange).
  • Either of them would have helped you through the lost decade for stocks.
  • Either of them would have given you an anchor to windward during 2008-2009.
  • Either of them earned you meaningfully more than a money market fund (yellow).
  • Either of them got you an average annual return of around 6-7%, with up-and-down fluctuations mostly in the 1-2% range, hitting 10% during the crisis when stocks dropped 50%.
  • To the extent you are worried about rising rates, you need to worry about both.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Sat Aug 10, 2013 6:10 pm

Nisi,

First that was such a great post that I want to thank you for it. It really helps put things in perspective.

Second that chart was very helpful. Sometimes visuals work best.

Best.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by G-Money » Sat Aug 10, 2013 6:38 pm

I use the TIPS fund (40% of fixed income). I don't use it for be explicit inflation protection. Rather, like Swensen, I believe it is a distinct asset class. I think it is a fundamentally different form of fixed income from nominal bonds. Historically, it has not been perfectly correlated with nominal bonds, which is a good thing; holding some of both creates the possibility of increasing returns and/or reducing portfolio volatility.

I don't view the longer (I don't think a duration of 8 years is "long") duration is a problem. The TIPS fund roughly matches that of the TIPS market. I believe the fixed income market is efficient, and the real yields for longer maturities is higher than this of shorter ones as compensation for the higher risk. I'm not a market timer, so I make no predictions of what interest rates or particular funds will do in the future.
Don't assume I know what I'm talking about.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by rnitz » Sat Aug 10, 2013 7:28 pm

I also favor Nisi's view that if you believe that the market is reasonably efficient, then bonds are bonds and you're just selecting your risk/reward tradeoffs (short term vs. long term for interest rate risk, AAA quality vs. high yield for default risk, etc.)

So TIPS are just Treasuries, with the exception of the inflation risk. If future inflation is exactly what the markets predict (currently around 1.8% for the next XXX years I believe, although I'll have to check) then it just doesn't matter. If you think inflation will be lower than this over the next XXX years then you definitely should avoid TIPS and go to other bonds. If you think inflation may be higher than this (or want to be protected to some extent if it is) then I'd think you want TIPS (or I-bonds) as part of your fixed income portfolio.

I also am old enough to have lived through the 70s/early 80s and want to be protected (somewhat) against this type of inflation possibility. I appreciate this type of diversification in my fixed income allocation, so I'm roughly 50% nominal bonds and 50% inflation adjusted bonds.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by dbr » Sat Aug 10, 2013 7:44 pm

G-Money wrote:I use the TIPS fund (40% of fixed income). I don't use it for be explicit inflation protection. Rather, like Swensen, I believe it is a distinct asset class. I think it is a fundamentally different form of fixed income from nominal bonds. Historically, it has not been perfectly correlated with nominal bonds, which is a good thing; holding some of both creates the possibility of increasing returns and/or reducing portfolio volatility.

You are right that this is a distinct asset class within bonds, but for this to be useful in the sense of diversification, you have to be attacking something that has enough risk (ie variability of returns) to be worth worrying about. In a portfolio of stocks and bonds, that isn't bonds. More than that, the benefit is in proportion to the variabilities. You will be making a small improvement in a factor that is not very important. I wonder if diversification within bonds, in the MPT sense, is really of much interest.

I don't view the longer (I don't think a duration of 8 years is "long") duration is a problem. The TIPS fund roughly matches that of the TIPS market. I believe the fixed income market is efficient, and the real yields for longer maturities is higher than this of shorter ones as compensation for the higher risk. I'm not a market timer, so I make no predictions of what interest rates or particular funds will do in the future.

Right, and there is a tendency for bond yield curves to have a sweet spot, usually somewhere in the intermediate durations. I also don't see why the duration of VIPSX is a problem for holding in a portfolio for the long term investor.

I suppose one concern is one on general principal that an investor rich in bonds would not want all TIPS just because it is a bad idea to be too concentrated in anything in particular. This is opposed by the idea that if inflation "insurance" is what is desired for the bond rich investor, then TIPS it is, excepting somehow accumulating a hoard of I bonds.



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Re: Inflation Bonds - Convince Me - Yes or No!

Post by gerrym51 » Sat Aug 10, 2013 7:45 pm

i don't buy them. you have to convince yourself.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by dbr » Sat Aug 10, 2013 7:46 pm

gerrym51 wrote:i don't buy them. you have to convince yourself.
I do buy them, the convince part you are right on.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by stlutz » Sat Aug 10, 2013 10:37 pm

Hi abuss,
The duration of the Vanguard Intermediate Term Inflation Protected Securities fund is 8.0. That is rather high and could probably be considered practically a long term bond fund. No interest in the short term fund.
You should first select the risk (duration) you are comfortable with and then choose the fund/combination of funds that fits that criteria. Owning a fund with a duration of 5 is the same thing as holding two funds, one with a duration of 2.5 and one with a duration of 7.5. You should not let VG bond managers or index providers determine your risk profile.
Next to nothing in income. Our goal is to build a solid and growing income stream from dividends for retirement.
If inflation comes in at what the bond market expects, the distributions from a nominal treasury fund and a TIPS fund will be exactly the same. Last year the dividends (not cap gains) were about 2.3% on VAIPX.
Related to the point above, if only Vanguard's Intermediate Term fund would become an index fund like the new short term fund, and pay dividends monthly like iShares, I would probably feel better!
If the iShares fund better meets your needs, then by all means use it.
We are "equal location" rather than "asset location" investors as Rick Ferri has also discussed. That is, the same funds in each account. Inflation bonds don't cut it in terms of taxes.
I'm an equal location person as well. I also like Treasury bonds/CDs and the like that don't have credit risk (I think Larry Swedroe has it right about taking on credit risk with bonds). With Treasury securities, you can reduce your tax exposure by a) harvesting short-term losses in years where you don't have long term capital gains (meaning you can deduct the loss at your regular federal+state rate), and b) harvesting capital gains when they are available--as this converts interest income into capital gains. Also note that the various ETF options out there are better than the VG fund tax wise as they tend to distribute less in short-term capital gains.
what happens to TIPS if floating rate bonds are issued?
Yields on floating rate bonds will be essentially equivalent to the T-bill rate. Essentially they eliminate the requirement that short-term debt buyers buy new bills every few months.
What happened to TIPS in the downturn of 2008 - 2009? I was always of the impression that treasury bonds rise in a downturn and panic. I did however read a while back that the decline in the value of TIPS during this period may have been related to the collapse of Lehman. Is this correct?
Not sure about Lehman, but remember that the fear in '08 and '09 was deflation, not inflation. As such, the price of inflation-protected bonds fell. The prices of TIPS funds change in response to changing expectations of future inflation (which is not the same thing as changing in response to actual inflation).

