Are TIPS really a good inflation hedge? Pros and Cons

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Sun Sep 15, 2019 12:21 pm

For investors who are past their working years and living off their portfolios, wealth income preservation is very important and unexpected inflation is major risk factor to wealth income preservation. The obvious choice for hedging unexpected inflation risk is inflation-linked bonds (TIPS). But there are some not-so-obvious considerations in deciding how to invest in TIPS and how much capital to allocate to them.

According to Vanguard, a good inflation hedge combines a strong correlation to inflation and a high "inflation beta" (volatility benchmarked to inflation). Here's why. Money invested in an asset with just a high correlation to inflation provides inflation protection for the money invested in that asset; but it does not provide protection for the rest of the portfolio. Investing in an asset with both high correlation and high inflation beta means that it's protection goes beyond the invested position and can help to protect the rest of the portfolio as well. This is a basic principal of portfolio diversification: the diversification benefit of an asset depends on both it's correlation and it's beta, or volatility.

The problem with TIPS is that there's no way to invest in them that provides both a high correlation to unexpected inflation and high beta.

A TIPs bond ladder with bonds held to maturity has a very high correlation of returns to inflation -- that's what they're designed to do. However, the returns have very low inflation beta. This means that a TIPS bond ladder does a good job of protecting the capital allocated from inflation, but does nothing to protect other investment assets from unexpected inflation.

The same is true for short-term TIPS index funds. According to Vanguard, the correlation of ST TIPS funds to inflation has been around 0.60, which offers decent inflation protection for the money invested in such a fund. But the inflation beta is very low, so the money allocated to ST TIPS fund does very little to protect the remaining assets in the portfolio from inflation.

Finally, we have TIPS funds with longer durations. This option has a higher inflation beta; however longer duration TIPS funds have a very low correlation of realized returns to inflation. Vanguard estimates that the correlation of the broad TIPs index with inflation is about 0.20 or less. This means that money invested in an intermediate to long term TIPS fund offers little protection from unexpected inflation to neither the invested position nor to the rest of the portfolio.

It would seem that in order to achieve a meaningful level of inflation protection from TIPS, a significant portion of one's wealth should be invested either in a maturing TIPS ladder or a ST TIPS fund. In both cases, the money invested will have significant protection which will shelter that portion of one's wealth from inflation risk. Small allocations to TIPs in any form would seem to offer very little protection from unexpected inflation, especially in the case of investing in TIPS fund with intermediate to long durations.

Seems to me TIPS are a good idea if you plan to put away a pretty significant amount in them by means of a TIPS ladder or ST TIPS fund to protect the invested capital from unexpected inflation. Otherwise?

You can read more here:

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
Last edited by CULater on Sun Sep 15, 2019 2:00 pm, edited 3 times in total.
On the internet, nobody knows you're a dog.

stlutz
Posts: 5466
Joined: Fri Jan 02, 2009 1:08 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by stlutz » Sun Sep 15, 2019 12:40 pm

CULater wrote:
Sun Sep 15, 2019 12:21 pm
For investors who are past their working years and living off their portfolios, wealth preservation is very important and unexpected inflation is major risk factor to wealth preservation.
Actually before you go any further the investor needs to clarify their reason for investing.

Wealth preservation is important for the person who is looking to pass their wealth along to somebody else or expects to have a very large one-time expense come up in the future.

Income preservation is important to the person who is living off of their portfolio. This person doesn't really care about the dollar value listed on their account statement at any one time. They care about the income they can draw from that portfolio.

These different approaches for what one wants to do with their money can lead to different approaches to fixed income allocation.

But in all cases, TIPS are not an inflation "hedge" in the way that gold is often considered to be.

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Sun Sep 15, 2019 12:43 pm

stlutz wrote:
Sun Sep 15, 2019 12:40 pm
CULater wrote:
Sun Sep 15, 2019 12:21 pm
For investors who are past their working years and living off their portfolios, wealth preservation is very important and unexpected inflation is major risk factor to wealth preservation.
Actually before you go any further the investor needs to clarify their reason for investing.

Wealth preservation is important for the person who is looking to pass their wealth along to somebody else or expects to have a very large one-time expense come up in the future.

Income preservation is important to the person who is living off of their portfolio. This person doesn't really care about the dollar value listed on their account statement at any one time. They care about the income they can draw from that portfolio.

These different approaches for what one wants to do with their money can lead to different approaches to fixed income allocation.

But in all cases, TIPS are not an inflation "hedge" in the way that gold is often considered to be.
Yes, I think that "income preservation" is a better more correct designation and I've made the edit to the original post.
On the internet, nobody knows you're a dog.

User avatar
Ben Mathew
Posts: 787
Joined: Tue Mar 13, 2018 11:41 am
Location: Seattle
Contact:

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Ben Mathew » Sun Sep 15, 2019 1:33 pm

Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)

User avatar
Doc
Posts: 9241
Joined: Sat Feb 24, 2007 1:10 pm
Location: Two left turns from Larry

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Doc » Sun Sep 15, 2019 1:48 pm

Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio.
Food for thought. Thanks.
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.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Sun Sep 15, 2019 2:00 pm

CULater wrote:
Sun Sep 15, 2019 12:21 pm
Finally, we have TIPS funds with longer durations. This option has a higher beta with respect to inflation; however longer duration TIPS funds have a very low correlation of returns to inflation.
This isn’t quite right, and the confusion likely stems from mismatching the units of time involved in making the comparison.

The return of a constant maturity TIPS portfolio will be a function of both realized unexpected inflation and changes in expected inflation. It’s protecting the investment against both, but Vanguard was only accounting for realized inflation.

Because of the methodology , the paper makes it easy to be misled to an inappropriate conclusion.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Sun Sep 15, 2019 2:03 pm

vineviz wrote:
Sun Sep 15, 2019 2:00 pm
CULater wrote:
Sun Sep 15, 2019 12:21 pm
Finally, we have TIPS funds with longer durations. This option has a higher beta with respect to inflation; however longer duration TIPS funds have a very low correlation of returns to inflation.
This isn’t quite right, and the confusion likely stems from mismatching the units of time involved in making the comparison.

The return of a constant maturity TIPS portfolio will be a function of both realized unexpected inflation and changes in expected inflation. It’s protecting the investment against both, but Vanguard was only accounting for realized inflation.

Because of the methodology , the paper makes it easy to be misled to an inappropriate conclusion.
I guess I'd need a more detailed explanation to grasp what you're saying here. Not an easy topic.
On the internet, nobody knows you're a dog.

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 2:04 pm

CULater wrote:
Sun Sep 15, 2019 12:21 pm
Seems to me TIPS are a good idea if you plan to put away a pretty significant amount in them by means of a TIPS ladder or ST TIPS fund to protect the invested capital from unexpected inflation.
In combination with SS benefits and any other non-portfolio income sources, I think that using TIPS in a sort of LMP approach is perfectly fine so as long as the resulting AA is reasonable. The rest of the portfolio (i.e. the 'risk' portfolio in LMP terms) could be invested as aggressively as the retiree wanted and be exclusively for discretionary spending.

