Have TIPS truly been tested yet?

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simplesauce
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Have TIPS truly been tested yet?

Post by simplesauce » Thu Nov 02, 2017 9:39 pm

TIPS (Treasury Inflation Protection Securities) are generally wonderful in my mind. I agree with Larry Swedroe. They are an amazing invention for investors to utilize because they protect you from Inflation, AND deflation. https://youtu.be/0OOi3XFNlA0

However, my concern is that they were only invented in the 1990’s. They have not been around for some of the crazy and unique market conditions of the past. We don’t really have the same track record to bank on, verses a fund like Total Bond Market.

Furthermore, I have read concerns about the index that TIPS track not being a proper measure of inflation. I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised? Some people have many concerns.

Can one really put 25-50% of their bond portfolio into TIPS comfortably?

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Re: Have TIPS truly been tested yet?

Post by AlohaJoe » Thu Nov 02, 2017 9:57 pm

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
However, my concern is that they were only invented in the 1990’s. They have not been around for some of the crazy and unique market conditions of the past. We don’t really have the same track record to bank on, verses a fund like Total Bond Market.
This isn't really correct. They were created in 1981. In 1981 inflation was 11.9%. In 1982 it was 8.6%. In 1990 it was 9.5%.

The world is bigger than just the US and inflation-linked government bonds weren't invented in the US. I'm talking about the UK's inflation-linked gilts, of course.

France, Italy, Australia, and Canada all have them as well (among many other places). So we could look at, say, Argentina's or Thailand's or Mexico's or Turkey's inflation-linked bonds and see if they defaulted despite having inflation rates over 10% in some of those countries. Argentina did default but not on their inflation-linked bonds.
Furthermore, I have read concerns about the index that TIPS track not being a proper measure of inflation. I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised? Some people have many concerns.
You shouldn't listen to wing-nut conspiracy theories from people who have a decades-long track record of being wrong at every single turn.

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Re: Have TIPS truly been tested yet?

Post by FIREchief » Thu Nov 02, 2017 10:02 pm

AlohaJoe wrote:
Thu Nov 02, 2017 9:57 pm
You shouldn't listen to wing-nut conspiracy theories from people who have a decades-long track record of being wrong at every single turn.
I was thinking about saying something like this, but I couldn't say it any better than Joe! :sharebeer
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Re: Have TIPS truly been tested yet?

Post by JBTX » Thu Nov 02, 2017 10:20 pm

About the worse thing I can think of is in some scenarios their inflation protection becomes in such high demand their real return becomes negative. But it would still hold up better than conventional bonds in such scenarios.

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Re: Have TIPS truly been tested yet?

Post by Chip » Fri Nov 03, 2017 7:39 am

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Sure. I have.

I agree with Aloha Joe's comments.

A couple of things to think about.

Your personal inflation rate will almost certainly not match the CPI. Could be higher, could be lower. That doesn't mean the CPI is "wrong" or that there is some massive conspiracy afoot.

TIPS will only inflation protect the portion of your portfolio that's invested in TIPS. No more, no less.

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Re: Have TIPS truly been tested yet?

Post by oldcomputerguy » Fri Nov 03, 2017 7:52 am

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
Furthermore, I have read concerns about the index that TIPS track not being a proper measure of inflation. I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised? Some people have many concerns.
TIPS are Treasury bonds, so "the issuer" is the United States Treasury. If they default on their commitment, we've got larger problems.
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Re: Have TIPS truly been tested yet?

Post by Leesbro63 » Fri Nov 03, 2017 7:56 am

One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Fri Nov 03, 2017 5:45 pm

AlohaJoe wrote:
Thu Nov 02, 2017 9:57 pm
...
This isn't really correct. They were created in 1981. In 1981 inflation was 11.9%. In 1982 it was 8.6%. In 1990 it was 9.5%.
...
I realize later in your post you referred to others, but OP's question was about TIPS specifically. TIPS were first issued in 1997. UK inflation-linked gilts were indeed introduced in 1981, as you wrote.
PJW

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Re: Have TIPS truly been tested yet?

Post by nisiprius » Fri Nov 03, 2017 7:08 pm

There's a lot of FUD (fear, uncertainty, and doubt) spread about TIPS.

"Have they been truly tested yet?"

If you mean, "can we understand and predict market movements of TIPS," you can make a case that we don't. Not that we really can with anything else, but TIPS may be less liquid than nominal Treasuries, and less predictable than nominal Treasuries.

They did have a seemingly mysterious 10% drop in 2008, preceded by an equally mysterious rise in 2007. These movements were not shared by nominal Treasuries. However, corporates had about the same 10% drop in 2008, which was not preceded by a rise. So, just in terms of market fluctuations, you can say that TIPS seem to have had more risk than nominal Treasuries, but less than corporates.

Market movements, though, are different from saying "will TIPS do what they are contractually obligated to do... pay out inflation-adjusted coupon payments during the life of the bond, and pay back an inflation-adjusted face value at maturity?"

If you mean, "do we know what they would do in hyperinflation," no, because so far we have never had hyperinflation in the United States. If you mean, "if the Treasury started defaulting on Treasury securities, can you guarantee that they wouldn't default selectively, TIPS first," no, we don't know, and we won't until there is a default.

However, I think those last two fall in territory of "black swans happen, but by definition you don't know enough about them to factor it intelligently into into decision-making."

If you mean "is the CPI accurate?" see Accuracy of the CPI for a summary of remarks pro and con. [Deleted some stuff here because of LadyGeek's caution below.]

