Are TIPS really a good inflation hedge? Pros and Cons

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

Post by FIREchief » Mon Sep 16, 2019 11:29 pm

CULater wrote:
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.
I "just don't get" buying a TIPS fund when owning individual TIPS that mature when I want them to is so darned easy (and free). Why pay a manager an ER to buy and sell TIPS with no control (by me) over the overall duration? :confused
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Mon Sep 16, 2019 11:30 pm

FIREchief wrote:
Mon Sep 16, 2019 11:29 pm
CULater wrote:
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.
I "just don't get" buying a TIPS fund when owning individual TIPS that mature when I want them to is so darned easy (and free). Why pay a manager an ER to buy and sell TIPS with no control (by me) over the overall duration? :confused
Even greater ease and access are the only reasons I can think of. But I agree with you that if can, buying individual TIPS in lieu of a fund is the way to go.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by pascalwager » Tue Sep 17, 2019 3:22 am

CULater wrote:
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.
All TIPS, regardless of term length, receive the same inflation rate adjustment as far as I know, every six months.

I'm not doing liability matching as you seem to be doing. I'm taking a total return approach for making redemptions from a risk portfolio which contains both stocks and bonds.

You seem to be ignoring reinvestment risk with ST TIPS. But If you're strongly convinced that interest rates are only going to rise, then ST makes more sense. I don't have that conviction, so I have no incentive to bet on ST TIPS.

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

Post by CULater » Tue Sep 17, 2019 8:02 am

pascalwager wrote:
Tue Sep 17, 2019 3:22 am
CULater wrote:
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.
All TIPS, regardless of term length, receive the same inflation rate adjustment as far as I know, every six months.

I'm not doing liability matching as you seem to be doing. I'm taking a total return approach for making redemptions from a risk portfolio which contains both stocks and bonds.

You seem to be ignoring reinvestment risk with ST TIPS. But If you're strongly convinced that interest rates are only going to rise, then ST makes more sense. I don't have that conviction, so I have no incentive to bet on ST TIPS.
As mentioned upthread, Vanguard uses ST TIPs in it's target funds. The allocation to ST TIPS is introduced at retirement (presumably about age 65) and reaches a level of 16.7% in their Target Retirement Income Fund by age 70. I suggest there's a reason they use ST TIPS and I suspect it's for the reason I've mentioned - ST TIPs actually function as a better inflation hedge than TIPs of longer duration. The higher interest from longer duration TIPs is not as important as the linkage of returns to inflation for a retirement income portfolio. If you are using TIPs and if you are in the income stage of taking withdrawals from your retirement portfolio that seems like the correct use of TIPs, IMO. I don't see the sense in trying to match fund duration to some guesstimate of life expectancy - TIPs operate differently from nominals since their purpose is to provide some inflation protection. The optimal way to do that is either by using a maturing TIPs ladder or a ST TIPs fund. Using longer duration TIPs funds introduces more interest rate risk into your portfolio returns. If you want interest rate risk, take it with nominals where you're getting paid more to do it, and use TIPS to protect from inflationary spikes. That appears to be Vanguard's strategy, as the TRIF also holds nominals.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 8:34 am

CULater wrote:
Tue Sep 17, 2019 8:02 am
Using longer duration TIPs funds introduces more interest rate risk into your portfolio returns.
This is backwards. The point of matching bond duration to investment horizon is to reduce interest rate risk.

In other words, using short-term TIPS when you have a long-term investment horizon doesn't decrease your interest rate risk: it INCREASES it.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 9:00 am

CULater wrote:
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.
You may want to refer back to the two threads you started last year on this topic.

viewtopic.php?f=10&t=240325&p=3768840&h ... r#p3768840

viewtopic.php?f=10&t=263164&p=4199771&h ... r#p4199771

BobK provides numerous explanations.

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

Post by CULater » Tue Sep 17, 2019 9:10 am

vineviz wrote:
Tue Sep 17, 2019 8:34 am
CULater wrote:
Tue Sep 17, 2019 8:02 am
Using longer duration TIPs funds introduces more interest rate risk into your portfolio returns.
This is backwards. The point of matching bond duration to investment horizon is to reduce interest rate risk.

In other words, using short-term TIPS when you have a long-term investment horizon doesn't decrease your interest rate risk: it INCREASES it.
This sounds backward. The point of owning short duration bonds is to decrease interest rate risk, not increase it. The longer the duration of the bond fund, the more term risk it has. Check Portfolio Visualizer.

You seem to be talking about immunization, which is matching loan duration to the duration of liabilities. Single point immunization means that there is a single target date on which liabilities are due and you would need to dynamically manage bond duration to do that. If liabilities are represented as a stream, then the bond portfolio must include bonds with a range of durations that parallel the stream of liabilities. Simply investing in one fund with a duration based on guesstimated life expectancy is a long way from this.

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

Post by Horton » Tue Sep 17, 2019 9:28 am

CULater wrote:
Tue Sep 17, 2019 9:10 am
vineviz wrote:
Tue Sep 17, 2019 8:34 am
CULater wrote:
Tue Sep 17, 2019 8:02 am
Using longer duration TIPs funds introduces more interest rate risk into your portfolio returns.
This is backwards. The point of matching bond duration to investment horizon is to reduce interest rate risk.

In other words, using short-term TIPS when you have a long-term investment horizon doesn't decrease your interest rate risk: it INCREASES it.
This sounds backward. The point of owning short duration bonds is to decrease interest rate risk, not increase it. The longer the duration of the bond fund, the more term risk it has. Check Portfolio Visualizer.
The source of your confusion is that you are not factoring in your investment horizon (or liability). If you are just looking at your portfolio in a silo, then yes LT bonds have more interest rate risk than ST bonds. However, if you have a liability you are trying to fund with the bonds, then you want to match the duration of your assets and liabilities. For example, trying to fund a retirement income stream with a duration of 20 years (i.e., the liability) with ST bonds introduces significant interest rate risk.

First step for you to do is to figure out your objective. Otherwise, we are running in circles.

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

Post by JackoC » Tue Sep 17, 2019 9:30 am

Ben Mathew wrote:
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.

UNEXPECTED INFLATION HELPS
Stocks (because companies generally owe nominal debt)
Mortgage
The reality is high inflation tends to ravage stocks.
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.
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.

