Larry Swedroe: TIPS Versus Nominal Bonds

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Random Walker
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Larry Swedroe: TIPS Versus Nominal Bonds

Post by Random Walker » Fri Aug 24, 2018 9:23 am

https://www.etf.com/sections/swedroe-ti ... nopaging=1

Excellent article probably worth reading more than once to grasp the concepts. It is an oversimplification to view the difference between TIPS yield and nominal yield as the implied inflation rate. Nominals provide some extra yield (depressed price) to compensate for the risk of unexpected inflation and nominals have some decreased yield (increased price) that investors pay for extra liquidity. The two effects somewhat offset each other. Larry mentions several papers making strong case for TIPS compared to nominals in a portfolio. At the end though, he discusses the higher yields CDs provide compared to treasuries, and this difference can make CDs preferable to TIPS for certain investors.

Dave

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by HomerJ » Fri Aug 24, 2018 9:39 am

Thanks, this was an interesting article.

I think I may be moving some of my Total Bond Market to a 3-year CD ladder.
The J stands for Jay

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Random Walker » Fri Aug 24, 2018 9:44 am

I have a muni ladder in a taxable account, but at the short end of the ladder I have CDs.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by CraigTester » Fri Aug 24, 2018 9:52 am

Random Walker wrote:
Fri Aug 24, 2018 9:23 am
https://www.etf.com/sections/swedroe-ti ... nopaging=1

Excellent article probably worth reading more than once to grasp the concepts. It is an oversimplification to view the difference between TIPS yield and nominal yield as the implied inflation rate. Nominals provide some extra yield (depressed price) to compensate for the risk of unexpected inflation and nominals have some decreased yield (increased price) that investors pay for extra liquidity. The two effects somewhat offset each other. Larry mentions several papers making strong case for TIPS compared to nominals in a portfolio. At the end though, he discusses the higher yields CDs provide compared to treasuries, and this difference can make CDs preferable to TIPS for certain investors.

Dave
Interesting article, thx for posting:

Another advantage of Direct (e.g. not Brokered) CD's over TIPS is the put option they offer in the form of their EWP (early withdrawal penalty). This effectively limits any inflation risk to the amount of your pre-agreed fee.

Additionally, while Larry focuses on the 5 year duration, at present, I would argue the current "sweet spot" on the yield curve is between 2 and 3 years.

As you progress from 3 years to 5 years, the yield curve is pretty frugal right now.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by BigJohn » Fri Aug 24, 2018 10:35 am

One of the most helpful and clear articles on this topic I’ve read. Reinforces my reasons for moving to a 50/50 split of TIPS vs nominals and gives me something to consider on whether I should go farther into TIPS.

Thanks to Larry for writing and Random Walker for posting.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by FIREchief » Fri Aug 24, 2018 12:22 pm

One of Larry's better articles. A few factors that he didn't mention:

a) There is a chance that unexpected inflation will be inflation that is less than expected, in which case there would be an offsetting negative premium for TIPS.
b) There is an emotional component for retail investors who don't understand the difference between real and nominal rates. We see this on the forum at times, so I'm certain that it is very common among the less educated investors out there (and maybe even their advisors in many cases). I think this tends to suppress the premiums we might otherwise pay for the inflation protection of TIPS. "Why should I buy a TIPS that is only paying 0.7% when I can buy a US Treasury that will pay me 2.75% (adding in the fact that many don't understand that TIPS are in fact US Treasuries)."
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by garlandwhizzer » Fri Aug 24, 2018 1:09 pm

Good article. Thanks for posting, Random Walker.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by grok87 » Fri Aug 24, 2018 3:03 pm

It’s a good article. Thanks for posting random walker and good job Larry.

That being said, i’m Not really a fan of the cd stuff at the closing.

CDs often incur state taxes.
Or if you hold in a tax deferred account there is extra hassle of rolling over iras etc.