One point that often seems to be missed: TIPS are sold to foreign investors as well as U.S. investors, and the stated terms of the security say that the secretary of the Treasury is obligated to play fair. Here is the actual language, quoted from TreasuryDirect:
If, while an inflation-protected security is outstanding, the CPI is (1) discontinued, (2) in the judgment of the Secretary, fundamentally altered in a manner materially adverse to the interests of an investor in the security, or (3) in the judgment of the Secretary, altered by legislation or Executive Order in a manner materially adverse to the interests of an investor in the security, Treasury, after consulting with the BLS, will substitute an appropriate alternative index."
Last edited by nisiprius on Fri Nov 03, 2017 9:52 pm, edited 1 time in total.
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Re: Have TIPS truly been tested yet?

Post by venkman » Fri Nov 03, 2017 7:55 pm

Leesbro63 wrote:
Fri Nov 03, 2017 7:56 am
One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.
But doesn't this apply to EVERY taxable investment, not just TIPS? The yield on all nominal bonds would presumably increase along with inflation. It might take a little time for the payments to catch up in, say, an intermediate bond fund, but existing investors in that fund would also have an opportunity for significant tax-loss harvesting.

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Re: Have TIPS truly been tested yet?

Post by Leesbro63 » Fri Nov 03, 2017 8:41 pm

venkman wrote:
Fri Nov 03, 2017 7:55 pm
Leesbro63 wrote:
Fri Nov 03, 2017 7:56 am
One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.
But doesn't this apply to EVERY taxable investment, not just TIPS? The yield on all nominal bonds would presumably increase along with inflation. It might take a little time for the payments to catch up in, say, an intermediate bond fund, but existing investors in that fund would also have an opportunity for significant tax-loss harvesting.
I don't think that's quite right. Frankly I'm not positive you're wrong, either, but something doesn't seem right about that. And even if you ARE right, the whole point of using TIPS instead of nominal bonds is to protect against inflation. The fact that the alternative (nominal bonds) doesn't protect against inflation isn't a reason to accept that TIPS might not protect.

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Re: Have TIPS truly been tested yet?

Post by pkcrafter » Fri Nov 03, 2017 9:04 pm

Have TIPS truly been tested yet?
Not in a rising interest rate market.

Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Sure, they are good, we just don't know what the interest rate will be.

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Re: Have TIPS truly been tested yet?

Post by simplesauce » Fri Nov 03, 2017 9:23 pm

nisiprius wrote:
Fri Nov 03, 2017 7:08 pm
There's a lot of FUD (fear, uncertainty, and doubt) spread about TIPS.

"Have they been truly tested yet?"

If you mean, "can we understand and predict market movements of TIPS," you can make a case that we don't. Not that we really can with anything else, but TIPS may be less liquid than nominal Treasuries, and less predictable than nominal Treasuries.

They did have a seemingly mysterious 10% drop in 2008, preceded by an equally mysterious rise in 2007. These movements were not shared by nominal Treasuries. However, corporates had about the same 10% drop in 2008, which was not preceded by a rise. So, just in terms of market fluctuations, you can say that TIPS seem to have had more risk than nominal Treasuries, but less than corporates.

Market movements, though, are different from saying "will TIPS do what they are contractually obligated to do... pay out inflation-adjusted coupon payments during the life of the bond, and pay back an inflation-adjusted face value at maturity?"

If you mean, "do we know what they would do in hyperinflation," no, because so far we have never had hyperinflation in the United States. If you mean, "if the Treasury started defaulting on Treasury securities, can you guarantee that they wouldn't default selectively, TIPS first," no, we don't know, and we won't until there is a default.

However, I think those last two fall in territory of "black swans happen, but by definition you don't know enough about them to factor it intelligently into into decision-making."

If you mean "is the CPI accurate?" see Accuracy of the CPI for a summary of remarks pro and con. Warning: there's a website out there, often referenced by conspiracy theorists, that claims to have its own CPI data that "reflects the CPI as if it were calculated using the methodologies in place in 1980." It's total nonsense, for several reasons. First, this site claims that the actual inflation rate since 2000 has been about 10%/year. If this were true, if would mean that prices should have doubled since 2007 and quadrupled since 2000. Do a reality check on that. Second, the methodologies in place in 1980 used actual housing prices instead of owner equivalent rent; if they were really using the 1980 methodologies, their inflation curve should have a noticeable notch around 2006 due to the housing crash, and it doesn't. I could go on and on...

One point that often seems to be missed: TIPS are sold to foreign investors as well as U.S. investors, and the stated terms of the security say that the secretary of the Treasury is obligated to play fair. Here is the actual language, quoted from TreasuryDirect:
If, while an inflation-protected security is outstanding, the CPI is (1) discontinued, (2) in the judgment of the Secretary, fundamentally altered in a manner materially adverse to the interests of an investor in the security, or (3) in the judgment of the Secretary, altered by legislation or Executive Order in a manner materially adverse to the interests of an investor in the security, Treasury, after consulting with the BLS, will substitute an appropriate alternative index."
Do you own any TIPS in your bond portfolio?

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Re: Have TIPS truly been tested yet?

Post by LadyGeek » Fri Nov 03, 2017 9:36 pm

As a reminder, comments regarding government manipulation of the Consumer Price Index are political in nature and off-topic. From the U.S. Bureau of Labor Statistics, here's why:
As an economic indicator. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.
Noted earlier, the wiki has further information: Accuracy of the CPI
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Re: Have TIPS truly been tested yet?

Post by nisiprius » Fri Nov 03, 2017 9:51 pm

simplesauce wrote:
Fri Nov 03, 2017 9:23 pm
...Do you own any TIPS in your bond portfolio?...
I am not presenting this as any kind of model or recommendation, but since you ask... I bought my first TIPS circa 1998, i.e. about a year after the first became available. For a long time I bought individual TIPS issues. A couple of years ago I decided that if "something happened" my wife was up to the task of dealing with a handful of mutual funds but not a 20-page statement listing individual TIPS and I exchanged them all for the Vanguard Inflation Protected Securities fund.