But even for those who prefer a traditional AA approach, stocks are pretty resilient over the long-term at least to inflation, as Ben Mathew pointed out. As such, a portfolio of all stocks and TIPS (of an appropriate maturity) should do fine if confronted with unexpected inflation, at least for long-term investors.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 2:07 pm

CULater wrote:
Sun Sep 15, 2019 2:03 pm
vineviz wrote:
Sun Sep 15, 2019 2:00 pm
CULater wrote:
Sun Sep 15, 2019 12:21 pm
Finally, we have TIPS funds with longer durations. This option has a higher beta with respect to inflation; however longer duration TIPS funds have a very low correlation of returns to inflation.
This isn’t quite right, and the confusion likely stems from mismatching the units of time involved in making the comparison.

The return of a constant maturity TIPS portfolio will be a function of both realized unexpected inflation and changes in expected inflation. It’s protecting the investment against both, but Vanguard was only accounting for realized inflation.

Because of the methodology , the paper makes it easy to be misled to an inappropriate conclusion.
I guess I'd need a more detailed explanation to grasp what you're saying here. Not an easy topic.
I think that the point is that TIPS' real value will not be manifested unless unexpected inflation actually shows up. In the relatively brief existence of TIPS, there has not been significant unexpected inflation, so backtesting the correlation of TIPS to realized inflation isn't going to be very useful. It's akin to saying that because you didn't make a claim on your homeowner's insurance policy over the last 20 years, the policy wasn't very good.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Sun Sep 15, 2019 2:09 pm

There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
Equities, on the other hand, tend to cycle between periods of high positive and high negative beta—their effect is not persistent. Our earlier analysis showed a near-zero correlation, but the actual beta experience is inconsistent. In essence, equities will suffer from unexpected inflation at times, and at other times they may perform better. But a consistent inflation counter they are not.
On the internet, nobody knows you're a dog.

Broken Man 1999
Posts: 3484
Joined: Wed Apr 08, 2015 11:31 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Broken Man 1999 » Sun Sep 15, 2019 2:35 pm

I think Series I Savings Bonds do a good job with inflation, and they also protect some against deflation. As well, with I Bonds you don't get hit with phantom income.
Of course the main drawback with I Bonds is the small amount an investor can purchase, though there are ways to increase the amount using trusts.

I have about 15% of our portfolio bond holdings in I Bonds. We currently are withdrawing expenses from our retirement portfolio, so I cannot currently purchase I Bonds, as it wouldn't make sense to pay taxes on the withdrawals from what would be required to invest outside our tax-deferred accounts. Perhaps when we are doing RMDs in a few years I might start buying I Bonds again with any funds not used for expenses. I can play with the beneficiaries and set up the grandkids with some legacy outside the main estate.

I do like having an investment that protects against inflation, but I'm not a fan of TIPS.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 2:52 pm

CULater wrote:
Sun Sep 15, 2019 2:09 pm
There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
Equities, on the other hand, tend to cycle between periods of high positive and high negative beta—their effect is not persistent. Our earlier analysis showed a near-zero correlation, but the actual beta experience is inconsistent. In essence, equities will suffer from unexpected inflation at times, and at other times they may perform better. But a consistent inflation counter they are not.
The problem is not that stocks haven't been a good long-term inflation hedge. It's that stocks are just plain volatile, and you cannot count on them performing well at the same time that unexpected inflation shows up. U.S. stocks' real return from 2000-2009 was -2.73%, and that arguably had virtually nothing to do with inflation, which was a cumulative 22% over that same period, quite low by historic standards.

If you want consistent inflation protection, then get TIPS and I bonds. Nothing else is likely to meet that standard.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 2:53 pm

Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I do like having an investment that protects against inflation, but I'm not a fan of TIPS.
Why?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Broken Man 1999
Posts: 3484
Joined: Wed Apr 08, 2015 11:31 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Broken Man 1999 » Sun Sep 15, 2019 3:04 pm

willthrill81 wrote:
Sun Sep 15, 2019 2:53 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I do like having an investment that protects against inflation, but I'm not a fan of TIPS.
Why?
I don't see the attraction unless you want more holdings in inflation protected bonds than I Bonds could provide.

I don't hold bonds to protect against inflation, I believe our allocation of 50% equities protects us well enough.

I think I Bonds are more useful to ME. Others no doubt prefer TIPS.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 3:05 pm

Broken Man 1999 wrote:
Sun Sep 15, 2019 3:04 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:53 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I do like having an investment that protects against inflation, but I'm not a fan of TIPS.
Why?
I don't see the attraction unless you want more holdings in inflation protected bonds than I Bonds could provide.

I don't hold bonds to protect against inflation, I believe our allocation of 50% equities protects us well enough.
But since you can 'buy' inflation protection for your bonds at little or no cost, why wouldn't you do so?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

rich126
Posts: 944
Joined: Thu Mar 01, 2018 4:56 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by rich126 » Sun Sep 15, 2019 3:10 pm

Can someone explain and provides examples of “unexpected inflation”? Is it different from an unexpected drop in the stock market? And when was expected inflation?

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 3:21 pm

rich126 wrote:
Sun Sep 15, 2019 3:10 pm
Can someone explain and provides examples of “unexpected inflation”? Is it different from an unexpected drop in the stock market? And when was expected inflation?
The market has expectations of what inflation will be. These are already 'baked in' to the prices of nominal bonds, at least in theory. There are various ways of measuring the market's expectations of future inflation, such as the break-even point between nominal Treasury bonds and TIPS of equal maturity. If the actual (i.e. realized) inflation we experience is greater than this, then TIPS are expected to do better than nominal bonds. Conversely, if realized inflation is lower than the market's expectations, then nominal bonds will do better.

The late 1970s were a classic example of unexpected inflation, and nominal bonds were absolutely hammered. Intermediate-term Treasuries lost 29% of their inflation-adjusted value from January, 1977, to October, 1981. Long-term Treasuries lost 47% of their inflation-adjusted value over the same period.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Broken Man 1999
Posts: 3484
Joined: Wed Apr 08, 2015 11:31 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Broken Man 1999 » Sun Sep 15, 2019 3:34 pm

willthrill81 wrote:
Sun Sep 15, 2019 3:05 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 3:04 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:53 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I do like having an investment that protects against inflation, but I'm not a fan of TIPS.
Why?
I don't see the attraction unless you want more holdings in inflation protected bonds than I Bonds could provide.