I used to be a fan of CDs. But now the rates are not much above treasuries and the early withdrawal penalties have really been jacked up.
Keep calm and Boglehead on. KCBO.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by grok87 » Fri Aug 24, 2018 3:04 pm

FIREchief wrote:
Fri Aug 24, 2018 12:22 pm
One of Larry's better articles. A few factors that he didn't mention:

a) There is a chance that unexpected inflation will be inflation that is less than expected, in which case there would be an offsetting negative premium for TIPS.
b) There is an emotional component for retail investors who don't understand the difference between real and nominal rates. We see this on the forum at times, so I'm certain that it is very common among the less educated investors out there (and maybe even their advisors in many cases). I think this tends to suppress the premiums we might otherwise pay for the inflation protection of TIPS. "Why should I buy a TIPS that is only paying 0.7% when I can buy a US Treasury that will pay me 2.75% (adding in the fact that many don't understand that TIPS are in fact US Treasuries)."
+1
Keep calm and Boglehead on. KCBO.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by garlandwhizzer » Fri Aug 24, 2018 4:00 pm

I am not a fan of CDs especially in the current environment. Bond funds re-invest dividends which CDs do not. Bond funds are liquid if and when you either need money or find a compelling investment option. CDs lack this liquidity completely or impose a financial penalty for early withdrawal. If interest rates continue to rise, CDs suffer the same opportunity cost from duration risk like all fixed income instruments. In a rising rate environment the future will offer you higher yielding bonds/CDs before today's fixed rate 5 year CDs mature. If interest rates fall, they, like all longer term instruments, will benefit. I believe in the short term (1 - 1.5 years) interest rates are more likely to rise than fall. The question of course comes down to the individual's circumstances. How important is liquidity to him/her? Does he/she have a strong opinion about the future course of interest rates over the term of the CD? How important is it to him/her to secure a guaranteed nominal return over a fixed time interval? For some CDs are a good choice. I am not one of them.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Richard1580 » Fri Aug 24, 2018 6:26 pm

The article was very interesting and ties in with a problem that I am currently noodling over - where to put my fixed income asset allocation?

However, one sentence (in the linked article) really stood out: "The survey’s third-quarter 2018 estimate for inflation over the next 10 years is 2.2%..."

A 10 year projection? I can't imagine how that could possibly be accurate, so I began looking for references to past 10 year projections by the Survey of Professional Forecasters. I was able to find an article from 2010, https://pdfs.semanticscholar.org/ce42/3 ... 25a161.pdf
that seemed to address this issue. However it was not clear to me whether they were looking at 1, 5 or 10 year projections (the projections since the mid 1970's seemed to be reasonably accurate, although they generally underestimated inflation. If they were only looking ahead one year, this would not be surprising. If they are 10 year projections, then they are incredible).

Does anyone have any data on how accurate these 10 year projections have been in the past?

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by galeno » Fri Aug 24, 2018 6:33 pm

TIPS compose 15% of our 40/60 port. 25% of the FI allocation.

The yield on TIPS is lower than for nominal treasuries because the "unexpected inflation" protection of the TIPS is insurance. All insurance has a cost.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by FIREchief » Fri Aug 24, 2018 6:51 pm

galeno wrote:
Fri Aug 24, 2018 6:33 pm
TIPS compose 15% of our 40/60 port. 25% of the FI allocation.

The yield on TIPS is lower than for nominal treasuries because the "unexpected inflation" protection of the TIPS is insurance. All insurance has a cost.
Are you mixing nominal and real yields here? The main reason that the published yields on TIPS is lower is because it is real yield. The impact of the inflation protection on yield is miniscule.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Big Dog » Fri Aug 24, 2018 7:05 pm

is there any reason not to hold tips in a fund, such as the Vanguard fund referenced in the article? Are tips' funds subject to any interest rate risk, or is owning a fund the same as owning an individual tip? (does that question make sense?)

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by galeno » Fri Aug 24, 2018 7:08 pm

My info comes from Ireland domiciled Vanguard and iShares bond ETFs purchased on the LSE. Published yields are nominal.

The published YTM on our US Treasury ETF is 2.80% (Ave Duration = 6.0 yr, ER = 0.12%). So "dirty SEC Yield" is 2.68%

The published YTM on our TIPS ETF is 2.82% (Ave Duration = 8.2 yr, ER = 0.25%). So "dirty SEC Yield" is 2.57%
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Peter G » Fri Aug 24, 2018 9:18 pm

The yield on TIPS is lower than for nominal treasuries because the "unexpected inflation" protection of the TIPS is insurance. All insurance has a cost.
Not sure that accords with my understanding.
Nominal treasuries return nominal principal, so their yield needs to be higher than just that component of the yield necessary to compensate you for not having the use of your money for a few years; and that extra yield is determined by the market's view of the inflation rate going forward.
Inflation protected treasuries, on the other hand, return your principal (and then some, to account for inflation). From that, it should be possible to say TIPS' yield is lower because of the 'expected inflation' protection.
Assume TIPS also have lower yield because of 'unexpected inflation'. Why wouldn't nominal bonds have a lower yield to match, as they provide protection against lower than expected inflation and deflation.
The total return of nominal and inflation protected bonds will be the same if the inflation rate turns out to be what was anticipated initially. If the rate turns out to be higher then TIPS win; if the inflation rate turns out lower, then nominals win.
If I've got that right, then one might be well served by a mix of nominal and inflation protected bonds, if bonds are your thing and you have equipoise about future inflation.
Of course, tax considerations are relevant. In some places interest is taxed more than capital gains, and perhaps vice versa in other places.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by stlutz » Fri Aug 24, 2018 9:26 pm