If you count series I savings bonds as "bonds" (there are reasons not to), then my bond portfolio is about 40% Vanguard Inflation Protected Securities fund, 20% series I savings bonds, 40% Vanguard Total Total Bond Market Index Fund.

I am a big believer that the easy, straightforward, effective way to deal with inflation is to use products that are explicitly linked to inflation. I have an inflation-indexed SPIA (income annuity), for example. As with index funds, I believe that the investing industry has a bias against TIPS because there isn't much profit opportunity in them--series I savings bonds even less. They would prefer to sell traditional "inflation hedges" that are claimed to sorta-kinda-tend-to keep up with inflation, but in reality they are loosey-goosey and unreliable. Stocks, for example are often claimed to be inflation edges but no less an authority than Benjamin Graham has written:
On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period 1966-1970. The rise in the cost of living was 22%... but both stock earnings and stock prices have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.
TIPS may be imperfect in many ways, they are not any kind of magic answer, but they are simple and straightforward and I see no reason not to use them. Remarks like "they are untested" seem to me just an easy rhetorical way to raise doubts.
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Re: Have TIPS truly been tested yet?

Post by nisiprius » Fri Nov 03, 2017 9:53 pm

LadyGeek wrote:
Fri Nov 03, 2017 9:36 pm
As a reminder, comments regarding government manipulation of the Consumer Price Index are political in nature and off-topic. From the U.S. Bureau of Labor Statistics, here's why:
As an economic indicator. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.
Noted earlier, the wiki has further information: Accuracy of the CPI
You're right, and I apologize for something I said in my long post above. I removed a portion of it and settled for citing the Wiki article.
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Re: Have TIPS truly been tested yet?

Post by venkman » Fri Nov 03, 2017 9:59 pm

Leesbro63 wrote:
Fri Nov 03, 2017 8:41 pm
venkman wrote:
Fri Nov 03, 2017 7:55 pm
Leesbro63 wrote:
Fri Nov 03, 2017 7:56 am
One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.
But doesn't this apply to EVERY taxable investment, not just TIPS? The yield on all nominal bonds would presumably increase along with inflation. It might take a little time for the payments to catch up in, say, an intermediate bond fund, but existing investors in that fund would also have an opportunity for significant tax-loss harvesting.
I don't think that's quite right. Frankly I'm not positive you're wrong, either, but something doesn't seem right about that. And even if you ARE right, the whole point of using TIPS instead of nominal bonds is to protect against inflation. The fact that the alternative (nominal bonds) doesn't protect against inflation isn't a reason to accept that TIPS might not protect.
TIPS are good for protecting against UNEXPECTED inflation. The market yield on a TIPS (in theory) equals the yield on a nominal Treasury, minus the expected rate of inflation over the term of the bond, minus a small premium for the added insurance the TIPS provides. Right now, 10 year nominal Treasuries are yielding about 1.87% more than 10-year TIPS, so that's about what the market expects inflation to average over the next 10 years. If inflation jumped up to 4%, the yield on new nominal bonds would go up, and the price of existing bonds would decline to match that yield. When the dust settled, nominal Treasuries would have a 4% higher rate than TIPS, but both would have about the same expected future real return. Existing Treasuries would suffer a price decline to get to that higher yield, while the price of existing TIPS would stay mostly stable. That's the insurance that TIPS provide.

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Re: Have TIPS truly been tested yet?

Post by FIREchief » Fri Nov 03, 2017 11:04 pm

venkman wrote:
Fri Nov 03, 2017 9:59 pm
When the dust settled, nominal Treasuries would have a 4% higher rate than TIPS, but both would have about the same expected future real return. Existing Treasuries would suffer a price decline to get to that higher yield, while the price of existing TIPS would stay mostly stable. That's the insurance that TIPS provide.
This is REALLY valuable insurance in today's market, and likely worth much more than recent treasury yields reflect. I attribute this mostly to the well known fact that "if we've learned anything from history, it's that we never learn a thing."
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Re: Have TIPS truly been tested yet?

Post by jalbert » Fri Nov 03, 2017 11:22 pm

However, my concern is that they were only invented in the 1990’s. They have not been around for some of the crazy and unique market conditions of the past. We don’t really have the same track record to bank on, verses a fund like Total Bond Market.
The Vanguard Total Bond Market index fund dates to 12/1986. TIPs were created in 1/1997. So TIPs have been around for almost 21 years, and the VG TBM fund for 11 more. Why is the TBM fund track record so much more reliable?
Index fund investor since 1987.

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Re: Have TIPS truly been tested yet?

Post by in_reality » Sat Nov 04, 2017 12:02 am

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised?
Doesn't high inflation reduce the actual US debt burden? So while TIPS payments might be an increased liability, overall wouldn't that be coincide with a lowered total burden?

Of course US credit may fail, but I don't see why high inflation would be the tipping point.

Not an expert or even well informed on this ... just my speculation.

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Re: Have TIPS truly been tested yet?

Post by AlohaJoe » Sat Nov 04, 2017 12:40 am

in_reality wrote:
Sat Nov 04, 2017 12:02 am
simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised?
Doesn't high inflation reduce the actual US debt burden? So while TIPS payments might be an increased liability, overall wouldn't that be coincide with a lowered total burden?

Of course US credit may fail, but I don't see why high inflation would be the tipping point.

Not an expert or even well informed on this ... just my speculation.
I agree. Looking at TIPS in isolation seems like the wrong way to think about such an unlikely risk. A quick google search turned up a 2008 report from the Treasury saying that TIPS make up only 5% of the total debt outstanding and 11% of the marketable debt outstanding. Hard to imagine any government willing to ruin its credit with the world for such a tiny obligation.

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Re: Have TIPS truly been tested yet?