Other things to keep in mind:

--TIPS have higher equity correlation than nominal treasuries (munis do as well). If you have a relatively equity-heavy portfolio, adding them could actually increase the volatility of your overall portfolio. As such, if I was you I would take my TIPS allocation from my muni bond allocation if I was going to do it.

--As far a buying individual TIPS (which you can do at Vanguard and Fidelity at no cost), I would recommend waiting until after the first of the year to do so. Beginning in 2014, brokers have to track cost basis on fixed income for you, which would make the record keeping far easier if you elected to sell before maturity for whatever reason.

I currently own no TIPS. I only owned them for a couple of years beginning in early 2009 as a tactical move when real yields were high. When the price went up and real yields went down, I sold (at a nice profit) and put the money back in nominals.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by tipswatcher » Sat Aug 10, 2013 11:43 pm

nisiprius wrote:Speaking as a big fan of TIPS myself, I don't see any reason to try to convince you. It's not a great big hairy deal, it's not going to make a lot of difference one way or another. I also think that unless one's stock allocation is virtually zero, it hardly matters what's in the bond allocation, provided it's high-grade bonds--the fluctuation of the stocks is going to dominate the portfolio to such an overwhelming extent that you aren't even going to see what the bonds are doing.

If you just don't like TIPS, you don't need 'em. Just ignore them.

I admit I'm fighting the last war--I remember circa-1980 well enough that I want some insurance against that specific, precise scenario, and I don't see any huge dangers in opting for TIPS; so, TIPS for me and I'm willing to forgive their being suboptimal if it turns out they're suboptimal. But of course the last thing that's likely to happen is a close repetition of circa-1980.
Awesome post, nisiprius. Although I am a fan of TIPS and I want to see them get higher yields and be more useful in a portfolio, I have to agree ... it probably doesn't matter. This is my particular investing hangup, a super-safe segment that is protected against inflation. But any sensible, low-cost, indexed stock/bond allocation would perform about the same, unless inflation goes wild.

If inflation goes wild ... I'll be pretty happy with TIPS and I Bond allocation. However, that probably won't happen. And if it doesn't happen, I'll still be pretty happy with my TIPS and I Bond allocation. Will I lose much against other bonds? Not much. Not with today's yields.
TIPS: Perfect investment for imperfect times?

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Geologist » Sun Aug 11, 2013 1:53 pm

abuss368 wrote:
* Related to the point above, if only Vanguard's Intermediate Term fund would become an index fund like the new short term fund, and pay dividends monthly like iShares, I would probably feel better!
TIPS have only been issued in January, February (and only a couple issues for those), April, and July. Consequently, they only pay interest in those months plus the ones six months apart (i.e., this adds only August, October). Other months have no interest payments, so monthly dividends can't occur (there is nothing to pay in those months, except accrued interest received, based on bonds sold, I suppose). This is why, unlike other Vanguard bond funds, the Vanguard TIPS fund includes interest in the NAV and pays quarterly.

Overall, I agree with dbr that the frequency of payment is a matter of convenience.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Beagler » Sun Aug 11, 2013 3:47 pm

With I Bonds you won't ever lose principal. What are your thoughts on those?
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Sun Aug 11, 2013 9:04 pm

Excellent thoughts and feedback thus far.

Please keep it coming!
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by MrMatt2532 » Sun Aug 11, 2013 9:24 pm

First, let me preface by saying I hold treasuries for my bond allocation as I don't believe the credit risk factor provides a good risk adjusted return.

Regarding tips vs. nominals, my basic thinking is if inflation is greater than expected, TIPS win, if not, nominals win. Over the long term, I expect there to be a diversification benefit in holding the two assets.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by linuxizer » Mon Aug 12, 2013 12:00 am

This thread seems to have picked up more than the usual share of fallacies:

- Rolling ladder vs. bond fund - They're equivalent, and thinking that the former will protect you from risks you see in the latter is simply wrong.
- Gold as inflation hedge - Somehow that suit that an oz of gold has bought "since Roman times" went from Armani (1980) to Men's Warehouse (2004) to Armani (2011).
- Avoiding tax efficient asset locations - Not sure why one would do this, especially if it starts driving you away from asset classes you otherwise think you should have.
- Total return vs. dividends - Not so hard to set up an automated sell order these days.

In short, if you think you should have protection against unexpected inflation, you should have TIPS in your portfolio. If not, then don't.

If the duration of the available fund is too long for you, mix it with the shorter TIPS fund until you get a duration you like. I believe Larry S. has said that it makes sense to be longer in TIPS since you don't have inflation risk, though.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Valuethinker » Mon Aug 12, 2013 3:48 am

Abuss

You cannot compare nominal duration (in other bond funds) with *real* duration in a TIPS fund-- they are different concepts.