The statement that TIPS protect you against "unexpected" inflation isn't always that helpful.

TIPS actually protect you against actual inflation (and usually provide some additional coupon in addition). If I buy a TIPS issue today at 100 and inflation is 5% over the next year, the par value of the bond will adjust to 105. "Unexpected" doesn't factor in at all.

Where the "unexpected" part comes in is if you are comparing TIPS against nominal bonds. If inflation is higher than expected, TIPS win. If it's lower than expected, nominals win.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by AlphaLess » Fri Aug 24, 2018 9:37 pm

Richard1580 wrote:
Fri Aug 24, 2018 6:26 pm
The article was very interesting and ties in with a problem that I am currently noodling over - where to put my fixed income asset allocation?

However, one sentence (in the linked article) really stood out: "The survey’s third-quarter 2018 estimate for inflation over the next 10 years is 2.2%..."

A 10 year projection? I can't imagine how that could possibly be accurate, so I began looking for references to past 10 year projections by the Survey of Professional Forecasters. I was able to find an article from 2010, https://pdfs.semanticscholar.org/ce42/3 ... 25a161.pdf
that seemed to address this issue. However it was not clear to me whether they were looking at 1, 5 or 10 year projections (the projections since the mid 1970's seemed to be reasonably accurate, although they generally underestimated inflation. If they were only looking ahead one year, this would not be surprising. If they are 10 year projections, then they are incredible).

Does anyone have any data on how accurate these 10 year projections have been in the past?
I also agree that a 'survey projection' is a pretty crappy way to determine forward inflation.

Inflation swap is the best instrument because it is tradable, and one can lock in a rate.
"You can get more with a kind word and a gun than with just a kind word." George Washington

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Peter G » Sat Aug 25, 2018 12:16 am

I wonder how the market prices into a nominal bond yield an estimate for 'unexpected inflation'?
If it's not expected to occur, then there should be no yield premium paid for it, surely?
If it's an amount of inflation that's not expected, but just possibly could occur, then it will be priced into the yield because to leave it out would be to take uncompensated risk, surely?
If it all boils down to whether a large handful of economists or the market is a better predictor of inflation, then I think I get it.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by grok87 » Sat Aug 25, 2018 2:24 am

AlphaLess wrote:
Fri Aug 24, 2018 9:37 pm
Richard1580 wrote:
Fri Aug 24, 2018 6:26 pm
The article was very interesting and ties in with a problem that I am currently noodling over - where to put my fixed income asset allocation?

However, one sentence (in the linked article) really stood out: "The survey’s third-quarter 2018 estimate for inflation over the next 10 years is 2.2%..."

A 10 year projection? I can't imagine how that could possibly be accurate, so I began looking for references to past 10 year projections by the Survey of Professional Forecasters. I was able to find an article from 2010, https://pdfs.semanticscholar.org/ce42/3 ... 25a161.pdf
that seemed to address this issue. However it was not clear to me whether they were looking at 1, 5 or 10 year projections (the projections since the mid 1970's seemed to be reasonably accurate, although they generally underestimated inflation. If they were only looking ahead one year, this would not be surprising. If they are 10 year projections, then they are incredible).

Does anyone have any data on how accurate these 10 year projections have been in the past?
I also agree that a 'survey projection' is a pretty crappy way to determine forward inflation.

Inflation swap is the best instrument because it is tradable, and one can lock in a rate.
Well i’m Not a huge fan of the survey approach either.

But i’d Be cautious about giving too much weight to the swap here. Just because it is a tradable instrument doesn’t mean it is unbiased. My sense is there is a lot more demand than supply and the breakevens for the swap are biased way high. Ie. It is a sellers market and buyers of inflation Protection in the swap market are overpaying.

One can the ask the question-why don’t they just buy tips instead? The answer I was told is that they don’t want the real interest rate risk.