I don't hold bonds to protect against inflation, I believe our allocation of 50% equities protects us well enough.
But since you can 'buy' inflation protection for your bonds at little or no cost, why wouldn't you do so?
Personal preference. I don't see the need to do so. And, since 1999 I have had no access to a 401k plan. I Bonds were (and are) an easy way to expand our tax-deferred space. That and our Vanguard Variable Annuity. And expand our tax-deferred space we did. Very much so. So I'm pretty happy with the I Bonds we hold.

The bulk of our remaining bond holdings are in treasury bond funds, short-term treasury index fund and intermediate-term treasury index fund. I do have some Total Bond Index I am slowly exiting from. Again, just a preference.

If 50% of our portfolio being in equities doesn't do a good enough job of protecting us from inflation, we have serious problems. Our retirement portfolio is large enough such that we don't need as much protection as perhaps other investors might. I can't say that I was such an astute investor to end up where we are, but here we are. I'm enjoying this bull market immensely. Perhaps at some point I might wish we had TIPS, but I haven't reached that point yet.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

Milo
Posts: 234
Joined: Thu Dec 27, 2007 7:24 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Milo » Sun Sep 15, 2019 3:36 pm

Perhaps this is why Vanguard has changed its Target Retirement funds' allocations from holding TIPS to holding ST TIPS.

User avatar
Horton
Posts: 390
Joined: Mon Jan 21, 2008 3:53 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Sun Sep 15, 2019 3:39 pm

TIPS in my opinion are the Toyota Camry of investment options - they provide exactly what they say they will provide...a stream of coupons and return of principal indexed by CPI, which can be used to provide income (in retirement) for a specified period of time.

If you want a sports car, then you need to look elsewhere. Don’t complain about the Camry’s 0-60 time.

The beauty of the floor/upside (LMP/RP) approach is that you buy a Camry and Corvette and use them for their respective purposes. (Substitute your favorite reliable car / sports car above as desired.) :beer
🏃 since 2005

pascalwager
Posts: 1565
Joined: Mon Oct 31, 2011 8:36 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by pascalwager » Sun Sep 15, 2019 4:02 pm

Milo wrote:
Sun Sep 15, 2019 3:36 pm
Perhaps this is why Vanguard has changed its Target Retirement funds' allocations from holding TIPS to holding ST TIPS.
ST TIPS are still TIPS. All maturities of TIPS are TIPS. The only difference is the duration/maturity.

Vanguard used ST TIPS rather than IT TIPS to reduce the overall fixed income duration for the income fund. I personally use the IT TIPS fund because I want a longer duration to better match my life expectancy.

User avatar
tc101
Posts: 3212
Joined: Tue Feb 20, 2007 3:18 pm
Location: Atlanta - Retired in 2004 at age 54

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by tc101 » Sun Sep 15, 2019 4:09 pm

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
My income stream is divided about equally between Stocks, Nominal bonds and Social Security. So I think I will be OK no matter what. I have never really clearly understood long term performance of TIPS, so until I do get around to doing more study, I will avoid what I don't understand.
. | The most important thing you should know about me is that I am not an expert.

pascalwager
Posts: 1565
Joined: Mon Oct 31, 2011 8:36 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by pascalwager » Sun Sep 15, 2019 4:18 pm

Broken Man 1999 wrote:
Sun Sep 15, 2019 3:34 pm
willthrill81 wrote:
Sun Sep 15, 2019 3:05 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 3:04 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:53 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I do like having an investment that protects against inflation, but I'm not a fan of TIPS.
Why?
I don't see the attraction unless you want more holdings in inflation protected bonds than I Bonds could provide.

I don't hold bonds to protect against inflation, I believe our allocation of 50% equities protects us well enough.
But since you can 'buy' inflation protection for your bonds at little or no cost, why wouldn't you do so?
Personal preference. I don't see the need to do so. And, since 1999 I have had no access to a 401k plan. I Bonds were (and are) an easy way to expand our tax-deferred space. That and our Vanguard Variable Annuity. And expand our tax-deferred space we did. Very much so. So I'm pretty happy with the I Bonds we hold.

The bulk of our remaining bond holdings are in treasury bond funds, short-term treasury index fund and intermediate-term treasury index fund. I do have some Total Bond Index I am slowly exiting from. Again, just a preference.

If 50% of our portfolio being in equities doesn't do a good enough job of protecting us from inflation, we have serious problems. Our retirement portfolio is large enough such that we don't need as much protection as perhaps other investors might. I can't say that I was such an astute investor to end up where we are, but here we are. I'm enjoying this bull market immensely. Perhaps at some point I might wish we had TIPS, but I haven't reached that point yet.

Broken Man 1999
As I recall, you have something like $5 million in stocks, so your unconcern with inflation is understandable. I only have $1.2 million in stocks and have no confidence in the likelihood of stocks keeping up with unexpected inflation; so I have 21% of portfolio in an IT TIPS fund and would like to have even more, but one of my accounts doesn't provide a TIPS fund.

Broken Man 1999
Posts: 3484
Joined: Wed Apr 08, 2015 11:31 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Broken Man 1999 » Sun Sep 15, 2019 4:25 pm

pascalwager wrote:
Sun Sep 15, 2019 4:18 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 3:34 pm
willthrill81 wrote:
Sun Sep 15, 2019 3:05 pm
Broken Man 1999 wrote:
Sun Sep 15, 2019 3:04 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:53 pm


Why?
I don't see the attraction unless you want more holdings in inflation protected bonds than I Bonds could provide.

I don't hold bonds to protect against inflation, I believe our allocation of 50% equities protects us well enough.
But since you can 'buy' inflation protection for your bonds at little or no cost, why wouldn't you do so?
Personal preference. I don't see the need to do so. And, since 1999 I have had no access to a 401k plan. I Bonds were (and are) an easy way to expand our tax-deferred space. That and our Vanguard Variable Annuity. And expand our tax-deferred space we did. Very much so. So I'm pretty happy with the I Bonds we hold.

The bulk of our remaining bond holdings are in treasury bond funds, short-term treasury index fund and intermediate-term treasury index fund. I do have some Total Bond Index I am slowly exiting from. Again, just a preference.

If 50% of our portfolio being in equities doesn't do a good enough job of protecting us from inflation, we have serious problems. Our retirement portfolio is large enough such that we don't need as much protection as perhaps other investors might. I can't say that I was such an astute investor to end up where we are, but here we are. I'm enjoying this bull market immensely. Perhaps at some point I might wish we had TIPS, but I haven't reached that point yet.