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.
In the age of fiat currencies 'large and unstable' deflation over long periods has not been known. Whereas a 'tax' on risk asset returns because of the 'deadweight losses' caused by high and unstable inflation has happened lots of places. Only in a totally US-centric view would that be considered exceptional historically. And keeping in mind that a US-centric view has become a steadily less accurate way to think about US treasuries since the US treasury yield curve is more and more influenced by overall global financial conditions.

Moreover I don't think the basic point here is about monetary policy history or the 'market was wrong' or 'is wrong'. My point is about how an efficient market could have either a positive or negative 'inflation insurance premium', positive meaning you give up yield for the 'protection' of inflation indexed bonds, negative meaning you actually get more yield from inflation indexed bonds. Just focusing on hold to maturity outcomes v inflation, although there are other factors at work in relative inflation indexed v nominal yields (like market to market correlations if you'd buy/sell the bonds prior to maturity). But just focusing on hold to maturity 'inflation insurance premium' that is I think about the market's perception of the shape of distribution of future inflation outcomes, rather than just assuming that distribution is symmetric. Which I think it's first of all obviously not. Again there's no historical specimen of persistent high deflation with fiat currency. Japan mid 1980's to now hasn't been high deflation, the significant (though still not really high) average deflation in USD ca. 1865-1900 wasn't with a pure fiat currency, etc. But there are lots of examples the other way in various currencies. And to the extent the market perceives those outcomes as somewhat likely, inflation indexed bonds have superior hold to maturity return correlation with stocks. Stocks are hurt by the economic inefficiencies of high/unstable inflation. Nominal bonds are hurt by inflation. So in that case inflation indexed bonds while they don't 'hedge' in the sense of bailing out the rest of the portfolio, don't add to the problem the way nominals do. So assuming that skew and correlation, you'd expect to give up yield to hold inflation indexed bonds, positive 'inflation insurance premium'.

The reason that premium could flip sign, and seems to have, would not be expectation of persistent 'large and unstable' deflation. It would be, IMO, that from today's starting low inflation point, 'high' inflation cases are more likely to still be within the range where stocks aren't hurt much. Whereas from today's starting point lower inflation outcomes, though they would not be 'large deflation', would be cases where stock returns were hurt by intensification of the 'global malaise', and nominal bond real returns would rise while inflation indexed real returns would not. So nominals might have the superior hold-to-maturity real return correlation v stocks, and you might have to give up yield to hold them based on 'inflation insurance premium' actually being negative, in addition to a 'liquidity premium' generally acting in that same direction.

But the explanation above doesn't say which is better. It depends how much that inflation premium (positive or negative) is worth to the particular investor v their perception of the value of the real return correlation in their situation. But as to the liquidity premium, that could pretty much go into the TIPS investor's pocket to the extent they buy TIPS for layers of their fixed income portfolio unlikely to be sold prior to maturity. Anyway today's situation is a probably zeroish 'inflation insurance premium' and a positive liquidity premium to hold TIPS. If forced to choose TIPS v nominals I'd hold TIPS personally. But again either one is outclassed right now IMO by best CD yields assuming a moderate term and ability to tie up the money.

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

Post by vineviz » Tue Sep 17, 2019 9:35 am

CULater wrote:
Tue Sep 17, 2019 9:10 am
vineviz wrote:
Tue Sep 17, 2019 8:34 am
In other words, using short-term TIPS when you have a long-term investment horizon doesn't decrease your interest rate risk: it INCREASES it.
This sounds backward. The point of owning short duration bonds is to decrease interest rate risk, not increase it. The longer the duration of the bond fund, the more term risk it has. Check Portfolio Visualizer.
Nope, this is incorrect. Interest rate risk has two components (price risk and reinvestment risk) that work in opposite directions, and one definition of duration is that it represents the precise point in time at which price risk and reinvestment risk cancel each other out. In short, when the duration of the assets (i.e. bonds) is equal to the duration of the liabilities (i.e. the investment horizon) then interest rate risk is precisely zero.
CULater wrote:
Tue Sep 17, 2019 9:10 am
You seem to be talking about immunization, which is matching loan duration to the duration of liabilities. Single point immunization means that there is a single target date on which liabilities are due and you would need to dynamically manage bond duration to do that. If liabilities are represented as a stream, then the bond portfolio must include bonds with a range of durations that parallel the stream of liabilities. Simply investing in one fund with a duration based on guesstimated life expectancy is a long way from this.
There's no need for a bond portfolio to contain bonds that match each individual liability in order to be fully immunized against interest rate changes: immunization is achieved when the weighted average durations of the assets and liabilities match.

It's true that the bond portfolio requires less management the more closely the cash flows match, but in principle you can immunize any liability with a duration of less than 30 years using just two assets: a 30-year zero coupon bond and a 30-day Treasury bill.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Tue Sep 17, 2019 10:29 am

There's no need for a bond portfolio to contain bonds that match each individual liability in order to be fully immunized against interest rate changes: immunization is achieved when the weighted average durations of the assets and liabilities match.
I don't disagree, but there has to be a match between the weighted average duration and the liabilities. If you have a single-point liability you can do that by using two or three bond funds with different average durations and weighting them to match the single-point liability. You have to do this dynamically - it's not a one and done because the liability target is a changing time period.

And, of course, you have to be able to define a single point liability as your objective to do this in the first place. In the case of a retirement income portfolio you don't have a single point liability; you have a continuous stream of liabilities so duration matching of that stream of liabilities is a dog's breakfast. Not something you could do even if you wanted to.

It boils down to your point that you have both interest rate risk and reinvestment risk to consider. In the case of selecting a TIPS fund, a ST fund will have more reinvestment risk, but longer duration funds will have more interest rate risk. It is my view that the purpose of owning TIPS is to mitigate inflation risk and that is best done by minimizing interest rate risk. If reinvestment risk shows up, ST TIPs funds will still be doing their job of tracking inflation closely. They will also still be doing their job if interest rate risk shows up; but longer duration TIPS funds won't be doing it as well.

I think that people are conflating inflation risk with other kinds of bond risk and have not clearly defined what their risk-management objective is. First identify the risk you're trying to manage and then invest accordingly. You know: you can't have your cake and eat it too.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 10:41 am

CULater wrote:
Tue Sep 17, 2019 10:29 am
In the case of a retirement income portfolio you don't have a single point liability; you have a continuous stream of liabilities so duration matching of that stream of liabilities is a dog's breakfast. Not something you could do even if you wanted to.
It's not that hard and it can easily be done as part of a regular rebalancing practice.
CULater wrote:
Tue Sep 17, 2019 10:29 am
It boils down to your point that you have both interest rate risk and reinvestment risk to consider. In the case of selecting a TIPS fund, a ST fund will have more reinvestment risk, but longer duration funds will have more interest rate risk. It is my view that the purpose of owning TIPS is to mitigate inflation risk and that is best done by minimizing interest rate risk. If reinvestment risk shows up, ST TIPs funds will still be doing their job of tracking inflation closely. They will also still be doing their job if interest rate risk shows up; but longer duration TIPS funds won't be doing it as well.