I’ll mention a 3rd approach that I think is worth considering. Just look at what recent actual inflation has been recently. Perhaps that is the best estimate going forward. Coincidentally I think it has been averaging 2.2% for the last few years...
Keep calm and Boglehead on. KCBO.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by steve321 » Sat Aug 25, 2018 3:20 am

This is a good article. A few questions:

a. Usually people on this Board say that we are better off ignoring forecasts. However Mr Swedroe speaks with respect of the 'Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters.' So are forecasts about inflation more trustworthy than forecasts about the stock market?

b. Why do CDs yield more than Treasuries? If the market is efficient and they are both basically riskless, why does one yield more than the other?

c. I just checked the yields of the Index-linked Gilts as I am in the UK. They are negatives, so I would lose money in real term even though the Gilts value is linked to inflation. Is that normal? I understand that you are likely to lose even if you buy CDs in the UK since inflation should be higher than their yields. So what are Bogleheads in the UK doing as far as bonds are concerned?

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by statman » Sat Aug 25, 2018 3:35 am

I am confused by Mr Swedroe's core argument. Please look at the following and unconfuse me. Mr Swedroe writes "As of this writing, August 14, 2018, the five-year TIPS was yielding 0.77% and the five-year nominal Treasury was yielding 2.76%. Thus, the breakeven inflation rate was 2.01%." I believe that should be 1.99%, but no matter.

Returns on nominal treasuries and TIPS disaggregate as follows:

Nominals: real rate + expected inflation + risk premium for unexpected inflation
TIPS: real rate + risk premium for illiquidity

Mr Swedroe takes the 2nd risk premium as a negative premium for liquidity of nominal treasuries. I prefer to take it as a positive premium for the relative illiquidity of TIPS. No matter, because I'm going to assume it's small enough to be ignored. If we also ignore the risk premium for unexpected inflation, we have three cases:

1. realized inflation < expected: nominals beat TIPS
2. realized inflation = expected: both bonds have similar performance
3. realized inflation > expected: TIPS beat nominals

Of course we can't ignore the risk premium, but the above illustrates a fundamental dynamic in the relative performance of TIPS and nominal treasuries. Mr Swedroe then cites estimates of expected inflation from sources outside the Treasury market, 2.2% and 2.4%, and recommends TIPS on this basis. Although we can't disaggregate the market expected inflation rate from the risk premium for unexpected inflation, the market expectation is no greater than 1.99%. Preferring 2.2% or 2.4% amounts to claiming that the Treasury market is mispriced. If we instead accept the market's expectations, then 2.2/2.4 amounts to thinking that realized inflation will exceed the market's expectation. We are in case 3 above, where TIPS outperform. I have no idea whether realized inflation will be higher or lower than market expectation. so this seems to me a weak argument for preferring TIPS.

Mr Swedroe also cites three academic papers. I have not had time to look at these, but they appear to (correctly) take a portfolio view rather than considering the T-bond in isolation. They appear to claim a diversification benefit for TIPS (perhaps due to lower correlation with equities). This would be a legitimate reason to prefer TIPS.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by jmk » Sat Aug 25, 2018 3:58 am

steve321 wrote:
Sat Aug 25, 2018 3:20 am
b. Why do CDs yield more than Treasuries? If the market is efficient and they are both basically riskless, why does one yield more than the other?
Possible factors:
  • While CDs have FDIC protection, they are still less safe than Treasuries. (FDIC might fail, there is a delay in getting money when banks fail, etc.)
  • Pensions and others may have restrictions on purchasing CDs and quantities may not be sufficient for needs
  • Banks may have individualized reasons for offering retail incentives to gain retail business not available to some who purchase treasuries.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by larryswedroe » Sat Aug 25, 2018 7:33 am

Few answers

Re Philly Fed, I'm not making any argument about the accuracy of their forecasts. It's that you have if memory serves 65 leading economists from the nations largest institutions and they not only shape inflation forecasts of investors but they impact prices with the actions of their institutions. All I've said is that the consensus, the wisdom of the crowd (not any individual economist) is perhaps a better estimate than the spread, which is definitely not the market's estimate because of the noise I mentioned from two factors, liquidity and unexpected inflation risk. And we cannot know what those two are, only that they are not measurable. Again, it's a wisdom of the crowds argument which is strengthened IMO by the fact that these people shape expectations of investors with their forecasts.