Broken Man 1999
As I recall, you have something like $5 million in stocks, so your unconcern with inflation is understandable. I only have $1.2 million in stocks and have no confidence in the likelihood of stocks keeping up with unexpected inflation; so I have 21% of portfolio in an IT TIPS fund and would like to have even more, but one of my accounts doesn't provide a TIPS fund.
My bold:

Ah, no. We do not have $5mil in our portfolio. I would love to have that much, but we do not. If the bull keeps running for a few more years, maybe, but not likely.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

dbr
Posts: 30806
Joined: Sun Mar 04, 2007 9:50 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by dbr » Sun Sep 15, 2019 4:58 pm

I think the technically complete answer is that for an all TIPS portfolio, then yes. Even then people get all tangled up regarding how to handle interest rate risk, reinvestment risk and so on. An LMP TIPS ladder is easy to understand in concept but may not be practical in reality. The other extreme of an inflation indexed SPIA is also easy to understand in concept but is not necessarily a recommended solution.

For a person holding stocks, bonds, and other things and having sources of income of different sorts, then probably owning some TIPS wouldn't function in the sense of a hedge.

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Sun Sep 15, 2019 6:25 pm

Broken Man 1999 wrote:
Sun Sep 15, 2019 2:35 pm
I think Series I Savings Bonds do a good job with inflation, and they also protect some against deflation. As well, with I Bonds you don't get hit with phantom income.
Of course the main drawback with I Bonds is the small amount an investor can purchase, though there are ways to increase the amount using trusts.

I have about 15% of our portfolio bond holdings in I Bonds. We currently are withdrawing expenses from our retirement portfolio, so I cannot currently purchase I Bonds, as it wouldn't make sense to pay taxes on the withdrawals from what would be required to invest outside our tax-deferred accounts. Perhaps when we are doing RMDs in a few years I might start buying I Bonds again with any funds not used for expenses. I can play with the beneficiaries and set up the grandkids with some legacy outside the main estate.

I do like having an investment that protects against inflation, but I'm not a fan of TIPS.

Broken Man 1999
I also like I-Bonds and so does Zvi Bodie. You have to start buying them early because of the annual limit and you can't buy them inside your tax-advantaged accounts. But they are superior to TIPS in several ways. As I was drilling down into this topic of inflation protection, I realized that I-Bonds won't exactly track inflation in the short term because the interest adjustments take place only every six months. So you'll have lagged tracking of inflation with I-Bonds. Maybe not a big deal, but if someone were liquidating I-Bonds on a continuous basis (e.g, monthly) for income and inflation was spiking up you could be selling bonds before you could collect the increased inflation rate on them. It would be nicer if that rate was adjusted more frequently, say monthly so your return matches the inflation rate more closely. TIPS have the same problem because they pay interest only every six months based on the adjusted principal. So the interest earned lags the inflation rate for those also.
On the internet, nobody knows you're a dog.

User avatar
dodecahedron
Posts: 4822
Joined: Tue Nov 12, 2013 12:28 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by dodecahedron » Sun Sep 15, 2019 6:57 pm

CULater wrote:
Sun Sep 15, 2019 6:25 pm
TIPS have the same problem because they pay interest only every six months based on the adjusted principal. So the interest earned lags the inflation rate for those also.
Actually TIPS don´t have quite the same lag problem as I bonds, because they are traded in the secondary market. If there is unexpected inflation, one expects that (ceteris paribus, all other things being equal) the nominal market price of TIPS will immediately be bid up in anticipation of the anticipated increased nominal return.

rascott
Posts: 1090
Joined: Wed Apr 15, 2015 10:53 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by rascott » Sun Sep 15, 2019 9:51 pm

willthrill81 wrote:
Sun Sep 15, 2019 2:52 pm
CULater wrote:
Sun Sep 15, 2019 2:09 pm
There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
Equities, on the other hand, tend to cycle between periods of high positive and high negative beta—their effect is not persistent. Our earlier analysis showed a near-zero correlation, but the actual beta experience is inconsistent. In essence, equities will suffer from unexpected inflation at times, and at other times they may perform better. But a consistent inflation counter they are not.
The problem is not that stocks haven't been a good long-term inflation hedge. It's that stocks are just plain volatile, and you cannot count on them performing well at the same time that unexpected inflation shows up. U.S. stocks' real return from 2000-2009 was -2.73%, and that arguably had virtually nothing to do with inflation, which was a cumulative 22% over that same period, quite low by historic standards.

If you want consistent inflation protection, then get TIPS and I bonds. Nothing else is likely to meet that standard.
I saw that equities had basically 1.5% real returns from 2000-2017. Maybe a little better than that now.... but this century has been a pretty terrible time to be an equity investor. On par with the '65-'85 time period.

https://www.marketwatch.com/story/the-s ... 2017-09-22

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 9:56 pm

rascott wrote:
Sun Sep 15, 2019 9:51 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:52 pm
CULater wrote:
Sun Sep 15, 2019 2:09 pm
There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
Equities, on the other hand, tend to cycle between periods of high positive and high negative beta—their effect is not persistent. Our earlier analysis showed a near-zero correlation, but the actual beta experience is inconsistent. In essence, equities will suffer from unexpected inflation at times, and at other times they may perform better. But a consistent inflation counter they are not.
The problem is not that stocks haven't been a good long-term inflation hedge. It's that stocks are just plain volatile, and you cannot count on them performing well at the same time that unexpected inflation shows up. U.S. stocks' real return from 2000-2009 was -2.73%, and that arguably had virtually nothing to do with inflation, which was a cumulative 22% over that same period, quite low by historic standards.

If you want consistent inflation protection, then get TIPS and I bonds. Nothing else is likely to meet that standard.
I saw that equities had basically 1.5% real returns from 2000-2017. Maybe a little better than that now.... but this century has been a pretty terrible time to be an equity investor. On par with the '65-'85 time period.
Real returns for U.S. over that period were 3.54%. Ex-U.S. was 1.67%.

Returns from 2010 through now have been much better, especially for the U.S. I don't know that it's really fair to say that this century has been bad for stocks, just the first decade.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

rascott
Posts: 1090
Joined: Wed Apr 15, 2015 10:53 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by rascott » Sun Sep 15, 2019 10:05 pm

willthrill81 wrote:
Sun Sep 15, 2019 9:56 pm
rascott wrote:
Sun Sep 15, 2019 9:51 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:52 pm
CULater wrote:
Sun Sep 15, 2019 2:09 pm
There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
Equities, on the other hand, tend to cycle between periods of high positive and high negative beta—their effect is not persistent. Our earlier analysis showed a near-zero correlation, but the actual beta experience is inconsistent. In essence, equities will suffer from unexpected inflation at times, and at other times they may perform better. But a consistent inflation counter they are not.
The problem is not that stocks haven't been a good long-term inflation hedge. It's that stocks are just plain volatile, and you cannot count on them performing well at the same time that unexpected inflation shows up. U.S. stocks' real return from 2000-2009 was -2.73%, and that arguably had virtually nothing to do with inflation, which was a cumulative 22% over that same period, quite low by historic standards.