I think that people are conflating inflation risk with other kinds of bond risk and have not clearly defined what their risk-management objective is. First identify the risk you're trying to manage and then invest accordingly. You know: you can't have your cake and eat it too.
The fact is that using TIPS to create an LMP is intended to mitigate inflation risk, interest rate risk, and reinvestment risk. If you use ST TIPS only, you might be mitigating inflation risk but you are still exposed to both interest rate risk and reinvestment risk. With risk comes some opportunity for reward, but also opportunity for loss. In retirement, I would prefer using bonds to mitigate these risks so that I can take on more risk with equities - i.e., you can have your cake and eat it too. In the accumulation phase, I'm less dogmatic.

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

Post by CULater » Tue Sep 17, 2019 11:10 am

Horton wrote:
Tue Sep 17, 2019 10:41 am
CULater wrote:
Tue Sep 17, 2019 10:29 am
In the case of a retirement income portfolio you don't have a single point liability; you have a continuous stream of liabilities so duration matching of that stream of liabilities is a dog's breakfast. Not something you could do even if you wanted to.
It's not that hard and it can easily be done as part of a regular rebalancing practice.
CULater wrote:
Tue Sep 17, 2019 10:29 am
It boils down to your point that you have both interest rate risk and reinvestment risk to consider. In the case of selecting a TIPS fund, a ST fund will have more reinvestment risk, but longer duration funds will have more interest rate risk. It is my view that the purpose of owning TIPS is to mitigate inflation risk and that is best done by minimizing interest rate risk. If reinvestment risk shows up, ST TIPs funds will still be doing their job of tracking inflation closely. They will also still be doing their job if interest rate risk shows up; but longer duration TIPS funds won't be doing it as well.

I think that people are conflating inflation risk with other kinds of bond risk and have not clearly defined what their risk-management objective is. First identify the risk you're trying to manage and then invest accordingly. You know: you can't have your cake and eat it too.
The fact is that using TIPS to create an LMP is intended to mitigate inflation risk, interest rate risk, and reinvestment risk. If you use ST TIPS only, you might be mitigating inflation risk but you are still exposed to both interest rate risk and reinvestment risk. With risk comes some opportunity for reward, but also opportunity for loss. In retirement, I would prefer using bonds to mitigate these risks so that I can take on more risk with equities - i.e., you can have your cake and eat it too. In the accumulation phase, I'm less dogmatic.
Yes, a TIPs ladder holding bonds to maturity has no reinvestment or interest rate risk when funding a stream of liabilities. That's because this is a cash-flow matching strategy and not a duration-matching strategy (assuming that you are liquidating the bonds at maturity). Also I-Bonds can be used and have the additional advantage that they also have no reinvestment or interest rate risk (liquidated) but don't have to be held to maturity. Any time you use a bond fund, you have both reinvestment and interest rate risk. If your primary goal with inflation-indexed securities is to protect as much as possible against inflation risk, the optimal investment is in a maturing TIPs ladder or I-Bonds. If you can't invest in those or they are insufficient, the optimal investment is a ST TIPs fund because they have low interest rate risk and track inflation more closely as a result. Reinvestment risk is largely immaterial if your objective is to track inflation.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 11:22 am

CULater wrote:
Tue Sep 17, 2019 10:29 am
And, of course, you have to be able to define a single point liability as your objective to do this in the first place. In the case of a retirement income portfolio you don't have a single point liability; you have a continuous stream of liabilities so duration matching of that stream of liabilities is a dog's breakfast. Not something you could do even if you wanted to.
It's not that hard, in fact, at least not to get a good enough approximation. If you can roughly estimate your annual expenses in retirement you can just as easily calculate the duration of that series of expenses.
CULater wrote:
Tue Sep 17, 2019 10:29 am
It boils down to your point that you have both interest rate risk and reinvestment risk to consider. In the case of selecting a TIPS fund, a ST fund will have more reinvestment risk, but longer duration funds will have more interest rate risk.
I think you're mixing up the concepts again. Interest rate risk = price risk + reinvestment risk.

Perhaps it might be more clear to use an example. A brand-new retiree who is 65 years old might reasonably want to plan for a 35 year retirement, which - assuming constant spending in real terms - gives them an investment horizon of roughly 17.5 years.

If their bond portfolio has a duration of less than 17.5 years, they have interest rate risk (because price risk > reinvestment risk when liability duration > asset duration).

If their bond portfolio has a duration of more than 17.5 years, they have interest rate risk (because reinvestment risk > price risk when liability duration < asset duration).

If their bond portfolio has a duration of exactly 17.5 years, they have no interest rate risk (because reinvestment risk = price risk when liability duration = asset duration).
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 11:27 am

CULater wrote:
Tue Sep 17, 2019 11:10 am
Any time you use a bond fund, you have both reinvestment and interest rate risk.
Only a small amount of interest rate risk exists and it is due to the following:

- You are relying on the duration of each fund as published by the investment manager. This duration is likely only posted on a monthly basis with some small lag.

- You are likely rebalancing between ST, IT, and LT funds on monthly, quarterly, annual, etc. basis, rather than continuously.

- Changes in the shape of the yield curve may introduce some risk, particularly if you are just using a ST and LT fund. Introducing an IT fund and using key rate duration to determine the allocations might be helpful.

We are really diving into the weeds and I consider the interest rate risk in this scenario to be pretty small though. If you are worried about it, then purchase a ladder.

In any event, there is much less interest rate risk that using short-term TIPS.

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

Post by CULater » Tue Sep 17, 2019 11:36 am

vineviz wrote:
Tue Sep 17, 2019 11:22 am
CULater wrote:
Tue Sep 17, 2019 10:29 am
And, of course, you have to be able to define a single point liability as your objective to do this in the first place. In the case of a retirement income portfolio you don't have a single point liability; you have a continuous stream of liabilities so duration matching of that stream of liabilities is a dog's breakfast. Not something you could do even if you wanted to.
It's not that hard, in fact, at least not to get a good enough approximation. If you can roughly estimate your annual expenses in retirement you can just as easily calculate the duration of that series of expenses.
CULater wrote:
Tue Sep 17, 2019 10:29 am
It boils down to your point that you have both interest rate risk and reinvestment risk to consider. In the case of selecting a TIPS fund, a ST fund will have more reinvestment risk, but longer duration funds will have more interest rate risk.
I think you're mixing up the concepts again. Interest rate risk = price risk + reinvestment risk.