CDs yield more because of
a) less liquidity, either have penalties for early withdrawal or if trade in secondary market have higher spread.
b) as noted, fewer buyers as governments and central banks and corporations don't buy CDs, only Treasuries and Treasuries is the global safe haven asset. Any one doubting that just look back to 2008 and see how treasury to TIPS spread widened dramatically,
c) even individual cannot buy CDs inside 401k plans or other corporate retirement plans. Less demand=higher price

Larry

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by stlutz » Sat Aug 25, 2018 8:39 am

The spread between TIPS and nominal bonds today seems reasonable. I suppose the Philly Fed survey backs that up.

Back in early 2016 when the spread was under 1.5%, that to me was a screaming buy signal at that wasn't a credible 10 year projection to me. There have been a few instances historically when it appeared that one could market-time the TIPS market. Most of the time (including today), that's not the case.

Instead, I think investors are better advised to choose between TIPS and nominal bonds based on what they need bonds for. If it's inflation protected income, then TIPS are preferred. If it's a asset that it more likely to counter-balance an equity decline, nominals have proven to be the better choice historically here.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by steve321 » Sat Aug 25, 2018 8:39 am

Thank you for these clarifications.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Valuethinker » Sat Aug 25, 2018 8:56 am

statman wrote:
Sat Aug 25, 2018 3:35 am
I am confused by Mr Swedroe's core argument. Please look at the following and unconfuse me. Mr Swedroe writes "As of this writing, August 14, 2018, the five-year TIPS was yielding 0.77% and the five-year nominal Treasury was yielding 2.76%. Thus, the breakeven inflation rate was 2.01%." I believe that should be 1.99%, but no matter.

Returns on nominal treasuries and TIPS disaggregate as follows:

Nominals: real rate + expected inflation + risk premium for unexpected inflation
TIPS: real rate + risk premium for illiquidity

Mr Swedroe takes the 2nd risk premium as a negative premium for liquidity of nominal treasuries. I prefer to take it as a positive premium for the relative illiquidity of TIPS. No matter, because I'm going to assume it's small enough to be ignored. If we also ignore the risk premium for unexpected inflation, we have three cases:

1. realized inflation < expected: nominals beat TIPS
2. realized inflation = expected: both bonds have similar performance
3. realized inflation > expected: TIPS beat nominals

Of course we can't ignore the risk premium, but the above illustrates a fundamental dynamic in the relative performance of TIPS and nominal treasuries. Mr Swedroe then cites estimates of expected inflation from sources outside the Treasury market, 2.2% and 2.4%, and recommends TIPS on this basis. Although we can't disaggregate the market expected inflation rate from the risk premium for unexpected inflation, the market expectation is no greater than 1.99%. Preferring 2.2% or 2.4% amounts to claiming that the Treasury market is mispriced. If we instead accept the market's expectations, then 2.2/2.4 amounts to thinking that realized inflation will exceed the market's expectation. We are in case 3 above, where TIPS outperform. I have no idea whether realized inflation will be higher or lower than market expectation. so this seems to me a weak argument for preferring TIPS.

Mr Swedroe also cites three academic papers. I have not had time to look at these, but they appear to (correctly) take a portfolio view rather than considering the T-bond in isolation. They appear to claim a diversification benefit for TIPS (perhaps due to lower correlation with equities). This would be a legitimate reason to prefer TIPS.
Fisher Formula

(1 + real) = (1 + nominal)/ (1 + inflation). This might be the source of the difference in calculated inflation expectation?

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by sabtastic » Sat Aug 25, 2018 10:18 am

I am a little confused regarding the article's fixed income asset allocation recommendations. Obviously there isn't much incentive for investors in the contribution phase to hold TIPS, but how much of a fixed income allocation should be dedicated to TIPS in the withdrawl phase, and should an investor tilt toward short/long or blend? Should investors be picking one OR the other or some ratio?

If we are using Vanguard target date funds as a benchmark, it looks like they recommend roughly 24% of fixed income in short dated TIPS if you hold their "income" fund, or about 19% if you hold the "2015" fund. Various other target date funds with similar target dates are all over the place, so there is definitely not a consensus.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by jeffyscott » Sat Aug 25, 2018 10:22 am

grok87 wrote:
Fri Aug 24, 2018 3:03 pm
CDs often incur state taxes.
Or if you hold in a tax deferred account there is extra hassle of rolling over iras etc.
I assume the rolling over hassle you are referring to would be for direct CDs? Brokered CDs should be no more difficult to keep funds invested in than treasuries are.
I used to be a fan of CDs. But now the rates are not much above treasuries and the early withdrawal penalties have really been jacked up.
Brokered 2-3 year CDs are paying about 2.8-3.0%, 2-3 year treasuries are paying 2.63-2.68%. In an IRA, why not earn the extra ~0.2% to 0.3%?