Essentially they are sensitive to changes in real interest rates.


TIPS have basically ranged from c. -1.0% (short) as the lowest yield to 4% real as the highest (shortly after inception).

With a duration of 8 years, if TIPS moved back to 4% real you could, theoretically, lose c. 32% of the price (assuming that the fund had a real interest rate of 0%)

HOWEVER that would imply a swing in TIPS yields as has hit TIPS since 1998. That's putting the 15 year swing (which included 2 recessions and the worst financial crash since 1929) in as an movement in interest rates in, say, 1 year. That's like saying US Treasuries can go back to 13% in 1 year.

It's certainly possible for TIPS to get hit. Indeed they will if nominal bond yields go back to 4%, say.

But to my mind it's very unlikely we will see long US TIPS at 3% real yields again, and ST ones correspondingly lower yields. The macro scenario associated with that would be the Fed *really* slamming on the brakes, in which case real interest rates shoot up, and nominal bonds get pounded as well.

There is a ST TIPS fund from VG now if that worries you as a scenario (I own Real Return Bonds directly, and have decided to just 'ride the curve' towards redemption-- market valuation be damned).

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Clive » Mon Aug 12, 2013 5:59 am

As a potential portfolio insurance a little exposure to long dated TIPS could help under the right circumstances. As ever however that insurance comes with a cost.

If another occurrence of a 1917 or 1946 event occurred - when conventional treasury yields remained low (suppressed) and inflation raged to near 20% yearly levels then real yields might move sharply negative. Whilst more so for the shorter dated end, likely the longer dated end would also see some general lowering/more negative real yields. Given more recent events/circumstances of yields being suppressed, that risk is perhaps greater than it has been during other times (half of that risk is already present (low yields), high/spike in inflation would complete that risk actually being encountered).

A relatively small amount of long dated TIPS (high duration) might help under such conditions. I'm UK so its easier for me to quote UK figures - 1.25% 2055 inflation bond has a recent modified duration of 35 i.e. price moves by around 35% for each 1% change in real yields. If real yields declined -5%, then that bond might see several hundred percent point change (gain) in price. Those gains could offset losses in other assets (or compensate for other assets declining in real terms).

If for instance you started with 5% weighting in long dated TIPS ($5) and subsequently conventional yields remained unchanged but inflation spiked to 20%, longer dated real yields declined 5% in reflection of that and each $5 originally invested in TIPS rose to $25 then whilst the remainder 95% ($95) of assets might have lost -9.5% ($9.50) in real terms as a collective set (assuming prices remained unchanged), the gains from the TIPS negated that loss and more i.e. there was capacity for the TIPS gains to also compensate for price declines in addition to general real value declines.

Should real yields rise and TIPS prices decline, then relative to the whole those losses might be an acceptable 'insurance' cost/premium for the protection they provided. The other assets might rise sufficiently to compensate for those TIPS losses.

A similar might be said for gold. Whilst some portfolio's might hold a sizeable initial allocation to gold, such as the Permanent Portfolio 25% gold weighting choice, under exceptional circumstances that might be not much better than having initially weighted to 5% gold due to the Permanent Portfolio's choice of timing (rebalancing). 25% gold and 40% rebalance bands (add more if declines to 15% weighting, sell back down to 25% weighting if a rise to 35% weighting occurs) may sell chunks of its gold holdings too soon. After 4 sequential 40% rises in the price of gold, such a rebalancing policy would have the portfolio holding around just 6.5% of the original amount of gold it originally purchased. Whilst the price may have nearly quadrupled and some profits been taken, those profits in being invested elsewhere may have seen the purchase power of those amounts decline harshly. And a quadrupling of the price of gold might just be the start of things - the price might subsequently continue to rise substantially more.

Image

A Permanent Portfolio with 25% initially in gold that repeatedly reduced gold after 40% rises could be far worse off than someone who initially bought 5% gold and held 5% throughout.

Simply, if you do employ some portfolio insurance by holding some TIPS (or gold etc.) then there's an additional complexity of when to time 'cashing-in' that insurance. Some investors might not bother with such insurance at all - similar to living in a home with no fire insurance protection and saving on the premiums. Others might have heavy insurance exposure, but cash in and reduce the insurance when a nearby tree gets burned, only to later see their home catching light when they have much less insurance cover. Buying a little insurance (5% long dated TIPS perhaps) and topping that up to 5% again when it drops down in weighting (maybe once yearly reviews), and holding on to that until things are really dire (whole house burnt down) might be the easiest/simplest way-to-go. A combined 10% perhaps in TIPS and gold will of course act as a drag on the portfolio for most of the time, but in practice that drag tends to not be too much (acceptable insurance premium cost). In Simba's backtest spreadsheet for instance the difference between 100% TSM to that of 90% TSM, 5% TIPS, 5% gold since 1972 appears as an almost insignificant difference.
What happened to TIPS in the downturn of 2008 - 2009? I was always of the impression that treasury bonds rise in a downturn and panic. I did however read a while back that the decline in the value of TIPS during this period may have been related to the collapse of Lehman. Is this correct?