Post by trasmuss » Sat Nov 04, 2017 2:10 am

If you are trying to protect against unexpected inflation TIPS are likely to meet your needs (as well or better than anything else).

I was surprised that they dropped in the 2008 stock crisis. They did not provide the protection that standard treasuries did. Once they recovered I exchanged what I had in the TIPS fund for Total Bond.

I want to feel that my bond allocation will provide protection in a major stock market correction/crash. The TIPs fund failed that test for me.

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Re: Have TIPS truly been tested yet?

Post by dcabler » Sat Nov 04, 2017 7:08 am

For those interested, there is a thread on what happened with TIPs in 2008.
viewtopic.php?t=159528

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Re: Have TIPS truly been tested yet?

Post by Valuethinker » Sat Nov 04, 2017 8:37 am

Leesbro63 wrote:
Fri Nov 03, 2017 8:41 pm
venkman wrote:
Fri Nov 03, 2017 7:55 pm
Leesbro63 wrote:
Fri Nov 03, 2017 7:56 am
One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.
But doesn't this apply to EVERY taxable investment, not just TIPS? The yield on all nominal bonds would presumably increase along with inflation. It might take a little time for the payments to catch up in, say, an intermediate bond fund, but existing investors in that fund would also have an opportunity for significant tax-loss harvesting.
I don't think that's quite right. Frankly I'm not positive you're wrong, either, but something doesn't seem right about that. And even if you ARE right, the whole point of using TIPS instead of nominal bonds is to protect against inflation. The fact that the alternative (nominal bonds) doesn't protect against inflation isn't a reason to accept that TIPS might not protect.
With TIPS the link between higher inflation and higher taxation is direct.

If you hold nominal bonds, it's the direct impact of inflation on your current investments which is of a concern. Higher yields in new bonds are your friend (although yes, you will also pay higher taxes on the interest income).

Leebros63 has identified a key flaw with TIPS. It's an exceptional instrument and should dominate in bond portfolios over straight bonds BUT:

- I have been put off by the low expected yields (UK Indexed Linked Gilts are much worse)
- they have proven to be very volatile and not as well correlated with inflation as one would like (this is why VG introduced a ST TIPS fund, because empirically the correlation is much better)
- the imputed income problem associated with inflation is a very real one for taxable accounts

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Re: Have TIPS truly been tested yet?

Post by Valuethinker » Sat Nov 04, 2017 8:39 am

trasmuss wrote:
Sat Nov 04, 2017 2:10 am
If you are trying to protect against unexpected inflation TIPS are likely to meet your needs (as well or better than anything else).

I was surprised that they dropped in the 2008 stock crisis. They did not provide the protection that standard treasuries did. Once they recovered I exchanged what I had in the TIPS fund for Total Bond.

I want to feel that my bond allocation will provide protection in a major stock market correction/crash. The TIPs fund failed that test for me.
We discussed it at length then.

We now know what happened.

A number of REPO (Repurchase Obligation i.e. collateralized short term liquidity lending, with bonds & other instruments as the collateral) transactions used TIPS as the underlying collateral. When Lehman Brothers failed, there was a scramble to unwind the REPOs, and forced sales of collateral.

For US Treasury securities, TIPS are quite illiquid (the buyers, typically insurance companies and pension funds that seek long term inflation protection to underpin their obligations to policy holders/ pensioners) and the sales just overwhelmed the market, causing sharp falls in price/ rises in yield.

In retrospect, it was the buying opportunity of the century (literally, so far).

Grok87 spotted it and alerted people here. Many people followed his advice-- and they were very shrewd.

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Re: Have TIPS truly been tested yet?

Post by Leesbro63 » Sat Nov 04, 2017 8:51 am

Valuethinker wrote:
Sat Nov 04, 2017 8:37 am
Leesbro63 wrote:
Fri Nov 03, 2017 8:41 pm
venkman wrote:
Fri Nov 03, 2017 7:55 pm
Leesbro63 wrote:
Fri Nov 03, 2017 7:56 am
One problem often overlooked here is TIPS for high income/high net worth people with taxable accounts. If we ever get massive inflation that TIPS are supposed to protect against, there will be a huge taxflation problem. Having to pay big taxes on big TIPS increases that are nominal but not real. I guess tax brackets do now go up with inflation, so maybe that negates the problem somewhat. But TIPS in large taxable accounts seem problematic to me if we ever get the thing they're supposed to protect against.
But doesn't this apply to EVERY taxable investment, not just TIPS? The yield on all nominal bonds would presumably increase along with inflation. It might take a little time for the payments to catch up in, say, an intermediate bond fund, but existing investors in that fund would also have an opportunity for significant tax-loss harvesting.
I don't think that's quite right. Frankly I'm not positive you're wrong, either, but something doesn't seem right about that. And even if you ARE right, the whole point of using TIPS instead of nominal bonds is to protect against inflation. The fact that the alternative (nominal bonds) doesn't protect against inflation isn't a reason to accept that TIPS might not protect.
With TIPS the link between higher inflation and higher taxation is direct.

If you hold nominal bonds, it's the direct impact of inflation on your current investments which is of a concern. Higher yields in new bonds are your friend (although yes, you will also pay higher taxes on the interest income).

Leebros63 has identified a key flaw with TIPS. It's an exceptional instrument and should dominate in bond portfolios over straight bonds BUT:

- I have been put off by the low expected yields (UK Indexed Linked Gilts are much worse)
- they have proven to be very volatile and not as well correlated with inflation as one would like (this is why VG introduced a ST TIPS fund, because empirically the correlation is much better)
- the imputed income problem associated with inflation is a very real one for taxable accounts
Thank you for the acknowledgment and confirmation. I’m stupid, but I ain’t dumb!

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Re: Have TIPS truly been tested yet?