Perhaps it might be more clear to use an example. A brand-new retiree who is 65 years old might reasonably want to plan for a 35 year retirement, which - assuming constant spending in real terms - gives them an investment horizon of roughly 17.5 years.

If their bond portfolio has a duration of less than 17.5 years, they have interest rate risk (because price risk > reinvestment risk when liability duration > asset duration).

If their bond portfolio has a duration of more than 17.5 years, they have interest rate risk (because reinvestment risk > price risk when liability duration < asset duration).

If their bond portfolio has a duration of exactly 17.5 years, they have no interest rate risk (because reinvestment risk = price risk when liability duration = asset duration).
He has no interest rate risk only at that one point of time and only in regard to a single point liability of 35 years. If he happens to be getting older and if he happens to be funding a continuous stream of liabilities, tell me how that works if he just hangs onto the same bond fund with a stationary 17.5 year duration. I don't think I'm the one who's confused, but I'm willing to consider that possibility if there's a stronger argument or if my brain fog clears enough that I can see what I'm missing.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 11:57 am

CULater wrote:
Tue Sep 17, 2019 11:36 am
If he happens to be getting older and if he happens to be funding a continuous stream of liabilities, tell me how that works if he just hangs onto the same bond fund with a stationary 17.5 year duration. I don't think I'm the one who's confused, but I'm willing to consider that possibility if there's a stronger argument or if my brain fog clears enough that I can see what I'm missing.
This is the part you are confused about. He is regularly determining the duration of his retirement income liability and adjusting the allocation of the TIPS funds such that the asset and liability duration are the same.

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

Post by CULater » Tue Sep 17, 2019 12:01 pm

Horton wrote:
Tue Sep 17, 2019 11:57 am
CULater wrote:
Tue Sep 17, 2019 11:36 am
If he happens to be getting older and if he happens to be funding a continuous stream of liabilities, tell me how that works if he just hangs onto the same bond fund with a stationary 17.5 year duration. I don't think I'm the one who's confused, but I'm willing to consider that possibility if there's a stronger argument or if my brain fog clears enough that I can see what I'm missing.
This is the part you are confused about. He is regularly determining the duration of his retirement income liability and adjusting the allocation of the TIPS funds such that the asset and liability duration are the same.
I'm not confused about that methodology( and I agree with it), but where do you see that Vineviz has outlined this methodology? As far as I can tell, all he's said is that the investor should invest in a bond fund with a duration that he thinks matches his life expectancy and then you're done. If I misunderstood, I apologize, but I don't think I was confused.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 12:08 pm

Horton wrote:
Tue Sep 17, 2019 11:57 am
CULater wrote:
Tue Sep 17, 2019 11:36 am
If he happens to be getting older and if he happens to be funding a continuous stream of liabilities, tell me how that works if he just hangs onto the same bond fund with a stationary 17.5 year duration. I don't think I'm the one who's confused, but I'm willing to consider that possibility if there's a stronger argument or if my brain fog clears enough that I can see what I'm missing.
This is the part you are confused about. He is regularly determining the duration of his retirement income liability and adjusting the allocation of the TIPS funds such that the asset and liability duration are the same.
Exactly.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Tue Sep 17, 2019 12:46 pm

vineviz wrote:
Tue Sep 17, 2019 12:08 pm
Horton wrote:
Tue Sep 17, 2019 11:57 am
CULater wrote:
Tue Sep 17, 2019 11:36 am
If he happens to be getting older and if he happens to be funding a continuous stream of liabilities, tell me how that works if he just hangs onto the same bond fund with a stationary 17.5 year duration. I don't think I'm the one who's confused, but I'm willing to consider that possibility if there's a stronger argument or if my brain fog clears enough that I can see what I'm missing.
This is the part you are confused about. He is regularly determining the duration of his retirement income liability and adjusting the allocation of the TIPS funds such that the asset and liability duration are the same.
Exactly.
OK. We seem to be in agreement about this. If you regularly adjust the average duration of your bond fund holding to match your remaining investment horizon, this "duration-matching" strategy sorta simulates a maturing bond ladder. BobK suggests that the more often average duration is adjusted the more similar this will be to an actual bond ladder; perhaps quarterly. He also suggests using a ST and a LT fund, and taking withdrawals from the ST fund because it has less interest rate volatility. If you do this with TIPs funds you have a simulated TIPs bond ladder.

This requires more management than simply buying a TIPs fund and sitting on it or just rebalancing in and out of it over time. But it will help to control interest rate risk. Again, it depends on your objective. If you don't want much interest rate risk this is a good strategy, and I believe that should be the case IF your purpose investing in TIPs is mainly to partially protect THE FUNDS INVESTED IN TIPS from inflation.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Tue Sep 17, 2019 1:01 pm

One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2. Not the total number of years in your IH. This is because a bond ladder you are trying to simulate that is designed to provide a fixed income for X years would have an average duration of X/2 years. So, for example, if your investment horizon (life expectancy estimate) is 20 years from now, you would want to hold bond funds with an average duration of 10 years, not 20 years. You would periodically re-adjust fund weights to decrease this over time.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 1:13 pm

CULater wrote:
Tue Sep 17, 2019 12:46 pm
This requires more management than simply buying a TIPs fund and sitting on it or just rebalancing in and out of it over time.
I agree it takes more management, but some may enjoy it. :twisted:

I will say that I’m personally undecided on whether I will create an LMP using funds or a ladder. Funds allow a lot of flexibility if the retirement cash flow stream needs to be adjusted. Funds also allow one to easily rebalance from equities to the LMP to raise the floor income across all years (“peanut butter style”). This is much harder with individual TIPS.

For the fund approach, the biggest drawback is the costs. You pay the annual expense ratio plus the investment manager may be incurring bid/ask spreads as they manage the duration of the specific fund (e.g., for LTPZ, when PIMCO sells a 30 year bond with only 15 years to maturity to purchase a new issue 30 year). I suppose there is also the possibility of liquidity issues/costs during a crisis that might be a drag on returns.