As an example, comparing (CUSIP 912810FQ6) TIPS 3.38% 15th April 2032 Bond with TLT (end of day prices) over the 2008/9 period when TLT rose to a spike and then declined back down again :

3rd November 2008 TLT = 92.71 TIPS = 102.03
15th December 2008 TLT = 113.65 TIPS = 118
8th June 2009 TLT = 89.61 TIPS = 118.78

As a income provision mechanism, a TIPS ladder can be built to provide future purchase power. If aged 30 for instance you might buy a years worth of income at age 60 with the same purchase power then as today by buying a 30 year TIP, which recently comes in at a 1.25% real yield. So instead of having to invest $1000 to buy $1000 of purchase power in 30 years time, you can conceptually deposit less into that rung today to provide $1000 of inflation adjusted purchase power in 30 years time. Whether after taxes etc. that is better/safer than alternative choices ??? - its very much a personal choice.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Bill M » Mon Aug 12, 2013 6:49 am

There is a huge difference between TIPS bonds and TIPS mutual funds; I think it is a huge mistake to try to discuss them together as if they were the same beasts. The mutual funds are subject to interest rate risk and fluctuate, and have no guaranteed payout on a particular future date. They are somewhat more volatile than non-TIPS bonds funds, since they vary both with current rates and with inflation expectations. I see little difference (from an analysis perspective) between a TIPS mutual fund and any other bond mutual fund.

TIPS (bonds, not mutual funds) are a way to preserve wealth with negligible risk. If you have a different problem you want to solve (like you want some growth), they are likely not the solution. But if wealth preservation is the problem, there is no better solution. Even then, it's not a simple solution, since you need to match the individual maturities to your withdrawal needs.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by billyt » Mon Aug 12, 2013 6:53 am

No. That's just plain wrong. There is not any difference between creating your own rolling ladder of TIPS and owning a mutual fund. They are equivalent.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Trurl Klapaucius » Mon Aug 12, 2013 8:24 am

Clive wrote:As a potential portfolio insurance a little exposure to long dated TIPS could help under the right circumstances. As ever however that insurance comes with a cost... Whether after taxes etc. that is better/safer than alternative choices ??? - its very much a personal choice.
Clive,

Borrowing your insurance policy analogy for TIPS; if held in a taxable account, the tax on TIPS is another “premium” paid for the insurance they provide against inflation. If inflation proves to be greater than expected, this premium increases; or perhaps a better analogy would be that the deductible on the insurance coverage increases. In other words, as long as the fixed interest rate of TIPS remains near zero, and the inflation adjustment of TIPS is taxable, the after-tax (real) yield on TIPS will be less than the inflation rate (unless either inflation or tax rates become less-than-or-equal-to zero; both unlikely). Thus, currently, in a taxable account, money invested in TIPS is effectively guaranteed to lose purchasing power because of inflation.

Personally, I’m not inclined to buy the TIPS insurance policy under these terms. Since stocks provide some measure of long-term inflation protection, I feel that the market risk on my stock holdings is enough “premium” to pay for inflation protection. The question is “How much insurance does an investor wish to have on his/her portfolio, given that there is a cost for coverage?” As you stated “It’s very much a personal choice.”

- Trurl

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by G-Money » Mon Aug 12, 2013 8:41 am

Bill M wrote:There is a huge difference between TIPS bonds and TIPS mutual funds; I think it is a huge mistake to try to discuss them together as if they were the same beasts.
I disagree. Set up your own TIPS ladder with the same weightings as the TIPS mutual fund, and the performance of the two will be virtually identical (with the exception of the savings of the ER, but possibly worse spreads on buys and sells).
Bill M wrote:The mutual funds are subject to interest rate risk and fluctuate,
. . . just like individual TIPS bonds. The only difference is if you own the TIPS bond directly, you can "hide" the interest rate risk by not marking to market. But ignoring the TIPS bond's interest rate risk is not the same as it not having interest rate risk.
Bill M wrote:and have no guaranteed payout on a particular future date.
But the TIPS bonds within the fund do.
Bill M wrote:They are somewhat more volatile than non-TIPS bonds funds, since they vary both with current rates and with inflation expectations.
All bond funds "vary both with current rates and with inflation expectations." Inflation expectations are a critical factor in the rates demanded by the market for TIPS and nominal bonds of all maturities.
Bill M wrote:I see little difference (from an analysis perspective) between a TIPS mutual fund and any other bond mutual fund.
Agree with you there.
Bill M wrote:TIPS (bonds, not mutual funds) are a way to preserve wealth with negligible risk.
Both directly-held TIPS and TIPS mutual funds will do this. If you're trying some liability matching approach, such that you have a real amount of money set aside for use at a particular time, directly-held TIPS may be more useful. Otherwise, there's no substantive difference regarding which one you use.
Bill M wrote:If you have a different problem you want to solve (like you want some growth), they are likely not the solution.
Equally true of all bonds and bond funds.
Bill M wrote:But if wealth preservation is the problem, there is no better solution. Even then, it's not a simple solution, since you need to match the individual maturities to your withdrawal needs.
Right, this is liability matching. It's not for everyone.
Don't assume I know what I'm talking about.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by G-Money » Mon Aug 12, 2013 8:45 am

Trurl Klapaucius wrote:
Clive wrote:As a potential portfolio insurance a little exposure to long dated TIPS could help under the right circumstances. As ever however that insurance comes with a cost... Whether after taxes etc. that is better/safer than alternative choices ??? - its very much a personal choice.
Clive,

Borrowing your insurance policy analogy for TIPS; if held in a taxable account, the tax on TIPS is another “premium” paid for the insurance they provide against inflation. If inflation proves to be greater than expected, this premium increases; or perhaps a better analogy would be that the deductible on the insurance coverage increases. In other words, as long as the fixed interest rate of TIPS remains near zero, and the inflation adjustment of TIPS is taxable, the after-tax (real) yield on TIPS will be less than the inflation rate (unless either inflation or tax rates become less-than-or-equal-to zero; both unlikely). Thus, currently, in a taxable account, money invested in TIPS is effectively guaranteed to lose purchasing power because of inflation.

Personally, I’m not inclined to buy the TIPS insurance policy under these terms. Since stocks provide some measure of long-term inflation protection, I feel that the market risk on my stock holdings is enough “premium” to pay for inflation protection. The question is “How much insurance does an investor wish to have on his/her portfolio, given that there is a cost for coverage?” As you stated “It’s very much a personal choice.”