Post by columbia » Sat Nov 04, 2017 12:19 pm

Valuethinker wrote:
Sat Nov 04, 2017 8:39 am
trasmuss wrote:
Sat Nov 04, 2017 2:10 am
If you are trying to protect against unexpected inflation TIPS are likely to meet your needs (as well or better than anything else).

I was surprised that they dropped in the 2008 stock crisis. They did not provide the protection that standard treasuries did. Once they recovered I exchanged what I had in the TIPS fund for Total Bond.

I want to feel that my bond allocation will provide protection in a major stock market correction/crash. The TIPs fund failed that test for me.
We discussed it at length then.

We now know what happened.

A number of REPO (Repurchase Obligation i.e. collateralized short term liquidity lending, with bonds & other instruments as the collateral) transactions used TIPS as the underlying collateral. When Lehman Brothers failed, there was a scramble to unwind the REPOs, and forced sales of collateral.

For US Treasury securities, TIPS are quite illiquid (the buyers, typically insurance companies and pension funds that seek long term inflation protection to underpin their obligations to policy holders/ pensioners) and the sales just overwhelmed the market, causing sharp falls in price/ rises in yield.

In retrospect, it was the buying opportunity of the century (literally, so far).

Grok87 spotted it and alerted people here. Many people followed his advice-- and they were very shrewd.

Out of curiosity, they were selling nominals to buy TIPS. I'm pretty cash poor (by design) and certainly wouldn't have had money just sitting around to make new purchases.

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Sat Nov 04, 2017 1:48 pm

Valuethinker wrote:
Sat Nov 04, 2017 8:37 am
...
Leebros63 has identified a key flaw with TIPS. It's an exceptional instrument and should dominate in bond portfolios over straight bonds BUT:

- I have been put off by the low expected yields (UK Indexed Linked Gilts are much worse)
- they have proven to be very volatile and not as well correlated with inflation as one would like (this is why VG introduced a ST TIPS fund, because empirically the correlation is much better)
TIPS are not mysterious no-risk securities. They are fixed income instruments, and as such their market prices rise and fall counter to prevailing yields just like other bonds, except they are responsive to prevailing real yields, rather than nominal ones. Nobody should be surprised when the current market value of a longer-term debt instrument fluctuates, be it nominal or real. Yes, short-term TIPS usually fluctuate less, just like all short-term fixed income securities, and can be expected, over the long run, to return less. Long- and short-term TIPS are equally protected against inflation, because their principal is adjusted by the same factor on the same days, and their coupons are based on adjusted principal.
Valuethinker wrote:- the imputed income problem associated with inflation is a very real one for taxable accounts
If one's fixed income investments are to keep pace with inflation, one must reinvest the portion of the return that matches realized inflation. Reinvested return is no more available to pay taxes with than imputed return. One good thing about TIPS is, with respect to the amount needed to keep up with inflation during their terms, there is no reinvestment risk.

PJW
Last edited by Phineas J. Whoopee on Sat Nov 04, 2017 4:42 pm, edited 1 time in total.

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Re: Have TIPS truly been tested yet?

Post by cjking » Sat Nov 04, 2017 2:42 pm

When I needed to use my personal rate of inflation over the last 20 years in a spreadsheet, I came to the conclusion that the estimated rate of inflation on my home (bought almost 20 years ago) was a much more appropriate measure than CPI. If I had put the purchase price of that home in an investment yielding CPI, it would have lost two thirds of its value house-buying-ability by now.

(My correct personal rate lies between CPI and house-price-inflation, but it's closer to house-price-inflation than CPI.)

It would probably be a fair to say that CPI has reasonably measured the change in my non-housing costs, so if past 20 years had been retirement rather than accumulation ones, my housing costs would have been adequately hedged by owning my home, a CPI-linked investment could have worked to cover the rest.

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Sat Nov 04, 2017 3:51 pm

cjking wrote:
Sat Nov 04, 2017 2:42 pm
...
It would probably be a fair to say that CPI has reasonably measured the change in my non-housing costs, so if past 20 years had been retirement rather than accumulation ones, my housing costs would have been adequately hedged by owning my home, a CPI-linked investment could have worked to cover the rest.
I would like to embellish a little, if I may.

The Consumer Price Index, in both its -U and -W forms (they're really not much different from each other) is based on a standardized basket of goods and services. The difference between the two forms is the weights of items in the basket. Prices of items are collected using surveys in many places, then calculated nationally. If one lives in Kansas City, for example, never-frozen beef may be cheaper than on the coasts, and fresh seafood more expensive, simply due to transportation costs. CPI measures it in aggregate.

You can read the CPI-U and -W basket and their weightings here.

It is not the case that everybody's costs will change in line with calculated CPI. Different people have different baskets and, as I noted, live in different places.

With respect to housing, decades ago CPI reflected the cost of buying a house. It doesn't any more, and that's one factor many people argue over. The idea was if one buys a house or apartment or whatever, there's an aspect of consumption, a place to live, plus an aspect of investment because the building, or at least the land it rests on, unlike rent will have residual value later. The change was to calculate homeowners' housing costs in terms of what rent they otherwise would have to pay if they did not own, but to strip out the residual value, thereby leveling calculated CPI between homeowners and renters.

I believe that change, made somewhere around 1980, is at the root of many discussions about whether a home is an investment.

The Bureau of Labor Statistics, which is within the Department of Labor, publishes its data, its weightings (linked above), and its methodology. Nothing is secret.

The Federal Reserve's Open Market Committee, FOMC, prefers a different measure, the Personal Consumption Expenditures Price Index less food and energy, and that's what it's targeting an annual 2% for. The PCE is calculated and published by the Bureau of Economic Analysis in the Department of Commerce. Food and energy prices are volatile, so many economists think it's better, when trying to analyze long-term trends, not to be distracted by them. The Commerce Department also publishes, monthly, the food and energy inclusive numbers.