Creating a TIPS ladder can be a pesky task because of the coupon payments. If I want to create the ladder over time, I have to factor in the fact that early years on the ladder will receive both an inflation-adjusted principal payment as well as a collection of coupon payments from later maturing TIPS. TIPS STRIPS would be an ideal product to solve this problem.

You also have to factor in bid/ask spreads if creating the ladder on the secondary market rather than over time through auctions.

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

Post by GAAP » Tue Sep 17, 2019 1:24 pm

I think of TIPS as short term, ~1-5 year protection against unexpected inflation -- inflation that is not priced into nominal bonds and stocks by the market. Any period longer that is more of an equity type play for me, for which I have a small allocation to REITs. REITs aren't perfect, but they are a lot cheaper than commodity futures.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by willthrill81 » Tue Sep 17, 2019 1:32 pm

GAAP wrote:
Tue Sep 17, 2019 1:24 pm
I think of TIPS as short term, ~1-5 year protection against unexpected inflation -- inflation that is not priced into nominal bonds and stocks by the market. Any period longer that is more of an equity type play for me, for which I have a small allocation to REITs. REITs aren't perfect, but they are a lot cheaper than commodity futures.
The problem with that strategy is that stocks and REITs can and have lagged inflation significantly over periods of time longer than 5 years. There was at least one period where U.S. stocks went 20 years with a 0% real return. From 2000-2012, the real return of U.S. stocks was -.15%.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by GAAP » Tue Sep 17, 2019 2:10 pm

willthrill81 wrote:
Tue Sep 17, 2019 1:32 pm
GAAP wrote:
Tue Sep 17, 2019 1:24 pm
I think of TIPS as short term, ~1-5 year protection against unexpected inflation -- inflation that is not priced into nominal bonds and stocks by the market. Any period longer that is more of an equity type play for me, for which I have a small allocation to REITs. REITs aren't perfect, but they are a lot cheaper than commodity futures.
The problem with that strategy is that stocks and REITs can and have lagged inflation significantly over periods of time longer than 5 years. There was at least one period where U.S. stocks went 20 years with a 0% real return. From 2000-2012, the real return of U.S. stocks was -.15%.
I do what I can to manage the risks I feel are truly manageable. My wife survived hyperinflation in Brazil during the 1980s, which makes anything that happened in the USA look minuscule by comparison. Her solution was to move here. If Inflation got bad enough here, I would move to a better environment...
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 2:17 pm

CULater wrote:
Tue Sep 17, 2019 12:46 pm
This requires more management than simply buying a TIPs fund and sitting on it or just rebalancing in and out of it over time.
Not much more management: anyone who can use a calculator can figure out how to rebalance to adjust their duration using just two funds in less than 90 seconds.

It's not as if an individual investor needs to match duration to three decimal places.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 2:20 pm

CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by dbr » Tue Sep 17, 2019 2:30 pm

vineviz wrote:
Tue Sep 17, 2019 2:20 pm
CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
How do you calculate an investment horizon?

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

Post by CULater » Tue Sep 17, 2019 2:32 pm

Horton wrote:
Tue Sep 17, 2019 1:13 pm
CULater wrote:
Tue Sep 17, 2019 12:46 pm
This requires more management than simply buying a TIPs fund and sitting on it or just rebalancing in and out of it over time.
I agree it takes more management, but some may enjoy it. :twisted:

I will say that I’m personally undecided on whether I will create an LMP using funds or a ladder. Funds allow a lot of flexibility if the retirement cash flow stream needs to be adjusted. Funds also allow one to easily rebalance from equities to the LMP to raise the floor income across all years (“peanut butter style”). This is much harder with individual TIPS.

For the fund approach, the biggest drawback is the costs. You pay the annual expense ratio plus the investment manager may be incurring bid/ask spreads as they manage the duration of the specific fund (e.g., for LTPZ, when PIMCO sells a 30 year bond with only 15 years to maturity to purchase a new issue 30 year). I suppose there is also the possibility of liquidity issues/costs during a crisis that might be a drag on returns.

Creating a TIPS ladder can be a pesky task because of the coupon payments. If I want to create the ladder over time, I have to factor in the fact that early years on the ladder will receive both an inflation-adjusted principal payment as well as a collection of coupon payments from later maturing TIPS. TIPS STRIPS would be an ideal product to solve this problem.

You also have to factor in bid/ask spreads if creating the ladder on the secondary market rather than over time through auctions.
Here's the way I'm thinking about it.

Perspective #1: You can think of TIPs as part of your overall portfolio asset allocation, even if your retirement portfolio is purposed for income withdrawals rather than wealth accumulation. That's what Vanguard does with it's Target Retirement Income Fund: around 17% is allocated to the ST TIPs fund. You then treat it as just another asset in your portfolio. If that's the way I was thinking of my TIPS, I might decide to use an intermediate or even a long term TIPs fund, and not a ST fund. There's more volatility and more "inflation beta" with longer duration funds, so there's a better chance such a fund would be a better portfolio diversifier. I don't particularly like the idea of owning a ST TIPs fund as part of my overall asset allocation, but it wouldn't be much different than the idea of having a "cash" allocation of some sort.

Perspective #2: You can think of TIPS as an inflation-protected income source; in this view I want my TIPS to be an income source, and not part of my portfolio AA -- an "inflation-indexed" savings account in effect. To do this, I would want to own TIPS as a TIPS ladder, a duration-matching bond ladder proxy, or perhaps just a ST TIPs fund that is mostly sensitive to inflation and not very sensitive to interest rate or reinvestment risk. This view is consistent with a Liability Matching Portfolio (LMP) strategy, but doesn't have to to be a full-blown LMP strategy. I'll include my TIPs income source with my Social Security, Pension, and Annuity as my principal source of retirement income.

I've adopted Perspective #2. Anything I invest in TIPs is purposed as inflation-protected income and will be split off into a TIPS ladder or duration-matched TIPS fund strategy. I won't invest in TIPS otherwise. My remaining assets comprise my "risk" portfolio. I don't want or need a TIPs fund as part of my risk portfolio; preferring to use nominal bond funds instead. My "risk' portfolio consists of stocks, intermediate-long term treasury funds, etc.