If you want consistent inflation protection, then get TIPS and I bonds. Nothing else is likely to meet that standard.
I saw that equities had basically 1.5% real returns from 2000-2017. Maybe a little better than that now.... but this century has been a pretty terrible time to be an equity investor. On par with the '65-'85 time period.
Real returns for U.S. over that period were 3.54%. Ex-U.S. was 1.67%.

Returns from 2010 through now have been much better, especially for the U.S. I don't know that it's really fair to say that this century has been bad for stocks, just the first decade.
What is it through today? Either way, it's certainly been "below-average". Not bad for accumulators.... but rough for an equity holding retiree. Fixed income has helped buoy them, most certainly. But can it really be expected to going forward? Much harder to see.

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Sun Sep 15, 2019 10:07 pm

rascott wrote:
Sun Sep 15, 2019 10:05 pm
willthrill81 wrote:
Sun Sep 15, 2019 9:56 pm
rascott wrote:
Sun Sep 15, 2019 9:51 pm
willthrill81 wrote:
Sun Sep 15, 2019 2:52 pm
CULater wrote:
Sun Sep 15, 2019 2:09 pm
There is a persistent myth that equities are the antidote to long term inflation, but anyone who actually read the Vanguard white paper saw this:
The problem is not that stocks haven't been a good long-term inflation hedge. It's that stocks are just plain volatile, and you cannot count on them performing well at the same time that unexpected inflation shows up. U.S. stocks' real return from 2000-2009 was -2.73%, and that arguably had virtually nothing to do with inflation, which was a cumulative 22% over that same period, quite low by historic standards.

If you want consistent inflation protection, then get TIPS and I bonds. Nothing else is likely to meet that standard.
I saw that equities had basically 1.5% real returns from 2000-2017. Maybe a little better than that now.... but this century has been a pretty terrible time to be an equity investor. On par with the '65-'85 time period.
Real returns for U.S. over that period were 3.54%. Ex-U.S. was 1.67%.

Returns from 2010 through now have been much better, especially for the U.S. I don't know that it's really fair to say that this century has been bad for stocks, just the first decade.
What is it through today?
No, the returns I quoted were from 2000-2017, straight from Portfolio Visualizer.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

greenhill
Posts: 52
Joined: Sun Aug 06, 2017 4:27 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by greenhill » Mon Sep 16, 2019 3:23 am

Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
High (unexpected) inflation tends to hurt stocks, for example during 1970s and 1916-1920. The interest rate usually go up along with inflation, thus suppressing the P/E ratio of stocks.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Mon Sep 16, 2019 7:03 am

greenhill wrote:
Mon Sep 16, 2019 3:23 am
High (unexpected) inflation tends to hurt stocks, for example during 1970s and 1916-1920. The interest rate usually go up along with inflation, thus suppressing the P/E ratio of stocks.
Valuations are always the wild card with equities: stocks have certainly had years of severely negative real returns.

Over periods of ten years or more, however, it's historically been incredibly rare for stocks have lower real returns than nominal bonds. This has been especially true if the stock portfolio is well-diversified (e.g. >20% in international, SCV, etc.).

On the other hand I don't think it's reasonable that anyone should count on stocks to provide a steady stream of income (real or otherwise) over any short-run period.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
nisiprius
Advisory Board
Posts: 39463
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by nisiprius » Mon Sep 16, 2019 7:54 am

A TIPS contracts to pay out precisely-known-in-advance inflation-adjusted ("real") amounts of money on specific dates, most of it at maturity. That is, measured in real terms, you know the exact amount you will be getting on specific future dates. Since most of it is paid out at maturity, it is at the very least a way to preserve purchasing power--precisely.

For a dollar investor, as far as I know only two things do this: TIPS and series I savings bonds. Nothing else. Nothing.

You can argue that the Treasury might default, or that you don't trust the CPI as a measure of purchasing power, or that that isn't what you mean by a "hedge." OK. (People also raise phony issues--e.g. income tax is levied on nominal return, not real return, as if that weren't true for all investments). People also point that the short-term correlation between fluctuations in CPI and fluctuations in the market value of TIPS isn't high, which is just another day of saying that since TIPS were created, fluctuations in CPI have been very small and their effect has been less than that of the effect of interest rate fluctuations.

But everything else, everything that isn't TIPS or series I savings bonds, is just a rough sorta-kinda tendency. Indeed, most things have a sorta-kinda tendency to track inflation over suitably long time periods. Nominal bonds and physical cash are the exception, not the rule. Thus almost everything can be claimed as an inflation hedge. But it's just a "tendency" and nobody is going to promise you anything or even give you a good apology if it fails.

Salaries follow inflation--quite accurately if you look at averages and step back from the chart and squint. If it's good enough for something to "tend to" follow inflation, then nobody with a job needs any inflation hedge. Your salary will just keep up. Mostly. Sorta-kinda. Statistically. If you are contributing a percentage to a 401(k) your 401(k) will keep up, automatically, almost regardless of what it's invested in--because your contributions will grow with inflation.

Stocks? Benjamin Graham wrote in 1973 that "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."

Real estate? The four centuries of data in the Herengracht data set show a crash in prices that stayed down for over a century before recovering.

Gold? Some of the most severe increases in the CPI ever recorded in the United States occurred post World War I despite the dollar being backed by gold at the time.

Real assets? Compare:
blue, PCRIX, PIMCO Commodity RealReturn Strategy fund since inception;
red; VIPSX, Vanguard [Treasury] Inflation-Protected Securities. Inflation-adjusted.

Well, OK, the commodities fund did eke out a microscopic positive real return, if you didn't mind the huge fluctuations in between, but... still...

Source
You'll have to re-check "logarithmic" and "inflation adjusted" if you use that "source" link.

Image

If by inflation protection you mean "highest possible real return, high enough to beat inflation despite fluctuations," that's not inflation hedging, that's just "high return."

But if by "inflation hedge" you mean known-in-advance accurate direct tracking of the CPI, not just a market-mediated tendency, then TIPS and series I savings bonds are unique. Nothing else does what they do.
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.

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Mon Sep 16, 2019 8:17 am

For a dollar investor, as far as I know only two things do this: TIPS and series I savings bonds. Nothing else. Nothing.
I believe you did say this, but it's worth emphasizing that TIPS preserve purchasing power best only when held as individual bonds to maturity. If you hold them in a TIPS fund, not reliably so. I-Bonds can only be held as individual securities. And, to reiterate one of the points of the original post, only the money thereby invested is "protected" or "hedged", not one's entire portfolio as some people might assume. Investing in a TIPs ladder or I-Bonds is the equivalent of setting aside a portion of one's portfolio and putting it into a savings account that pays interest that is adjusted by the CPI. Done this way, it is not an investment asset as much as it is an income source and should be treated as such.
On the internet, nobody knows you're a dog.