Thanks, cjking, for giving me an opportunity to expound, although it isn't as if I ever wait for one. :wink:

PJW
Last edited by Phineas J. Whoopee on Sun Nov 05, 2017 4:44 pm, edited 1 time in total.

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Re: Have TIPS truly been tested yet?

Post by nisiprius » Sun Nov 05, 2017 8:19 am

And in this world of disinformation perhaps it as well to remind people, for the record, that the CPI-U index on which TIPS adjustments are based (as well as all economists' calculations of "real return"), and the CPI-W to which Social Security is indexed,

does include price increases in food and gasoline.

In 2017, line 9 of this table,

--food was counted at 13.6% of expenditures, and

--"motor fuel: gasoline (all types)," line 137, at 3.4%. Dare I say, "your mileage may vary?"
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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Re: Have TIPS truly been tested yet?

Post by simplesauce » Sun Nov 05, 2017 2:42 pm

Can somebody help me understand TIPS and taxes? I have always heard to not buy TIPS in a taxable account.

However, buying a TIPS Fund in a taxable account seems perfectly fine. It is only when you buy individual TIPS that becomes an issue with taxes.

Is this correct?

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Sun Nov 05, 2017 3:31 pm

simplesauce wrote:
Sun Nov 05, 2017 2:42 pm
Can somebody help me understand TIPS and taxes? I have always heard to not buy TIPS in a taxable account.

However, buying a TIPS Fund in a taxable account seems perfectly fine. It is only when you buy individual TIPS that becomes an issue with taxes.

Is this correct?
It depends on what you're thinking the issue is.

It sounds like you're talking about imputed income, that is to say, having to pay income tax on the upward adjustments in the value of individual TIPS, which follow CPI-U with a two-month lag. Lots of people talk about that, and indeed, you will owe, in taxable, income tax on money you didn't receive in a checking-account sense, but only in a principal-increase sense.

TIPS funds pay out both the inflation adjustments and the coupons as cash.

The thing people need to understand is, if they are to keep pace with inflation the returns of any fixed-income instrument must be reinvested to the extent they match realized inflation, inflation that really truly literally just happened.

If one uses the inflation adjustment part of TIPS fund distributions to pay taxes with, rather than reinvest it, the investment will not keep up with inflation as it compounds. Some people may be OK with that, but others won't be. The problem I see comes in when people don't get the difference.

Fund or otherwise, reinvested return is not available to pay taxes with.

I agree for some individual under a high-inflation scenario it might be hard to pay income tax out of coupons alone, but such a person is always free to sell part of their TIPS portfolio, or part of their TIPS fund, to raise the needed money, the tax-ignoring math of which is no different than not reinvesting the inflation adjustments.

I agree with the related point that TIPS will do a better job of keeping up with inflation in tax-advantaged accounts.

Does that help? If not please say so and I'll try again.

PJW
Last edited by Phineas J. Whoopee on Sun Nov 05, 2017 3:42 pm, edited 1 time in total.

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Re: Have TIPS truly been tested yet?

Post by simplesauce » Sun Nov 05, 2017 3:41 pm

Phineas J. Whoopee wrote:
Sun Nov 05, 2017 3:31 pm
simplesauce wrote:
Sun Nov 05, 2017 2:42 pm
Can somebody help me understand TIPS and taxes? I have always heard to not buy TIPS in a taxable account.

However, buying a TIPS Fund in a taxable account seems perfectly fine. It is only when you buy individual TIPS that becomes an issue with taxes.

Is this correct?
It depends on what you're thinking the issue is.

It sounds like you're talking about imputed income, that is to say, having to pay income tax on the upward adjustments in the value of individual TIPS, which follow CPI-U with a two-month lag. Lots of people talk about that, and indeed, you will owe, in taxable, income tax on money you didn't receive in a checking-account sense, but only in a principal-increase sense.

TIPS funds pay out both the inflation adjustments and the coupons as cash.

The thing people need to understand is, if they are to keep pace with inflation the returns of any fixed-income instrument must be reinvested to the extent they match realized inflation, inflation that really truly literally just happened.

If one uses the inflation adjustment part of TIPS fund distributions to pay taxes with, rather than reinvest it, the investment will not keep up with inflation as it compounds. Some people may be OK with that, but others won't be. The problem I see comes in when people don't get the difference.

Fund or otherwise, reinvested return is not available to pay taxes with.

I agree for some individual under a high-inflation scenario it might be hard to pay income tax out of coupons alone, but such a person is always free to sell part of their TIPS portfolio, or part of their TIPS fund, to raise the needed money, the math of which is no different than not reinvesting the inflation adjustments.

I agree with the related point that TIPS will do a better job of keeping up with inflation in tax-advantaged accounts.

Does that help? If not please say so and I'll try again.

PJW
Thank you. I’m still not perfectly clear on the story with taxable accounts. Let’s say I want to build a full portfolio in my taxable account. I would like to combine a muni bond fund, a treasury bond fund, and a TIPS fund. Am I at a strong disadvantage tax-wise with the TIPS fund? Or is that only an issue if I bought individual TIPS?

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Sun Nov 05, 2017 3:47 pm

simplesauce wrote:
Sun Nov 05, 2017 3:41 pm
...
Thank you. I’m still not perfectly clear on the story with taxable accounts. Let’s say I want to build a full portfolio in my taxable account. I would like to combine a muni bond fund, a treasury bond fund, and a TIPS fund. Am I at a strong disadvantage tax-wise with the TIPS fund? Or is that only an issue if I bought individual TIPS?
To begin with, a TIPS fund is merely a vehicle by which to own a portfolio of TIPS. All mutual funds are like that. It can be clearer to see in index mutual funds. With TIPS funds there are logistical differences from directly-held securities, but not fundamental ones.