So, from my perspective, the only time I'd invest in longer-duration TIPS funds would be as part of my duration-matching TIPS income account (if I had one). In that case, I might have some holdings in ST, IT, and LT TIPs funds in order to implement duration-matching. Just as with a TIPs bond ladder, this would be meant to remain in place once it has been set up; otherwise, it won't work very well as a stable income source.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by pdavi21 » Tue Sep 17, 2019 3:02 pm

Which assets other than nominal bonds need an "inflation hedge"?
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by beehivehave » Tue Sep 17, 2019 3:09 pm

nisiprius wrote:
Mon Sep 16, 2019 7:54 am
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.
And that is exactly why they can play an important role in any well-diversified portfolio, certainly for retirees. In fact I would argue that they should be the last fixed income investments in a retirement portfolio to be liquidated since they are the safest asset, i.e., protect against default and big changes in inflation, which is critically important for those who possess limited human capital. (No, equities do not offer a better protection against inflation - stocks protect against unexpected inflation but not expected inflation, whereas TIPS protect against both.)
PS: I favor I bonds in taxable accounts and TIPS ladders in tax-deferred accounts (because of the complicated bookkeeping).
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 3:16 pm

dbr wrote:
Tue Sep 17, 2019 2:30 pm
vineviz wrote:
Tue Sep 17, 2019 2:20 pm
CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
How do you calculate an investment horizon?
The same way you'd calculate the Macaulay duration of a bond, but here's a simplified walk through. You can refine this by modifying some of the assumptions, but honestly this will be close enough for planning purposes.

The starting assumptions will be that we are making our calculations using real (inflation-adjusted) dollars and that retirement expenses in real dollars will be the same in each year.

First, you simply figure out how many years worth of annual expenses you are planning for. For the purposes of this example let's say it's 30 years, starting at age 70 and lasting until age 99. It's actuarially unlikely that you live to be 99, but let's assume that if you DO live that long that you'd prefer not to be bankrupt. You can work this out however you think is appropriate.

You express each of these annual expenses in terms of years from today (e.g. if you are 60 years old and your first retirement expense is planned for the year you turn 70, then the first annual expense is 10 years; the second is 11 years; and so forth) and take the simple average. For our example, we've got a series of numbers from 10 to 39: the average is 24.5. This is your investment horizon.

Now as it turns out according to the Social Security actuarial life table, a man at age 60 has a life expectancy of 21.61 years and a woman at age 60 has a life expectancy of 24.6 years.

In other words, remaining life expectancy at your current age is a very close approximation of investment horizon under the assumptions above (30 year retirement starting at age 70). It remains very close (within a year or so) for the entirety of retirement, and reasonably close (within 2-3 years) under a wide range of assumptions.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Horton » Tue Sep 17, 2019 3:29 pm

vineviz wrote:
Tue Sep 17, 2019 3:16 pm
dbr wrote:
Tue Sep 17, 2019 2:30 pm
vineviz wrote:
Tue Sep 17, 2019 2:20 pm
CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
How do you calculate an investment horizon?
The same way you'd calculate the Macaulay duration of a bond, but here's a simplified walk through. You can refine this by modifying some of the assumptions, but honestly this will be close enough for planning purposes.

The starting assumptions will be that we are making our calculations using real (inflation-adjusted) dollars and that retirement expenses in real dollars will be the same in each year.

First, you simply figure out how many years worth of annual expenses you are planning for. For the purposes of this example let's say it's 30 years, starting at age 70 and lasting until age 99. It's actuarially unlikely that you live to be 99, but let's assume that if you DO live that long that you'd prefer not to be bankrupt. You can work this out however you think is appropriate.

You express each of these annual expenses in terms of years from today (e.g. if you are 60 years old and your first retirement expense is planned for the year you turn 70, then the first annual expense is 10 years; the second is 11 years; and so forth) and take the simple average. For our example, we've got a series of numbers from 10 to 39: the average is 24.5. This is your investment horizon.

Now as it turns out according to the Social Security actuarial life table, a man at age 60 has a life expectancy of 21.61 years and a woman at age 60 has a life expectancy of 24.6 years.

In other words, remaining life expectancy at your current age is a very close approximation of investment horizon under the assumptions above (30 year retirement starting at age 70). It remains very close (within a year or so) for the entirety of retirement, and reasonably close (within 2-3 years) under a wide range of assumptions.
You could then obtain a quote for a real annuity and set aside the cost in a combination of TIPS funds that match the duration above. Repeat every quarter or year. If you don’t buy the annuity, then the annuity cost goes down every year (because your life expectancy decreases) - this is basically what you pull out of the funds to spend. Or, you may eventually decide to buy the annuity.

The rest of your portfolio can be invested aggressively because you have the “floor” taken care of.

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

Post by CULater » Tue Sep 17, 2019 3:48 pm

You express each of these annual expenses in terms of years from today (e.g. if you are 60 years old and your first retirement expense is planned for the year you turn 70, then the first annual expense is 10 years; the second is 11 years; and so forth) and take the simple average. For our example, we've got a series of numbers from 10 to 39: the average is 24.5. This is your investment horizon.
If annual distributions are the same, you want the average duration of your duration-matching bond fund portfolio to be 1/2 the duration of your planned investment horizon at the point you begin taking the distributions. In this example, that would be 29/2 = 14.5. If you are delaying the first distribution for 10 years, you would add 10. The result is 24.5. Just another way to look at it.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 4:04 pm

CULater wrote:
Tue Sep 17, 2019 3:48 pm
If annual distributions are the same, you want the average duration of your duration-matching bond fund portfolio to be 1/2 the duration of your planned investment horizon at the point you begin taking the distributions.
I’m not sure where this notion of “1/2 duration” is coming from, but it’s not right.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by vineviz » Tue Sep 17, 2019 4:11 pm

CULater wrote:
Tue Sep 17, 2019 3:48 pm
If annual distributions are the same, you want the average duration of your duration-matching bond fund portfolio to be 1/2 the duration of your planned investment horizon at the point you begin taking the distributions. In this example, that would be 29/2 = 14.5.
Note that this usage of the term "duration" isn't congruent with the financial meaning of that term: it looks like you're using the word duration to mean the length of the retirement.

At the point the investor in my example begins taking distributions, their duration is no longer 29 years: at that point their duration is actually 14.5 years, not 29.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by dbr » Tue Sep 17, 2019 4:17 pm

vineviz wrote:
Tue Sep 17, 2019 3:16 pm
dbr wrote:
Tue Sep 17, 2019 2:30 pm
vineviz wrote:
Tue Sep 17, 2019 2:20 pm
CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
How do you calculate an investment horizon?
The same way you'd calculate the Macaulay duration of a bond, but here's a simplified walk through. You can refine this by modifying some of the assumptions, but honestly this will be close enough for planning purposes.