If you were comparing two funds with ERs that differed by 0.2-.03%, would you say that is not much of difference?
press on, regardless - John C. Bogle

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Dottie57 » Sat Aug 25, 2018 10:25 am

stlutz wrote:
Fri Aug 24, 2018 9:26 pm
The statement that TIPS protect you against "unexpected" inflation isn't always that helpful.

TIPS actually protect you against actual inflation (and usually provide some additional coupon in addition). If I buy a TIPS issue today at 100 and inflation is 5% over the next year, the par value of the bond will adjust to 105. "Unexpected" doesn't factor in at all.

Where the "unexpected" part comes in is if you are comparing TIPS against nominal bonds. If inflation is higher than expected, TIPS win. If it's lower than expected, nominals win.
Great explanation of TIPS vs Other typesfbonds

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Top99% » Sat Aug 25, 2018 10:40 am

Thanks for posting an interesting article. I learned a lot from the article itself and the replies on the thread. TIPS + CD ladders seems like a good way to hedge your bets to me. I think the fact that CDs are more of a hassle to deal with earns a bit of a premium as well.
Adapt or perish

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by smectym » Sat Aug 25, 2018 10:59 am

jmk wrote:
Sat Aug 25, 2018 3:58 am
steve321 wrote:
Sat Aug 25, 2018 3:20 am
b. Why do CDs yield more than Treasuries? If the market is efficient and they are both basically riskless, why does one yield more than the other?
Possible factors:
  • While CDs have FDIC protection, they are still less safe than Treasuries. (FDIC might fail, there is a delay in getting money when banks fail, etc.)
  • Pensions and others may have restrictions on purchasing CDs and quantities may not be sufficient for needs
  • Banks may have individualized reasons for offering retail incentives to gain retail business not available to some who purchase treasuries.
The quest for theoretical explanations for “why CD’s yield more than treasuries” is perplexing. Um, typically bank certificates of deposit DON’T yield more than treasury securities of the same term. Check the term sheets for Chase, Wells Fargo etc. They yield far less. But OK, how about the credit union PenFed, a perennial Boglehead board favorite? Their rates right now are pretty good. But still, PF’s 2-year certificate, e.g., falls short of the mark compared to the Treasury 2-year—and that’s before accounting for state taxes.

If you hunt around in the world of brokered CD’s or luckily run across a special bank or credit union promo, you *might* find a product with a better yield than the same-term treasury equivalent. But there is no general law that CD’s yield more than treasuries (far from it). Therefore, no need to come up with theoretical “explanations” for a non-existent phenomenon.

Smectym

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Doc » Sat Aug 25, 2018 11:27 am

jeffyscott wrote:
Sat Aug 25, 2018 10:22 am
Brokered 2-3 year CDs are paying about 2.8-3.0%, 2-3 year treasuries are paying 2.63-2.68%. In an IRA, why not earn the extra ~0.2% to 0.3%?
Assuming state IT is not an issue:

Liquidity is still worth something. How much that is worth depends on our individual needs. If one's portfolio is such that he will never, ever need to or want to sell that CD before maturity then go ahead and take that extra 20 some bps.

BTW as of 7/21/18 buying a 2 year Treasury and selling at 1 year was worth ~8 bps and 3 to 1 ~9 bps in "roll down yield".
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Turbo29 » Sat Aug 25, 2018 11:47 am

smectym wrote:
Sat Aug 25, 2018 10:59 am

If you hunt around in the world of brokered CD’s or luckily run across a special bank or credit union promo, you *might* find a product with a better yield than the same-term treasury equivalent. But there is no general law that CD’s yield more than treasuries (far from it). Therefore, no need to come up with theoretical “explanations” for a non-existent phenomenon.

Smectym
There is no "might" about it and no "hunting" required. Brokered CDs 2yr and longer are paying more than treasuries.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by jeffyscott » Sat Aug 25, 2018 11:50 am

Doc wrote:
Sat Aug 25, 2018 11:27 am
jeffyscott wrote:
Sat Aug 25, 2018 10:22 am
Brokered 2-3 year CDs are paying about 2.8-3.0%, 2-3 year treasuries are paying 2.63-2.68%. In an IRA, why not earn the extra ~0.2% to 0.3%?
Assuming state IT is not an issue:

Liquidity is still worth something. How much that is worth depends on our individual needs. If one's portfolio is such that he will never, ever need to or want to sell that CD before maturity then go ahead and take that extra 20 some bps.
Agree that CDs should only be used for funds that you are certain to not need prior to maturity. I choose to get liquidity elsewhere (bond funds), myself.