TIPS are Treasury Inflation Protected Securities, so they are literally Treasuries, but often people use the words differently. I'm not complaining about that, just pointing it out.

If you reinvest at least the portion of a TIPS fund's distributions that represent realized inflation you are no better nor worse off, in terms of taxation, than if you held the securities directly. Some investors may be tempted to spend the fund's inflation adjustment payouts, perhaps on income tax, in which case the value of their fund investment will not keep up with inflation as it compounds.

PJW

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Re: Have TIPS truly been tested yet?

Post by grok87 » Fri Nov 24, 2017 4:59 pm

Valuethinker wrote:
Sat Nov 04, 2017 8:39 am
trasmuss wrote:
Sat Nov 04, 2017 2:10 am
If you are trying to protect against unexpected inflation TIPS are likely to meet your needs (as well or better than anything else).

I was surprised that they dropped in the 2008 stock crisis. They did not provide the protection that standard treasuries did. Once they recovered I exchanged what I had in the TIPS fund for Total Bond.

I want to feel that my bond allocation will provide protection in a major stock market correction/crash. The TIPs fund failed that test for me.
We discussed it at length then.

We now know what happened.

A number of REPO (Repurchase Obligation i.e. collateralized short term liquidity lending, with bonds & other instruments as the collateral) transactions used TIPS as the underlying collateral. When Lehman Brothers failed, there was a scramble to unwind the REPOs, and forced sales of collateral.

For US Treasury securities, TIPS are quite illiquid (the buyers, typically insurance companies and pension funds that seek long term inflation protection to underpin their obligations to policy holders/ pensioners) and the sales just overwhelmed the market, causing sharp falls in price/ rises in yield.

In retrospect, it was the buying opportunity of the century (literally, so far).

Grok87 spotted it and alerted people here. Many people followed his advice-- and they were very shrewd.
thanks

thread linked here
viewtopic.php?t=64679
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Re: Have TIPS truly been tested yet?

Post by abuss368 » Fri Nov 24, 2017 11:23 pm

trasmuss wrote:
Sat Nov 04, 2017 2:10 am
If you are trying to protect against unexpected inflation TIPS are likely to meet your needs (as well or better than anything else).

I was surprised that they dropped in the 2008 stock crisis. They did not provide the protection that standard treasuries did. Once they recovered I exchanged what I had in the TIPS fund for Total Bond.

I want to feel that my bond allocation will provide protection in a major stock market correction/crash. The TIPs fund failed that test for me.
Same here. I believe we removed the TIPS fund 10 years ago or so. No need. Total Bond has worked very well.
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Re: Have TIPS truly been tested yet?

Post by dbr » Sun Nov 26, 2017 10:24 am

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm

Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Of course. I do.

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Re: Have TIPS truly been tested yet?

Post by nisiprius » Sun Nov 26, 2017 1:04 pm

dbr wrote:
Sun Nov 26, 2017 10:24 am
simplesauce wrote:
Thu Nov 02, 2017 9:39 pm

Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Of course. I do.
I do. If I count series I savings bonds as "bonds," my bond allocation is 40% TIPS funds, 20% series I savings bonds, 40% Total Bond.

I don't feel any discomfort at all in terms of credit quality. That is, I believe all U.S. Treasury obligations (TIPS, regular Treasury securities, savings bonds), and FDIC-insured bank accounts, are as safe as anything gets.

In terms of value fluctuation due to liquidity issues, I believe TIPS are at least as safe as investment-grade corporate bonds.

If they screw around with the CPI-U (and don't honor the Treasury Secretary's stated obligation to find a better index if CPI-U "the CPI is fundamentally altered in a manner materially adverse to the interests of an investor in the security"), I think it will be in a small way--cheap chiseling (the difference between the "chained" CPI and the current CPI, back-calculated, has been on the order of 0.25%/year).

The only "risk" I see is "ego risk" or "hindsight regret," the possible regret that I was a smartypants and someone else who didn't trust TIPS ends up getting a higher return than me.
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Re: Have TIPS truly been tested yet?

Post by dcabler » Sun Nov 26, 2017 1:54 pm

nisiprius wrote:
Sun Nov 26, 2017 1:04 pm
dbr wrote:
Sun Nov 26, 2017 10:24 am
simplesauce wrote:
Thu Nov 02, 2017 9:39 pm

Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Of course. I do.
I do. If I count series I savings bonds as "bonds," my bond allocation is 40% TIPS funds, 20% series I savings bonds, 40% Total Bond.

I don't feel any discomfort at all in terms of credit quality. That is, I believe all U.S. Treasury obligations (TIPS, regular Treasury securities, savings bonds), and FDIC-insured bank accounts, are as safe as anything gets.

In terms of value fluctuation due to liquidity issues, I believe TIPS are at least as safe as investment-grade corporate bonds.

If they screw around with the CPI-U (and don't honor the Treasury Secretary's stated obligation to find a better index if CPI-U "the CPI is fundamentally altered in a manner materially adverse to the interests of an investor in the security"), I think it will be in a small way--cheap chiseling (the difference between the "chained" CPI and the current CPI, back-calculated, has been on the order of 0.25%/year).

The only "risk" I see is "ego risk" or "hindsight regret," the possible regret that I was a smartypants and someone else who didn't trust TIPS ends up getting a higher return than me.
Same here. About 1/3 of my bond holdings are in TIPs.

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Re: Have TIPS truly been tested yet?

Post by Phineas J. Whoopee » Sun Nov 26, 2017 2:15 pm

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
...
Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Sure. Disclosing nothing I've not posted before, my portfolio is: 25% total us stock; 15% total international stock; 40% inflation-linked fixed income; and 20% nominal fixed income. I lump TIPS (all in tax-advantaged) and Series I Savings Bonds together in the 40%, which is 2/3 of the fixed income portion of my holdings.