The starting assumptions will be that we are making our calculations using real (inflation-adjusted) dollars and that retirement expenses in real dollars will be the same in each year.

First, you simply figure out how many years worth of annual expenses you are planning for. For the purposes of this example let's say it's 30 years, starting at age 70 and lasting until age 99. It's actuarially unlikely that you live to be 99, but let's assume that if you DO live that long that you'd prefer not to be bankrupt. You can work this out however you think is appropriate.

You express each of these annual expenses in terms of years from today (e.g. if you are 60 years old and your first retirement expense is planned for the year you turn 70, then the first annual expense is 10 years; the second is 11 years; and so forth) and take the simple average. For our example, we've got a series of numbers from 10 to 39: the average is 24.5. This is your investment horizon.

Now as it turns out according to the Social Security actuarial life table, a man at age 60 has a life expectancy of 21.61 years and a woman at age 60 has a life expectancy of 24.6 years.

In other words, remaining life expectancy at your current age is a very close approximation of investment horizon under the assumptions above (30 year retirement starting at age 70). It remains very close (within a year or so) for the entirety of retirement, and reasonably close (within 2-3 years) under a wide range of assumptions.
OK Thanks.

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

Post by CULater » Tue Sep 17, 2019 4:30 pm

vineviz wrote:
Tue Sep 17, 2019 4:11 pm
CULater wrote:
Tue Sep 17, 2019 3:48 pm
If annual distributions are the same, you want the average duration of your duration-matching bond fund portfolio to be 1/2 the duration of your planned investment horizon at the point you begin taking the distributions. In this example, that would be 29/2 = 14.5.
Note that this usage of the term "duration" isn't congruent with the financial meaning of that term: it looks like you're using the word duration to mean the length of the retirement.

At the point the investor in my example begins taking distributions, their duration is no longer 29 years: at that point their duration is actually 14.5 years, not 29.
Yes. Terminology. If the period of equal withdrawals = X, then the duration of spending = X/2
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by illumination » Tue Sep 17, 2019 6:49 pm

GAAP wrote:
Tue Sep 17, 2019 2:10 pm
willthrill81 wrote:
Tue Sep 17, 2019 1:32 pm
GAAP wrote:
Tue Sep 17, 2019 1:24 pm
I do what I can to manage the risks I feel are truly manageable. My wife survived hyperinflation in Brazil during the 1980s, which makes anything that happened in the USA look minuscule by comparison. Her solution was to move here. If Inflation got bad enough here, I would move to a better environment...


Any country where inflation has gotten out of hand, traditional rules go out the window very quickly. Which is why I think TIPS offer inflation protection only at the margins. If inflation went to 4-5%, I can see them paying as promised. But I don't believe for one minute if we had a real crisis they would really pay out as a hedge.

It's almost like paying a high price for catastrophic health insurance but knowing the insurance company won't have the money to really cover it. You might get a doctor visit or minor procedure covered, but not brain surgery or a heart bypass.

Look at various municipal pensions, there have been cases where they just wipe out the COLA with the stroke of a pen. I could easily see CPI being redefined or some sort of forced buyback or conversion. Again, normal rules go out the window and whenever this has happened.

I can see a case for them, but if my real concern was serious inflation, I would probably be in precious metals.

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

Post by pascalwager » Tue Sep 17, 2019 9:37 pm

vineviz wrote:
Tue Sep 17, 2019 3:16 pm
dbr wrote:
Tue Sep 17, 2019 2:30 pm
vineviz wrote:
Tue Sep 17, 2019 2:20 pm
CULater wrote:
Tue Sep 17, 2019 1:01 pm
One important addendum to the bond fund duration-matching strategy is that your average duration target should actually be = Investment Horizon / 2.
This rule of thumb generally comes from people who either don't know how to properly calculate the investment horizon or who are making unacknowledged assumptions about the future path of interest rates.
How do you calculate an investment horizon?
The same way you'd calculate the Macaulay duration of a bond, but here's a simplified walk through. You can refine this by modifying some of the assumptions, but honestly this will be close enough for planning purposes.

The starting assumptions will be that we are making our calculations using real (inflation-adjusted) dollars and that retirement expenses in real dollars will be the same in each year.

First, you simply figure out how many years worth of annual expenses you are planning for. For the purposes of this example let's say it's 30 years, starting at age 70 and lasting until age 99. It's actuarially unlikely that you live to be 99, but let's assume that if you DO live that long that you'd prefer not to be bankrupt. You can work this out however you think is appropriate.

You express each of these annual expenses in terms of years from today (e.g. if you are 60 years old and your first retirement expense is planned for the year you turn 70, then the first annual expense is 10 years; the second is 11 years; and so forth) and take the simple average. For our example, we've got a series of numbers from 10 to 39: the average is 24.5. This is your investment horizon.

Now as it turns out according to the Social Security actuarial life table, a man at age 60 has a life expectancy of 21.61 years and a woman at age 60 has a life expectancy of 24.6 years.

In other words, remaining life expectancy at your current age is a very close approximation of investment horizon under the assumptions above (30 year retirement starting at age 70). It remains very close (within a year or so) for the entirety of retirement, and reasonably close (within 2-3 years) under a wide range of assumptions.
This needs to be in the Wiki, or otherwise featured on the BH site. How can we invest if we don't know how to calculate our investment horizon?

So now at age 77, if I assume living and redeeming until 99--that's a 22 year span. Using the above calculation method, I get an investment horizon of 11.5 years. That compares to my current SS life expectancy of ten years. So, my present overall bonds duration of 6.8 years is not ideal.

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

Post by pascalwager » Tue Sep 17, 2019 9:57 pm

vineviz wrote:
Tue Sep 17, 2019 4:04 pm
CULater wrote:
Tue Sep 17, 2019 3:48 pm
If annual distributions are the same, you want the average duration of your duration-matching bond fund portfolio to be 1/2 the duration of your planned investment horizon at the point you begin taking the distributions.
I’m not sure where this notion of “1/2 duration” is coming from, but it’s not right.
For calculations for situations where the retiree is already redeeming, 1/2 seems like a close approximation, but a bit on the low side.