- Trurl
But this is true of nominal bonds, too. If inflation equals expected inflation, taxable nominal bonds held in taxable accounts will also have an after-tax yield less than inflation. And there is no inflation-insurance feature in nominal bonds.
Don't assume I know what I'm talking about.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by G-Money » Mon Aug 12, 2013 8:51 am

dbr wrote:
G-Money wrote:I use the TIPS fund (40% of fixed income). I don't use it for be explicit inflation protection. Rather, like Swensen, I believe it is a distinct asset class. I think it is a fundamentally different form of fixed income from nominal bonds. Historically, it has not been perfectly correlated with nominal bonds, which is a good thing; holding some of both creates the possibility of increasing returns and/or reducing portfolio volatility.

You are right that this is a distinct asset class within bonds, but for this to be useful in the sense of diversification, you have to be attacking something that has enough risk (ie variability of returns) to be worth worrying about. In a portfolio of stocks and bonds, that isn't bonds. More than that, the benefit is in proportion to the variabilities. You will be making a small improvement in a factor that is not very important. I wonder if diversification within bonds, in the MPT sense, is really of much interest.
I don't disagree. But the cost of holding both TBM and TIPS is essentially $0 (the ER for admiral shares of the two funds is the same). So even if the improvement is small, it's worth it to me.
Don't assume I know what I'm talking about.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Bill M » Mon Aug 12, 2013 9:43 am

G-Money wrote:
Bill M wrote:There is a huge difference between TIPS bonds and TIPS mutual funds; I think it is a huge mistake to try to discuss them together as if they were the same beasts.
I disagree. Set up your own TIPS ladder with the same weightings as the TIPS mutual fund, and the performance of the two will be virtually identical (with the exception of the savings of the ER, but possibly worse spreads on buys and sells).
If you set up your TIPS ladder totally oblivious to your liabilities, then you will need to sell the individual TIPS bonds before they mature -- you will then be subject to the same interest rate and inflation expectation risk of a TIPS mutual fund. But you don't need to be totally oblivious. You can be intelligent about the bond maturities. That's what makes the difference.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by nisiprius » Mon Aug 12, 2013 9:52 am

Bill M wrote:
G-Money wrote:
Bill M wrote:There is a huge difference between TIPS bonds and TIPS mutual funds; I think it is a huge mistake to try to discuss them together as if they were the same beasts.
I disagree. Set up your own TIPS ladder with the same weightings as the TIPS mutual fund, and the performance of the two will be virtually identical (with the exception of the savings of the ER, but possibly worse spreads on buys and sells).
If you set up your TIPS ladder totally oblivious to your liabilities, then you will need to sell the individual TIPS bonds before they mature -- you will then be subject to the same interest rate and inflation expectation risk of a TIPS mutual fund. But you don't need to be totally oblivious. You can be intelligent about the bond maturities. That's what makes the difference.
In particular, when you are ready, you can quit buying a new bond every time an old one matures. At some point, you can just harvest each as it matures.

One big fundamental difference between stocks and bonds is that there is no way to get your "principal" out of the stock except to sell it on the market and incur market risk. With bonds, you can sell it on the market and incur market risk, or you can hold to maturity and avoid market risk. (However, the known value of bonds at maturity tends to tether the market value of bonds--the market value of a bond which is going to pay off $1,000 tomorrow can't be very different from $1,000--which is why bonds are less risky than stocks to begin with).
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by G-Money » Mon Aug 12, 2013 10:09 am

Bill M wrote:
G-Money wrote:
Bill M wrote:There is a huge difference between TIPS bonds and TIPS mutual funds; I think it is a huge mistake to try to discuss them together as if they were the same beasts.
I disagree. Set up your own TIPS ladder with the same weightings as the TIPS mutual fund, and the performance of the two will be virtually identical (with the exception of the savings of the ER, but possibly worse spreads on buys and sells).
If you set up your TIPS ladder totally oblivious to your liabilities, then you will need to sell the individual TIPS bonds before they mature -- you will then be subject to the same interest rate and inflation expectation risk of a TIPS mutual fund. But you don't need to be totally oblivious. You can be intelligent about the bond maturities. That's what makes the difference.
Yes, you're referencing liability matching, so directly held TIPS are great for you. My impression is not many folks on this forum (or elsewhere) implement that strategy. For them, there's no appreciable difference between directly holding TIPS and using a TIPS mutual fund.
Don't assume I know what I'm talking about.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Clive » Mon Aug 12, 2013 10:43 am

Trurl Klapaucius wrote:Borrowing your insurance policy analogy for TIPS; if held in a taxable account, the tax on TIPS is another “premium” paid for the insurance they provide against inflation.
With TIPS in a taxable account yes. There are some differences between UK 'TIPS' (Index Linked Gilts) and US TIPS. US TIPS (I believe) repay at least par - if there is deflation over the bonds life then you win in real terms as par value would have grown in purchase power. With UK TIPS the value can mature at a below par value to reflect deflation (repay less than par). With UK TIPS however the inflation uplift element is tax-free - you only pay taxes on any additional real income. They're also exempt from capital gains tax if sold for a capital gain prior to maturity (I guess the UK treasury figure that the capital gains are an overall zero sum game and can't be bothered expending the time/effort to track/collect/refund taxes against capital value changes).

i.e. there are additional tax risks. That risk I suspect would be more likely to actually be encountered at a time when you least wanted it to be applied.

A similar effect of that sort of risk can be seen from the withdrawal of new issues of our iBond equivalents in more recent years (Index Linked Savings Certificates). When you perhaps need a particular asset the most, the availability or taxation policy might be changed to make it prohibitively expensive to buy/own or maybe not even be available at all. Personally I read the withdrawal of new issues of UK iBonds as being the treasury expecting a period of high inflation and low (suppressed nominal yields) to be on the horizon (debt erosion via inflation).