I like to avoid treasuries in tax deferred accounts, I feel I am getting cheated by losing the state income tax exemption (unless I keep complicated records forever).
press on, regardless - John C. Bogle

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Blueskies123 » Sat Aug 25, 2018 12:19 pm

Over the last 18 years it does look like TIPs have done better than treasuries but if you look at problem years like 2007/2008/, 2013, and 2015 it seems treasuries do better during crises. If interest rates continue up but inflation stays at 2% it would seem TIPS would lag. Since almost everyone thinks interest rates are going up somewhat from here and inflation seems muted (so far) I have just shortened my durations to mitigate risk rather than make a big move into TIPS.
My bond allocations first and foremost for crisis protection.


https://www.portfoliovisualizer.com/bac ... &TIPS2=100

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by FIREchief » Sat Aug 25, 2018 12:29 pm

Blueskies123 wrote:
Sat Aug 25, 2018 12:19 pm
If interest rates continue up but inflation stays at 2% it would seem TIPS would lag.
Please explain this comment.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Doc » Sat Aug 25, 2018 12:31 pm

Blueskies123 wrote:
Sat Aug 25, 2018 12:19 pm
Over the last 18 years it does look like TIPs have done better than treasuries but if you look at problem years like 2007/2008/, 2013, and 2015 it seems treasuries do better during crises.
Yep, just look at the max drawdown and market correlation from your Backtest

Drawdown: TIPS vs Nominal -12.50 vs -4.48 - Point goes to nominals

Correlation: TIPS vs Nominal 0.01 vs -0.33 - Point goes to nominals again.

The TIPS vs Nominals question can't be answered in the absence of the rest of your portfolio and to each of our rebalancing methods.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Blueskies123 » Sat Aug 25, 2018 1:10 pm

FIREchief wrote:
Sat Aug 25, 2018 12:29 pm
Blueskies123 wrote:
Sat Aug 25, 2018 12:19 pm
If interest rates continue up but inflation stays at 2% it would seem TIPS would lag.
Please explain this comment.
To clarify, the longer-dated TIPs do have duration risk. A 10-year Tip bond will decrease in value if the Fed raises rates, say, 100 basis points and assuming no underlying change in inflation. Look at 2013 in the link on my previous post. And this link (https://www.investopedia.com/terms/t/taper-tantrum.asp)

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by FIREchief » Sat Aug 25, 2018 1:17 pm

Blueskies123 wrote:
Sat Aug 25, 2018 1:10 pm
FIREchief wrote:
Sat Aug 25, 2018 12:29 pm
Blueskies123 wrote:
Sat Aug 25, 2018 12:19 pm
If interest rates continue up but inflation stays at 2% it would seem TIPS would lag.
Please explain this comment.
To clarify, the longer-dated TIPs do have duration risk. A 10-year Tip bond will decrease in value if the Fed raises rates, say, 100 basis points and assuming no underlying change in inflation. Look at 2013 in the link on my previous post. And this link (https://www.investopedia.com/terms/t/taper-tantrum.asp)
Yes, but the same is true for nominal treasuries. Why did you just single out TIPS in your prior post?
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by Blueskies123 » Sat Aug 25, 2018 2:29 pm

You are correct that a single tip bond vs a single nominal bond with the exact same duration should behave the same with a 100 basis point rise in interest rates but for tip funds look at page 4 on this link if it shows on your screen like my screen:
https://www.verusinvestments.com/docume ... f-tips.pdf

You can see this in action in 2013 with tips vs treasuries and the additional benefit of a liquidity premium given treasuries in 2008/2009.