Here's what I did and why, and a couple of years later I answered some questions about it.

I offer the links as an example of an approach that isn't age based, but for the record I think an age-based allocation, however calculated, will be far more practical for most investors.

PJW

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Re: Have TIPS truly been tested yet?

Post by White Coat Investor » Sun Nov 26, 2017 3:34 pm

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
TIPS (Treasury Inflation Protection Securities) are generally wonderful in my mind. I agree with Larry Swedroe. They are an amazing invention for investors to utilize because they protect you from Inflation, AND deflation. https://youtu.be/0OOi3XFNlA0

However, my concern is that they were only invented in the 1990’s. They have not been around for some of the crazy and unique market conditions of the past. We don’t really have the same track record to bank on, verses a fund like Total Bond Market.

Furthermore, I have read concerns about the index that TIPS track not being a proper measure of inflation. I have also read concerns that if inflation gets out of control, will the issuer honor the commitment promised? Some people have many concerns.

Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Yes. I've had 50% of my bond portfolio in TIPS for over a decade and I'm comfortable. Are they as old as index funds? No. But they've only been around 20 years longer. But even publicly traded stock markets have only been around for a couple hundred years. Is that really long enough? Maybe not. And there are plenty of things newer than TIPS- P2P loans, crowdfunded hard money loans etc.
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Re: Have TIPS truly been tested yet?

Post by dbr » Sun Nov 26, 2017 3:41 pm

It is not as if TIPS are not essentially Treasury securities the same as any other notes, bonds, or bills.

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Re: Have TIPS truly been tested yet?

Post by rnitz » Sun Nov 26, 2017 9:06 pm

simplesauce wrote:
Thu Nov 02, 2017 9:39 pm
Can one really put 25-50% of their bond portfolio into TIPS comfortably?
Yes, of course. I'm another one. Remember, the risk in bonds is not interest rate risk (which you regain in roughly the number of years of the duration of your bonds) but inflation risk - which is permanent.

If it gives you confidence, you might look at the types of posters that are comfortable with TIPS (Nisiprius, dbr, Phineas J. Whoopee, White Coat Investor, etc.)

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Re: Have TIPS truly been tested yet?

Post by whomever » Sun Nov 26, 2017 9:52 pm

I think the proper question isn't 'are TIPS 100.0000000% safe', it is 'how safe are they relative to nominal treasuries'.

-If we have a blip of high inflation like the late 70's/early 80's, I'd expect TIPS payments to be completely honored, and so TIPS holders would be happier than nominal bond holders
-If we have Weimar Republic hyper inflation, society at large might decide not to fully honor TIPS - but I'd think TIPS holders would still come out ahead of nominal bond holders
-If the CPI measure doesn't keep up with high inflation, I think TIPS holders will still end up better off than nominal bond holders; after all, nominal bonds use a fixed 0% estimate for their CPI adjustment :-). Or more correctly, I guess, they use the nominal TIPS rate as their CPU adjustment.
-As far as taxes, same deal - Adam has nominals and runaway inflation happens; he pays taxes on his negligible gains. Bob has TIPS and runaway inflation happens; he pays taxes on his very large gains. I'd rather be Bob paying large taxes on large gains than Adam having no gains to tax.

Nominals only come out ahead if everything goes well; when unexpected bad things happen, TIPS shield you from all or some of unexpected storms, but it's hard to see how they leave you worse off in those storms.

(Well, they leave you less well off if there is deflation, and the CPI declines faster than actual deflation. That seems like an unlikely combination)

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Re: Have TIPS truly been tested yet?

Post by fennewaldaj » Sun Nov 26, 2017 11:39 pm

TIPs seem better than nominal treasuries to me a current yields. The break even inflation rate is ~1.7-1.8% and as was shown above most situations where TIPs are not fully honored nominal bonds will be worse. I suppose TIPS might be worse in term of overall portfolio performance due to higher volitility and poor performance in certain types of crisis but judged in isolation they seem much better than nominal treasuries .

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Re: Have TIPS truly been tested yet?

Post by MrPotatoHead » Mon Nov 27, 2017 1:37 am

I have to say I find this thread a bit on the bizarre side. On the one hand you have a broken concept called TIPs that cannot fulfill the goal it is intended to because you are being taxed on phantom income under an inflation scenario. If the point was to make sure a dollar kept pace with inflation it would be a tax-exempt security.

On the other hand you have people actually trying to defend what amounts to the illogical and indefensible.

Bizarre...it is like there is a cult of TIP people out there.

Just sayin'.

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Re: Have TIPS truly been tested yet?

Post by FIREchief » Mon Nov 27, 2017 1:55 am

whomever wrote:
Sun Nov 26, 2017 9:52 pm

(Well, they leave you less well off if there is deflation, and the CPI declines faster than actual deflation. That seems like an unlikely combination)
Not true if you buy TIPS at auction and hold them to maturity! 8-)
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Re: Have TIPS truly been tested yet?

Post by Theoretical » Mon Nov 27, 2017 1:58 am

Something to consider is from Bill Bernstein's Deep Risk, where he talks about German bund holders in the Weimar hyperinflation. Fiat nominal bonds got totally wiped out. The partially gold backed bonds something like a quarter of the value owed in the end. So not everything but a lot more than nothing.

Especially in that era, I'd consider a gold bond to be a spiritual precursor to GILTS and TIPS.

Geoplitically, it's far safer to inflate away the nominal debt (at a terrible cost to the populace but where it's part of the risk of investing in nominal bonds) than it is to screw with the inflation protection (except in a more generous direction). The former is a known risk. The latter may as well be Argentina.

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