You might end up having paid an insurance premium for many years, only to find that the insurance has become null and void or unavailable just when you needed it the most.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by tipswatcher » Mon Aug 12, 2013 10:52 am

I live in a parallel universe from most Bogleheads, I guess. I am not saying they are wrong, and I am definitely not admitting I am wrong. We are both right -- you in your universe and me in mine.

In my universe, I create a TIPS ladder with the 100% intention of holding to maturity. Not 99.9%, 100%. I am not selling before maturity, I won't need to sell before maturity. Once a TIPS reaches maturity, I either spend the money, reinvest elsewhere, or reinvest in TIPS. My intention is to reinvest in TIPS, most of the time, and be a net buyer of TIPS each year.

In my universe, I track the par value of the TIPS, plus inflation adjustment. I never look at secondary market values, why would I? I am holding to maturity. The only number that matters to me is par value plus inflation adjustment.

In my universe, my TIPS holdings didn't soar in value over the last two years. That happened on the secondary market, but not in my universe. And in my universe, my TIPS holdings didn't decline by 7% since March. That happened in the secondary market, not in my universe. My eventual intention is to stop rolling over the TIPS and spend the money in retirement, with specific amounts maturing each year. I am punting money forward to the future, with inflation protection.

Many Bogleheads will criticize this point as 'simplistic' or 'irrational' or 'naive' or possibly 'crazy.'

But it works for me, in my universe.
TIPS: Perfect investment for imperfect times?

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by dbr » Mon Aug 12, 2013 10:59 am

Trurl Klapaucius wrote:
Borrowing your insurance policy analogy for TIPS; if held in a taxable account, the tax on TIPS is another “premium” paid for the insurance they provide against inflation.
- Trurl
I don't think this is right. There is no "tax on TIPS" meaning some special tax liability that TIPS require. There is no difference between this and the tax on the yield of any other bond except that TIPS are taxed a little LESS than some bonds because they are state tax exempt. The fact that the Treasury pays part of the dividend on a single TIPS bond by incrementing the principal rather than by cutting a check for the interest seems to cause incredible but unneeded confusion. The fact that there is a tax liability on the whole is exactly what should be expected for any income received as understood in the tax code.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by dbr » Mon Aug 12, 2013 11:04 am

tipswatcher wrote:I live in a parallel universe from most Bogleheads, I guess. I am not saying they are wrong, and I am definitely not admitting I am wrong. We are both right -- you in your universe and me in mine.

In my universe, I create a TIPS ladder with the 100% intention of holding to maturity. Not 99.9%, 100%. I am not selling before maturity, I won't need to sell before maturity. Once a TIPS reaches maturity, I either spend the money, reinvest elsewhere, or reinvest in TIPS. My intention is to reinvest in TIPS, most of the time, and be a net buyer of TIPS each year.

In my universe, I track the par value of the TIPS, plus inflation adjustment. I never look at secondary market values, why would I? I am holding to maturity. The only number that matters to me is par value plus inflation adjustment.

In my universe, my TIPS holdings didn't soar in value over the last two years. That happened on the secondary market, but not in my universe. And in my universe, my TIPS holdings didn't decline by 7% since March. That happened in the secondary market, not in my universe. My eventual intention is to stop rolling over the TIPS and spend the money in retirement, with specific amounts maturing each year. I am punting money forward to the future, with inflation protection.

Many Bogleheads will criticize this point as 'simplistic' or 'irrational' or 'naive' or possibly 'crazy.'

But it works for me, in my universe.
There is nothing wrong with keeping the books this way as long as one is aware that one is mixing up methods of accounting for the value of assets and keeping straight which is which. In your case the complication of gathering the data to mark to market is not worth it and doesn't tell you what you want to know, which you already know anyway by your own method.

An alternative is to mark to market for the present but to have a plan that projects asset values, and in that plan the par plus inflation accrued is entered at the date of maturity. In the meantime you would have to construct a constantly updated curve that tracks from present market to termination. I am sure you would find no utility in that, but it is probably what I would do as stuff like that is entertaining.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Trurl Klapaucius » Mon Aug 12, 2013 11:06 am

G-Money wrote:
Trurl Klapaucius wrote:
Clive wrote:As a potential portfolio insurance a little exposure to long dated TIPS could help under the right circumstances. As ever however that insurance comes with a cost... Whether after taxes etc. that is better/safer than alternative choices ??? - its very much a personal choice.
Clive,

Borrowing your insurance policy analogy for TIPS; if held in a taxable account, the tax on TIPS is another “premium” paid for the insurance they provide against inflation. If inflation proves to be greater than expected, this premium increases; or perhaps a better analogy would be that the deductible on the insurance coverage increases. In other words, as long as the fixed interest rate of TIPS remains near zero, and the inflation adjustment of TIPS is taxable, the after-tax (real) yield on TIPS will be less than the inflation rate (unless either inflation or tax rates become less-than-or-equal-to zero; both unlikely). Thus, currently, in a taxable account, money invested in TIPS is effectively guaranteed to lose purchasing power because of inflation.

Personally, I’m not inclined to buy the TIPS insurance policy under these terms. Since stocks provide some measure of long-term inflation protection, I feel that the market risk on my stock holdings is enough “premium” to pay for inflation protection. The question is “How much insurance does an investor wish to have on his/her portfolio, given that there is a cost for coverage?” As you stated “It’s very much a personal choice.”