JBTX
Posts: 5539
Joined: Wed Jul 26, 2017 12:46 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by JBTX » Mon Sep 16, 2019 8:31 am

Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
The reality is high inflation tends to ravage stocks. Your PEs fall due to higher nominal discount rate. In terms of dividend growth discount model, real discount rates likely rise due to the uncertainty of nominal rates. One only has to look at the 70s to see the impact. Also inflation just brings a higher level of uncertainty to the economy in general.

A modest gradual expected inflation increase may mostly avoid this, but I highly doubt you keep 30 PES with 10% inflation. Ive always thought the stocks are an inflation hedge argument is greatly exaggerated.

JackoC
Posts: 1009
Joined: Sun Aug 12, 2018 11:14 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by JackoC » Mon Sep 16, 2019 9:31 am

JBTX wrote:
Mon Sep 16, 2019 8:31 am
Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
The reality is high inflation tends to ravage stocks. Your PEs fall due to higher nominal discount rate. In terms of dividend growth discount model, real discount rates likely rise due to the uncertainty of nominal rates. One only has to look at the 70s to see the impact. Also inflation just brings a higher level of uncertainty to the economy in general.

A modest gradual expected inflation increase may mostly avoid this, but I highly doubt you keep 30 PES with 10% inflation. Ive always thought the stocks are an inflation hedge argument is greatly exaggerated.
I agree, blanket classification of stocks under 'unexpected inflation helps' is highly questionable if you look at financial history lots of places but including the US in the last prolonged bout where inflation tended higher than expected, mid 1960's to early 1980's.

High inflation tends to be unstable. So while in simplistic theory companies could just correct for it in their planning, pricing and investment, that's not how it really works above a certain inflation level. Instead there's an extra deadweight loss to the uncertainty. Plus some markets (labor and retail goods) are seriously affected by money illusion. The mass public does not interpret significant inflation correctly even when it's stable, wrongly feeling that nominal $ outcomes have any importance, making those markets less efficient. High and therefore generally less stable inflation in (non-simplistic) theoretical terms should make companies less valuable, and that seems to actually happen in the real world.

Inflation higher than a certain level. But now, as has been discussed in recent threads on TIPS valuations, that market seems to believe that 'unexpected' inflation would most likely be a still generally healthy level, where real growth prospects improved relative to the general global malaise that has prevailed, thus good for stocks. The market seems to give a low likelihood to inflation high enough to bring back the effects discussed above which are bad for stocks. And OTOH the market seems to believe that even lower inflation/deflation and deepening funk is a real risk. That's why some analytical models now say the 'inflation insurance premium' is negative, that investors give up yield in *nominal* bonds not TIPS to get the positive reaction of higher real returns if inflation falls. The previous assumption is that premium would always be the other way around, you'd have to accept less expected return from TIPS to get away from the drop in real returns that happens to nominal bonds when inflation goes up.

So seems to me that on a longer term basis, where everything is highly uncertain, TIPS can be attractive. Since there's time for the 1960's-80's situation to possibly return: high enough inflation to expose the vulnerability of stocks to high inflation. In the near term say to 5 yrs, a burst of damagingly high inflation might be viewed as unlikely enough to ignore TIPS. Again in the near term it seems a likely bump up in inflation would be highly correlated with a bump up in global growth prospects (commodity inflation due to demand in EM's, that kind of thing) and not bad or even good for stocks. However the market knows this, and TIPS expected returns and inflation breakevens make nominal treasuries a pretty grim prospect as investment now IMO. 'Sticky' 5 yr CD yields still around 3%, highest, seem to me clearly superior now to nominal treasuries or TIPS, for money you can tie up for 5 yrs. Not as extremely so as a couple of weeks ago at the recent bottom of treas rates, but still.

User avatar
Svensk Anga
Posts: 600
Joined: Sun Dec 23, 2012 5:16 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Svensk Anga » Mon Sep 16, 2019 10:19 am

One could make the case that when TIPS were new and had 3-4% coupon rates, they did hedge more than their own value. For the last decade, when we struggled to find any real yield at all, not so much.

A TIPS with a high coupon rate will return your inflation adjusted principal at maturity. In addition, especially if inflation spikes up, it will deliver a growing stream of income that could offset losses elsewhere in the portfolio, a hedge, although a mild one. If you mark your TIPS to market, maybe this does not hold up, but if you hold individual TIPS to maturity you do get your real principal back.

Try this with a ladder of nominal bonds and in an inflation spike, you get an ever shrinking stream of real coupon payments and at maturity, your inflation impaired principal back.

garlandwhizzer
Posts: 2512
Joined: Fri Aug 06, 2010 3:42 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by garlandwhizzer » Mon Sep 16, 2019 12:47 pm

The Vanguard paper that CULater lists in his post IMO gives an excellent analysis of protection from unexpected inflation. ST TIPs, unlike nominal bonds, preserve real purchasing power in the face of inflation, whether it is expected or unexpected. ST TIPS also provide the reduced risk/volatility relative to equity that is the key role for bonds in a portfolio. Commodities on the other hand tend to be very volatile and have very low close to zero expected long term returns, but with inflation, expected or unexpected especially if severe, they can produce outsized positive real gains thus making a substantial impact on overall portfolio returns in this circumstance. Both ST TIPS and commodities have low expected real long term returns. Inflation protection doesn't come free of charge. It appears to me that the Vanguard ST TIPS fund at current yields (0.46% real) seems to me to me to offer inflation protection free of charge or even better, ST Treasury Fund (1.54% nominal). The breakeven inflation rate cooked into these numbers is 1.08%, considerably lower than current inflation (1.91%).

Garland Whizzer

User avatar
Ben Mathew
Posts: 787
Joined: Tue Mar 13, 2018 11:41 am
Location: Seattle
Contact:

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Ben Mathew » Mon Sep 16, 2019 1:55 pm

greenhill wrote:
Mon Sep 16, 2019 3:23 am
Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
High (unexpected) inflation tends to hurt stocks, for example during 1970s and 1916-1920. The interest rate usually go up along with inflation, thus suppressing the P/E ratio of stocks.
The real interest rate should not be affected by inflation if all prices adjust relatively quickly and painlessly. Prices of course don't always adjust quickly and painlessly, so there are indirect pathways through which the real economy is affected. The problem though is that these indirect pathways are unreliable and might behave differently each time around. It's important to note that what happened in the 1970s was unusual. The prevailing idea at the time was that deficit spending and inflation should lead to economic growth and boom times. The opposite happened. In the Keynes vs Friedman debate, it was a win for Friedman.

One can also find situations where deflation is linked to poor economic growth.

There is no strong a priori connection between long term inflation and long run economic growth and stock returns. In the long run, prices adjust and the real economy tends to be money neutral. In the short run, all sorts of things can happen, but the direction and magnitude of the relationship is not clear enough to warrant hedging, IMO.
Last edited by Ben Mathew on Mon Sep 16, 2019 4:23 pm, edited 1 time in total.