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FIREchief
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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by FIREchief » Sat Aug 25, 2018 3:38 pm

Blueskies123 wrote:
Sat Aug 25, 2018 2:29 pm
You are correct that a single tip bond vs a single nominal bond with the exact same duration should behave the same with a 100 basis point rise in interest rates but for tip funds look at page 4 on this link if it shows on your screen like my screen:
https://www.verusinvestments.com/docume ... f-tips.pdf

You can see this in action in 2013 with tips vs treasuries and the additional benefit of a liquidity premium given treasuries in 2008/2009.
Thanks for posting that link. I can't see a chart on page 4. Unless I'm misreading something, the following statement in that article appears to be 100% wrong:
After inflation data is released from the Bureau of Labor Statistics each quarter, the underlying principal of TIPS is adjusted upwards if inflation comes in above expectation, not adjusted if inflation equals expectation, or adjusted downwards if inflation is below expectation.
They do cover a lot of very basic concepts about bonds and duration risk and inflation risk. Nothing particularly new or useful. As with some other articles we see linked here on the forum, you kind of have to look to the final "punch line" to understand what the hidden motives might be. It appears that they are selling the following:
we believe that investors should consider high yield bonds and floating rate bank loans
It is difficult to compare nominal bond performance and TIPS performance when they are held in funds (versus individual bonds). Durations for TIPS funds are somewhat undefined and nominal and real interest rates don't move in lock step with each other.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by grok87 » Sat Aug 25, 2018 5:31 pm

jeffyscott wrote:
Sat Aug 25, 2018 10:22 am
grok87 wrote:
Fri Aug 24, 2018 3:03 pm
CDs often incur state taxes.
Or if you hold in a tax deferred account there is extra hassle of rolling over iras etc.
I assume the rolling over hassle you are referring to would be for direct CDs? Brokered CDs should be no more difficult to keep funds invested in than treasuries are.
I used to be a fan of CDs. But now the rates are not much above treasuries and the early withdrawal penalties have really been jacked up.
Brokered 2-3 year CDs are paying about 2.8-3.0%, 2-3 year treasuries are paying 2.63-2.68%. In an IRA, why not earn the extra ~0.2% to 0.3%?

If you were comparing two funds with ERs that differed by 0.2-.03%, would you say that is not much of difference?
Thanks, good points. I’m still thinking about it. I suppose it boils down to how much extra spread does one want for the il-liquidity of brokered cds.
Keep calm and Boglehead on. KCBO.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by smectym » Sat Aug 25, 2018 10:51 pm

Turbo29 wrote:
Sat Aug 25, 2018 11:47 am
smectym wrote:
Sat Aug 25, 2018 10:59 am

If you hunt around in the world of brokered CD’s or luckily run across a special bank or credit union promo, you *might* find a product with a better yield than the same-term treasury equivalent. But there is no general law that CD’s yield more than treasuries (far from it). Therefore, no need to come up with theoretical “explanations” for a non-existent phenomenon.

Smectym
There is no "might" about it and no "hunting" required. Brokered CDs 2yr and longer are paying more than treasuries.
Fair enough, Turbo. And (A) Brokered CD’s are a fraction of the total CD market, so to state that “CD’s” in general pay higher rates than treasuries is at best imprecise—but let’s just say inaccurate; (B) even within the universe of brokered CD’s, you carefully circumscribe the term within which the “superior yield” claim applies; (C) as best I can tell, the yield edge for many brokered CD’s in the 2-3 year time frame, while (as I allowed in my original post) it can exist, borders on the evanescent if the depositor is subject to state income tax, or if any transaction cost pertains to the brokered CD purchase.

Smectym

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by larryswedroe » Sun Aug 26, 2018 7:36 am

BTW, go out to five years and see about 2.7 for Treasuries and 3.4 for CDs, so big difference. At times these spreads are even wider, like in financial crises when liquidity premium for Treasuries rises. Also state taxes not an issue often because if in higher brackets than buying munis not taxables. Though at times CDs are even the preferred choice at shorter end of the curve for taxable investors.

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by jeffyscott » Sun Aug 26, 2018 7:51 am

larryswedroe wrote:
Sun Aug 26, 2018 7:36 am
Also state taxes not an issue often because if in higher brackets than buying munis not taxables.
But many state income tax systems are much flatter than federal. I am the lowest Federal bracket (12%) but effective state tax bracket is 7.5% (there is one nominally higher bracket, 7.65%). Munis make no sense for me, but treasuries over CDs in taxable may.

However, those of us who have spent our lives in the lower tax brackets may also typically have most or all investments in tax deferred accounts, as I do. So most or all fixed income investing can be done in those tax deferred accounts.
press on, regardless - John C. Bogle

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Re: Larry Swedroe: TIPS Versus Nominal Bonds

Post by munemaker » Sun Aug 26, 2018 7:23 pm

garlandwhizzer wrote:
Fri Aug 24, 2018 4:00 pm
Bond funds re-invest dividends which CDs do not.

Garland Whizzer
Bank CD interest is compounded, not paid out.

Mune

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