- Trurl
But this is true of nominal bonds, too. If inflation equals expected inflation, taxable nominal bonds held in taxable accounts will also have an after-tax yield less than inflation. And there is no inflation-insurance feature in nominal bonds.
G-Money,

I agree, under these circumstances neither TIPS nor nominal Treasuries will match inflation. But in my opinion, this is a reason not to invest in either! For the fixed-income portion of my portfolio, I would like at least some small chance of matching (or beating) inflation. Perhaps this might come from a ladder of AAA/AA rated 10-year munis with an after-tax yield similar to the recent 10-year inflation rate of 2-3 percent? Although this tactic will fail if inflation is higher than expected, it will succeed if inflation is similar (or less) than expected. As in duplicate bridge, sometimes it is better to take a finesse than to just assume you will lose the trick.

- Trurl
Last edited by Trurl Klapaucius on Sat Aug 17, 2013 6:35 am, edited 3 times in total.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Clive » Mon Aug 12, 2013 12:13 pm

tipswatcher wrote:I live in a parallel universe from most Bogleheads, I guess. I am not saying they are wrong, and I am definitely not admitting I am wrong. We are both right -- you in your universe and me in mine.

In my universe, I create a TIPS ladder with the 100% intention of holding to maturity. Not 99.9%, 100%. I am not selling before maturity, I won't need to sell before maturity. Once a TIPS reaches maturity, I either spend the money, reinvest elsewhere, or reinvest in TIPS. My intention is to reinvest in TIPS, most of the time, and be a net buyer of TIPS each year.
A straight ladder, where each rung is bought and then held to maturity, will generally lag a 'managed' bond fund.

The best indicator of value is the yield curve, buying near/at the peak of the steepest part of that yield curve, as that is where the price will appreciate the most/fastest if the yield curve remains the same.

Comparing a ladder with a fund will generally see the fund relatively outperform the ladder.

This holds for both conventional and inflation bonds. For instance, recent 7 year inflation bonds are yielding ... (http://www.treasury.gov/resource-center ... =realyield) ... -0.08% whilst 5 year yields are -0.55%. If you buy a 7 year and hold for 2 years until the bond is a 5 year and the yield curve is the exact same after 2 years as it is today, then the bond will have gained ... (http://www.fixedincomeinvestor.co.uk/x/yieldcalc.html) ... 2.38% in value. Equivalent to another 1.2% yearly benefit.

Assuming the yield curve remained forever like that, buying a 7 year and holding to maturity repeatedly yields a -0.08% real return. Buying the 7 year, holding for 2 years and selling to re-buy another 7 year yields a +1.1% real return.

Of course the yield curve isn't static and sometimes it might move against you, at other times it might work in your favour. Readjusting to buy near the steepest part of the yield curve reflects buying the best valued at the time assuming the yield curve remains unchanged. And the best predictor of tomorrow's yield curve are today's yield curve.

EDIT : I didn't calculate whether 7 years was the steepest part of the yield curve (just looked perhaps close). Also that calculation is just a general approximation. Another point is that worst case if you held to maturity perhaps due to the yield curve moving significantly against you then a 7 year -0.08% would lose a grand total of -0.56% real over the life of that bond (exc. taxes/costs). Whereas if the yield curve moved favourably the capital gain could be sizeable - if for instance a -0.08% 7 year bought today became a -4% tomorrow, the bond might have risen +32%

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by technovelist » Tue Aug 13, 2013 4:30 pm

chicagobear wrote:I wouldn't buy TIPS. The tax treatment is terrible and you can lose money if real rates go up. I own online savings accounts for liquidity and gold bullion for inflation protection.
Also TIPS are not volatile enough to provide big gains in the case of serious inflation anyway, which gold is.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Clive » Tue Aug 13, 2013 4:56 pm

Also TIPS are not volatile enough to provide big gains in the case of serious inflation anyway, which gold is.
I wouldn't be so sure about that. UK 2055 'TIPS' (index linked gilts) recently have a 35 modified duration. I've seen others with 45 i.e. a potential 45% price move for each 1% change in real yields.

If another 1917 or 1946 occurred with something like sub 4% nominal yields (suppressed) and inflation spikes to near 20%, there's a potential for multiple 40% price moves. Nothing to stop perhaps a 700%+ gains or more (approx -6% or more decline in real yields).

Gold can be like a undated zero coupon inflation bond. i.e. even more volatile than long dated TIPS.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Clive » Tue Aug 13, 2013 5:22 pm

The best hedge against a hyperinflation event isn't gold nor TIPS, but FX.

The best choice of FX play isn't to hold currencies and interest rates, but to invest the foreign currencies in respective stocks of the foreign currency(s).

100% out of a collapsing currency is better than perhaps 25% in gold, as gold might just preserve purchase power in foreign currencies (but soar in domestic purchase power terms) - being little different to had you just held 25% in foreign currencies.

Iceland, whilst a tiny example, saw gold soar in domestic currency terms during 2008. Gold in Euro's however remained more or less level. An Icelandic holding 25% gold would have faired as equally as well as having held 25% in Euro's. Gold however has a higher 'insurance' cost as during less fearful times it tends to lag stocks.

TIPS are possibly even worse. Taxation and withdrawals or changes to taxation policies at the worst possible times are likely. Such that you pay insurance for long periods of time during stable periods, only to see all those insurance premiums having gone to waste as the insurance becomes null and void just when you needed it the most.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by lindisfarne » Tue Aug 13, 2013 7:54 pm

abuss368 wrote: Related to paying taxes now or at retirement, it is amazing how many clients I see are investing in Roth IRA's now instead of Traditional IRA's due to a preference to not paying taxes in retirement regardless of present or expected tax brackets.
I'm not one of them. For now, I don't think I'll be in a higher tax bracket upon retirement & thus, use a TIRA.
I have a small Roth IRA I use to hold my emergency funds since contributions (not earnings) can be withdrawn without any tax implications. I may however down the road contribute more into the Roth IRA to have some retirement income that doesn't trigger things like taxes on social security. For now, I'm happy getting the tax deduction on the TIRA (and 401K) funds.