JackoC
Posts: 1009
Joined: Sun Aug 12, 2018 11:14 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by JackoC » Mon Sep 16, 2019 2:04 pm

garlandwhizzer wrote:
Mon Sep 16, 2019 12:47 pm
Inflation protection doesn't come free of charge. It appears to me that the Vanguard ST TIPS fund at current yields (0.46% real) seems to me to me to offer inflation protection free of charge or even better, ST Treasury Fund (1.54% nominal). The breakeven inflation rate cooked into these numbers is 1.08%, considerably lower than current inflation (1.91%).
That's the thing. Lately 'inflation protection' does appear to come free of charge or you even get paid to accept it. Again the reason for that would seem to be market's perception that 'unexpected inflation' will still likely be moderate inflation that correlates with the world economy getting out of its growth funk hence also good for stocks; not high/uncertain inflation/stagflation which hurts stock returns as in late 1960's-early 80's. And OTOH the market sees even lower inflation/deflation as a serious risk to stocks, the economic environment accompanying that I mean, in which case nominal bond real returns would go up more than TIPS returns would*. In that case it makes sense the 'inflation insurance premium' would be negative or IOW 'insurance' is a misnomer. It's a risk premium based on correlations. If the correlations change sign so can the sign of the premium.

*TIPS real returns start to rise when there is deflation in total over the life of the bond since it can't be redeemed for less than the initial nominal face amount. But in between low inflation and zero TIPS real return is constant where nominal bond real return rises, and for seasoned TIPS issues with index factor already greater than 1, deflation over the rest of the bond's life doesn't necessarily hit the floor on redemption amount.

User avatar
Ben Mathew
Posts: 787
Joined: Tue Mar 13, 2018 11:41 am
Location: Seattle
Contact:

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Ben Mathew » Mon Sep 16, 2019 2:18 pm

JackoC wrote:
Mon Sep 16, 2019 9:31 am
JBTX wrote:
Mon Sep 16, 2019 8:31 am
Ben Mathew wrote:
Sun Sep 15, 2019 1:33 pm
Stocks are claims on the real assets of the business, and so are naturally protected from inflation. In fact, since companies usually take on nominal debt, stocks should in theory be helped by unexpectedly high inflation. So hedging against inflation for stocks could potentially make things worse.

Nominal bonds are subject to inflation risk. If you replace all nominal bonds with TIPS, then inflation isn't really much of a problem for your portfolio. If you have a mortgage, that could make inflation a good thing.

Many investors might be in a position where unexpected inflation will help, not hurt, the portfolio. Exercise caution when trying to hedge against inflation, because you might already be overhedged depending on your portfolio.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage

UNEXPECTED INFLATION HURTS
Nominal bonds

NEUTRAL TO INFLATION
Inflation indexed bonds (TIPS)
Real annuities, including social security
Real assets (companies that have no debt)
The reality is high inflation tends to ravage stocks. Your PEs fall due to higher nominal discount rate. In terms of dividend growth discount model, real discount rates likely rise due to the uncertainty of nominal rates. One only has to look at the 70s to see the impact. Also inflation just brings a higher level of uncertainty to the economy in general.

A modest gradual expected inflation increase may mostly avoid this, but I highly doubt you keep 30 PES with 10% inflation. Ive always thought the stocks are an inflation hedge argument is greatly exaggerated.
I agree, blanket classification of stocks under 'unexpected inflation helps' is highly questionable if you look at financial history lots of places but including the US in the last prolonged bout where inflation tended higher than expected, mid 1960's to early 1980's.

High inflation tends to be unstable. So while in simplistic theory companies could just correct for it in their planning, pricing and investment, that's not how it really works above a certain inflation level. Instead there's an extra deadweight loss to the uncertainty. Plus some markets (labor and retail goods) are seriously affected by money illusion. The mass public does not interpret significant inflation correctly even when it's stable, wrongly feeling that nominal $ outcomes have any importance, making those markets less efficient. High and therefore generally less stable inflation in (non-simplistic) theoretical terms should make companies less valuable, and that seems to actually happen in the real world.
All of this is correct, but would also apply to a deflationary shock. The mechanism you are describing is a real shock to the real economy caused by unstable monetary policies. Large and unexpected deflation would be just as bad as a large and unexpected inflation. So it's not inflation that's the problem. It's the instability and uncertainty caused by unstable prices. The long run relationship between the real economy and inflation is close enough to neutral. The short run relationship is complicated enough that hedging stocks against inflation can lead to a worse outcome than just leaving it alone.

To highlight how complicated the relationship between short term inflation and growth is, note that what happened in the 1970s was unusual, and was a surprise to most economists at the time. The prevailing Keynesian model said that deficit spending and inflation would lead to growth. The unexpected events of the 1970s ("stagflation"), led to this idea being reconsidered, but never really going away. Trying to hedge stocks against inflation in light of such a tenuous and complicated relationship where we aren't even certain of the direction let alone the magnitude, seems to me to be a bad idea. My feeling is that the assumption of long run money neutrality, while not exactly right, is good enough for long term investing.

If unexpected inflation or deflation is small and accrues slowly over time, then stocks will be okay, even if the total inflation or deflation over a lifetime is large. If unexpected inflation or deflation comes in large and destabilizing bouts, the real economy and stocks will probably take a hit. It's part of the risk we have to take with stocks. I don't see a good way to get rid of it without potentially making things worse.
Last edited by Ben Mathew on Mon Sep 16, 2019 4:33 pm, edited 1 time in total.

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Mon Sep 16, 2019 4:14 pm

pascalwager wrote:
Sun Sep 15, 2019 4:02 pm
Milo wrote:
Sun Sep 15, 2019 3:36 pm
Perhaps this is why Vanguard has changed its Target Retirement funds' allocations from holding TIPS to holding ST TIPS.
ST TIPS are still TIPS. All maturities of TIPS are TIPS. The only difference is the duration/maturity.

Vanguard used ST TIPS rather than IT TIPS to reduce the overall fixed income duration for the income fund. I personally use the IT TIPS fund because I want a longer duration to better match my life expectancy.
I don't really understand this strategy, perhaps you could explain it to me. What is special about matching bond duration to your life expectancy (which this doesn't do anyway unless your life expectance is about 7 years)? You are presumably withdrawing money from your income portfolio all along and an IT TIPs fund has higher volatility and provides less predictable returns because of term risk. Wouldn't it be better to match duration more closely to the timing of your withdrawals, which is what a ST TIPS fund does better than a longer duration fund. I don't get it???
On the internet, nobody knows you're a dog.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Mon Sep 16, 2019 5:12 pm

CULater wrote:
Mon Sep 16, 2019 4:14 pm
pascalwager wrote:
Sun Sep 15, 2019 4:02 pm
Milo wrote:
Sun Sep 15, 2019 3:36 pm
Perhaps this is why Vanguard has changed its Target Retirement funds' allocations from holding TIPS to holding ST TIPS.
ST TIPS are still TIPS. All maturities of TIPS are TIPS. The only difference is the duration/maturity.

Vanguard used ST TIPS rather than IT TIPS to reduce the overall fixed income duration for the income fund. I personally use the IT TIPS fund because I want a longer duration to better match my life expectancy.
I don't really understand this strategy, perhaps you could explain it to me. What is special about matching bond duration to your life expectancy (which this doesn't do anyway unless your life expectance is about 7 years)? You are presumably withdrawing money from your income portfolio all along and an IT TIPs fund has higher volatility and provides less predictable returns because of term risk. Wouldn't it be better to match duration more closely to the timing of your withdrawals, which is what a ST TIPS fund does better than a longer duration fund. I don't get it???
To a first-order approximation for an investor on their first day of retirement, life expectancy and investment horizon are so closely linked that - with some entirely reasonable assumptions - they can be considered to be equivalent.

Because in most cases an individual investor should not, without relying on the risk pooling of an annuity, allocate precisely to their actuarial life expectancy they should probably set their withdrawal and allocation plans assuming that they live longer than average. So even an investor who has no desire to leave a bequest but does have a desire to not be broke before they die, effectively has an investment horizon longer than their life expectancy.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Northern Flicker
Posts: 4926
Joined: Fri Apr 10, 2015 12:29 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Northern Flicker » Mon Sep 16, 2019 5:41 pm

TIPS do not hedge a portfolio from inflation. They are bonds that hedge themselves from inflation.
Index fund investor since 1987.

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Mon Sep 16, 2019 6:17 pm

Northern Flicker wrote:
Mon Sep 16, 2019 5:41 pm
TIPS do not hedge a portfolio from inflation. They are bonds that hedge themselves from inflation.
That certainly seems to be the case.

Gold would appear to me to have been a better inflation hedge. The correlation between gold's return and CPI since 1972 has been .50. Even since 2000, when inflation has been very low, the correlation has still been .41. But gold has been even more volatile than stock, so it's not going to qualify as a consistent inflation hedge.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

pascalwager
Posts: 1565
Joined: Mon Oct 31, 2011 8:36 pm

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by pascalwager » Mon Sep 16, 2019 9:39 pm

CULater wrote:
Mon Sep 16, 2019 4:14 pm
pascalwager wrote:
Sun Sep 15, 2019 4:02 pm
Milo wrote:
Sun Sep 15, 2019 3:36 pm
Perhaps this is why Vanguard has changed its Target Retirement funds' allocations from holding TIPS to holding ST TIPS.
ST TIPS are still TIPS. All maturities of TIPS are TIPS. The only difference is the duration/maturity.

Vanguard used ST TIPS rather than IT TIPS to reduce the overall fixed income duration for the income fund. I personally use the IT TIPS fund because I want a longer duration to better match my life expectancy.
I don't really understand this strategy, perhaps you could explain it to me. What is special about matching bond duration to your life expectancy (which this doesn't do anyway unless your life expectance is about 7 years)? You are presumably withdrawing money from your income portfolio all along and an IT TIPs fund has higher volatility and provides less predictable returns because of term risk. Wouldn't it be better to match duration more closely to the timing of your withdrawals, which is what a ST TIPS fund does better than a longer duration fund. I don't get it???
I'm 77. My life expectancy is only 10 years, so 7 years is, perhaps, a reasonable approximation. I don't have easy access to longer term TIPS funds.

A ST TIPS fund might be fine for the first two or three years--providing lower interest rate risk--but thereafter introduces higher reinvestment risk. So, how can ST TIPS be a longer term strategy? By themselves, ST TIPS might be suitable for an 85-year old, but I'm not there yet.

Another bond fund strategy might be to divide the investment horizon by two to determine the overall bond funds duration in order to balance the two types of risk over the entire period as an average. Someone here, more than once, has promoted that strategy:

Investment horizon (years) / 2 = overall bond funds duration (years)*

*This would apply to a retiree making regular withdrawals.

User avatar
Topic Author
CULater
Posts: 2323
Joined: Sun Nov 13, 2016 10:59 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Mon Sep 16, 2019 10:05 pm

I can understand buying an individual bond with a maturity date based on some particular target date in order to meet a liability on that date. I just don't get buying a bond fund with a duration based on some date (such as life expectancy) because there's really no liability target date. If there were, I'd just buy an individual bond. What difference does it make? Why shouldn't I own a long term bond fund with an 18-year duration even if I'm 80 with an actuarial life expectance of 5 years? Heck, I could live for 20 years for all I know. But if the purpose of my TIPs bond fund is to provide an inflation-protected income stream, then I really ought to own a ST TIPs fund because it's returns actually closely track the inflation rate, while longer-duration TIPs fund don't, as pointed out in previous posts.
On the internet, nobody knows you're a dog.

Northern Flicker
Posts: 4926
Joined: Fri Apr 10, 2015 12:29 am

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Northern Flicker » Mon Sep 16, 2019 11:03 pm

willthrill81 wrote:
Mon Sep 16, 2019 6:17 pm
Northern Flicker wrote:
Mon Sep 16, 2019 5:41 pm
TIPS do not hedge a portfolio from inflation. They are bonds that hedge themselves from inflation.
That certainly seems to be the case.

Gold would appear to me to have been a better inflation hedge. The correlation between gold's return and CPI since 1972 has been .50. Even since 2000, when inflation has been very low, the correlation has still been .41. But gold has been even more volatile than stock, so it's not going to qualify as a consistent inflation hedge.
Gold also has a zero real expected return so over long periods it has even less to offer as an inflation hedge beyond hedging itself compared to TIPS (as long as TIPS have a positive real yield).
Index fund investor since 1987.

User avatar
willthrill81
Posts: 13969
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Mon Sep 16, 2019 11:20 pm

Northern Flicker wrote:
Mon Sep 16, 2019 11:03 pm
willthrill81 wrote:
Mon Sep 16, 2019 6:17 pm
Northern Flicker wrote:
Mon Sep 16, 2019 5:41 pm
TIPS do not hedge a portfolio from inflation. They are bonds that hedge themselves from inflation.
That certainly seems to be the case.

Gold would appear to me to have been a better inflation hedge. The correlation between gold's return and CPI since 1972 has been .50. Even since 2000, when inflation has been very low, the correlation has still been .41. But gold has been even more volatile than stock, so it's not going to qualify as a consistent inflation hedge.
Gold also has a zero real expected return so over long periods it has even less to offer as an inflation hedge beyond hedging itself compared to TIPS (as long as TIPS have a positive real yield).
But despite being a yellow metal that doesn't produce dividends or interest, it's outperformed stocks and bonds this century. Just saying. :wink:
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Post Reply