I don't think there's a compelling advantage of TIPS - but there's probably not a compelling disadvantage. I just think they'd complicate things.

I've never been convinced there's any rationality to investing in gold.

The paper on tips (linked to above) was published in 2006 - it would be interesting to see more recent research.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Bill M » Wed Aug 14, 2013 8:17 am

tipswatcher wrote:I live in a parallel universe from most Bogleheads, I guess. ... In my universe, I create a TIPS ladder with the 100% intention of holding to maturity. ... I track the par value of the TIPS, plus inflation adjustment. ... my TIPS holdings didn't soar in value over the last two years. ... my TIPS holdings didn't decline by 7% since March. ... I am punting money forward to the future, with inflation protection.
I live in that same parallel universe as tipswatcher.

I'm surprised that more bogleheads don't live there too. LBYM and super-saving appear here frequently. Take it just one step further -- try summing the real value of your withdrawals needed&wanted from your savings up through age, say, 105. Is it so unusual that this number is less than your savings balance? That's the portion for TIPS -- the strategy is simply transferring that real value forward until the time it is needed, and TIPS are the easiest way to do that. Buy them at auction, let them sit until they mature, and don't watch the fluctuations. It goes on auto-pilot, and provides guaranteed income. The remainder of the savings is for growth, and gets all the attention.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Wed Aug 14, 2013 8:34 am

This has been a really interesting thread to my original question. I appreciate all the response as there have been a lot of good ones.

I intend to go back and re-read the responses again.

Thanks!
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by abuss368 » Fri Aug 16, 2013 6:07 pm

I looked at Vanguard performance figures tonight for the intermediate fund. Total Bond is now ahead for the YTD, 1 year, and 3 year. 5 year is not far off and then inception. The long duration of 8 plus is killing this fund!
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by nisiprius » Sat Aug 17, 2013 3:57 pm

abuss368 wrote:I looked at Vanguard performance figures tonight for the intermediate fund. Total Bond is now ahead for the YTD, 1 year, and 3 year. 5 year is not far off and then inception. The long duration of 8 plus is killing this fund!
Because bond funds have relatively low return, it doesn't take too much in the way of short-term fluctuations to make big changes in past performance figures. 1-3-5-10 numbers are evil. It is like trying to watch a baseball game through four knotholes. It is worse, because in addition to following short-term fluctuations, they each include within them and upside-down version of the short-term fluctuations that were occurring 1, 3, 5, or 10 years ago. This is a case where one's intuitions are wrong; one intuitively feels that a 5-year moving average is some kind of "track record" that ought to be pretty stable, but it isn't so.
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Sunny Sarkar » Mon Aug 19, 2013 1:26 pm

I must admit that I am feeling a bit uncomfortable about all this "you don't really need TIPS if you own nominals" attitude that is emerging and recurring in various recent threads. I am not convinced this is **not** due to recency - the double whammy of getting fooled by the recent long stretch of low inflation (like frogs boiling in gradually warming water), and the bitter taste of the recent highly visible negative real yields of TIPS (negative real yields of nominals are not thrown on our faces daily like TIPS) exaggerated by the slightly higher 8 year average maturity of the TIPS fund versus the intermediate-term nominal funds.

Back in the mid years of the last decade, when stocks were stumbling, everybody was renewing their vows with their bond allocations while singing "You're always on my mind - If I made you feel second best, I'm sorry I was blind", and the TIPS fund was posting high numbers :greedy, the attitudes right here were very different. Everyone agreed that TIPS was a separate asset class - a common justification used to "diversify into" the latest hottest thing. Studies emerged showing how TIPS had an even lower correlation with stocks compared to nominals. Everyone understood the (then important) difference between direct and indirect inflation protection. David Swensen's elegant justification for TIPS was oft quoted. 50% TIPS was the starting point of bond allocations, and everyone complained why Vanguard maintained a zero-to-low allocation of TIPS in the TRF funds. Michael LaBeouf said in the Bogleheads experts Q&A that he liked a 50/50 TIPS/nominal allocation - when asked why, he said: because Taylor said so; and when we followed up with Taylor, he said: because Mel said so (btw, anyone follow up with Mel?). Rick Ferri explained why it was a good thing that everyone's favorite TIPS fund was not an index fund, and we index (funda)mentalists collectively removed our hands off our noses. Zvi Bodie came out with a book proposing a 100% TIPS portfolio, and it was being discussed/considered seriously by some - despite grandma's warning that 100% of anything must be bad. Nominals were thrown out of Scott Burns' Margaritaville, and TIPS was welcomed with some fanfare. Even Taylor posted that, if he was forced to choose, the TIPS fund was his favorite single bond fund in the 3-fund portfolio.

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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Index Fan » Mon Aug 19, 2013 1:51 pm

Oh how short our memories are!

I've taken to looking at this forum and playing, 'What's The Recency Bias Of The Day?'
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Re: Inflation Bonds - Convince Me - Yes or No!

Post by Jazztonight » Mon Aug 19, 2013 10:08 pm

It is so ironic that just today I reviewed my portfolio with a Vanguard Flagship CFA who asked me why 1/3 of my fixed income allocation is in the TIPS fund (I'm 40/60). I asked why he was asking.

He replied that Vanguard does not at this time recommend TIPS unless the client "is expecting a big increase in inflation." He'd just recommend Total Bond Index in tax protected accounts and either muni funds or other tax free bond funds in non-IRA/401k accounts.

I realize there's no one answer and no perfect answer. Just opinions and confusing answers. 8-)

Great thread!
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