For example:

10 years of redemptions: 5.5 years true duration compared to 10/2 = 5 years
22 years of redemptions: 11.5 years true duration compared to 22/2 = 11 years

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

Post by CULater » Tue Sep 17, 2019 10:19 pm

So now at age 77, if I assume living and redeeming until 99--that's a 22 year span. Using the above calculation method, I get an investment horizon of 11.5 years. That compares to my current SS life expectancy of ten years. So, my present overall bonds duration of 6.8 years is not ideal.
Not that you asked, but just to get nit-picky, if you take your first withdrawal at age 77 and the last withdrawal at age 99, that is actually a 23 year period. 23/2 = 11.5, which is your spending duration if spending is level. Same result you got. If you wanted to use the duration-matching strategy to minimize the impact of interest rate risk on the amount invested in TIPs, and are starting withdrawals right now, you should have an average bond duration of about 10-11 years and adjust that lower as often as every three months (recommended by BobK). This assumes that you withdraw the same inflation-adjusted amount during each period (e.g., annually).

It might be worth mentioning that BobK suggests taking a duration-matching bond strategy out no further than your mid-80s or so. Unless you have someone who can manage it for you, cognitive decline might make it difficult to keep that strategy in place -- certainly not to age 99. Unless you can do that it might make more sense to just use an intermediate term TIPs fund and plan to purchase a SPIA with the money invested in your mid-80s. I'd perhaps consider a ST TIPs fund which will minimize term risk while maintaining real value over this period. Just sayin'
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by CULater » Tue Sep 17, 2019 10:29 pm

10 years of redemptions: 5.5 years true duration compared to 10/2 = 5 years
22 years of redemptions: 11.5 years true duration compared to 22/2 = 11 years
Not exactly. 10 years of redemptions has a starting point of 0 years (the starting date) and an ending date of 10 years, which is actually an 11-year spending period. Duration is 11/2 = 5.5.

Similarly, 22 years of redemptions is a 23-year spending period. Duration is 23/2 = 11.5.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Northern Flicker » Tue Sep 17, 2019 10:53 pm

This sounds backward. The point of owning short duration bonds is to decrease interest rate risk, not increase it. The longer the duration of the bond fund, the more term risk it has. Check Portfolio Visualizer.

You seem to be talking about immunization...
That would be immunization against interest rate term risk. Term risk measured by short-term volatility is the risk of being unable fund a short-term liability. You eliminate all interest rate risk by matching the duration of asset to duration of liabilities.

However, a mistake I see made is overloading fixed income assets by insisting that they both match the duration of liabilities and diversify equity risk, which will not necessarily sync up, depending on which equity risks you care about.
Index fund investor since 1987.

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

Post by pascalwager » Wed Sep 18, 2019 1:41 am

CULater wrote:
Tue Sep 17, 2019 10:19 pm
So now at age 77, if I assume living and redeeming until 99--that's a 22 year span. Using the above calculation method, I get an investment horizon of 11.5 years. That compares to my current SS life expectancy of ten years. So, my present overall bonds duration of 6.8 years is not ideal.
Not that you asked, but just to get nit-picky, if you take your first withdrawal at age 77 and the last withdrawal at age 99, that is actually a 23 year period. 23/2 = 11.5, which is your spending duration if spending is level. Same result you got. If you wanted to use the duration-matching strategy to minimize the impact of interest rate risk on the amount invested in TIPs, and are starting withdrawals right now, you should have an average bond duration of about 10-11 years and adjust that lower as often as every three months (recommended by BobK). This assumes that you withdraw the same inflation-adjusted amount during each period (e.g., annually).

It might be worth mentioning that BobK suggests taking a duration-matching bond strategy out no further than your mid-80s or so. Unless you have someone who can manage it for you, cognitive decline might make it difficult to keep that strategy in place -- certainly not to age 99. Unless you can do that it might make more sense to just use an intermediate term TIPs fund and plan to purchase a SPIA with the money invested in your mid-80s. I'd perhaps consider a ST TIPs fund which will minimize term risk while maintaining real value over this period. Just sayin'
Yes, if I live long enough, ST TIPS will finally provide the right duration.

My integrative medicine doctor specifically targets potential dementia and I do things every day that might be preventive. But no guarantees, of course--just like investing.

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

Post by usagi » Wed Sep 18, 2019 2:06 am

"Are TIPS really a good inflation hedge? Pros and Cons"

Answer: no.

For one they simply protect their own purchasing power in a loose sort of way that may or may no tbe relevant to you. They do nothing to protect any asset that is not a TIP.

But the biggest issue, and the one academic discussions like this gloss over (because reality is not sexy) is the point nisiprius loosely made, that the CPI may not preserve the purchasing power for the basket of goods that is relevant to you. As people age the disparity grows as the percentage of your income that goes to medical care generally rises, a component that not only is likely a larger percentage of your budget but also one that is likely to outstrip the reported inflation rate. The core of the issue is everyone has a personal basket of goods and it is unlikely that is will be adequately reflected in the inflation adjustments you receive. It is not a trivial point.

And of course the infamous taxation issue.

However, other than I-bonds, nothing works quite like them, that being said, they really do a poor job or preserving purchasing power because there is no way to insulate your particular basket of goods.

When they were first issues with a decent real return they made a level of sense, now...to each their own.

But the answer to your question is a firm no.

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

Post by CULater » Wed Sep 18, 2019 7:16 am

usagi wrote:
Wed Sep 18, 2019 2:06 am
"Are TIPS really a good inflation hedge? Pros and Cons"

Answer: no.

For one they simply protect their own purchasing power in a loose sort of way that may or may no tbe relevant to you. They do nothing to protect any asset that is not a TIP.

But the biggest issue, and the one academic discussions like this gloss over (because reality is not sexy) is the point nisiprius loosely made, that the CPI may not preserve the purchasing power for the basket of goods that is relevant to you. As people age the disparity grows as the percentage of your income that goes to medical care generally rises, a component that not only is likely a larger percentage of your budget but also one that is likely to outstrip the reported inflation rate. The core of the issue is everyone has a personal basket of goods and it is unlikely that is will be adequately reflected in the inflation adjustments you receive. It is not a trivial point.

And of course the infamous taxation issue.

However, other than I-bonds, nothing works quite like them, that being said, they really do a poor job or preserving purchasing power because there is no way to insulate your particular basket of goods.

When they were first issues with a decent real return they made a level of sense, now...to each their own.

But the answer to your question is a firm no.
In Finance and Investing, nothing is ever perfect. It is an exercise in doing the next best thing. I'm not sure anyone is disputing that government issued inflation-linked securities are not the next best thing when it comes to preserving one's purchasing power. That said, it does make a difference in how you go about it. Then life goes on...
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by Valuethinker » Wed Sep 18, 2019 7:28 am

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?
If you take the 10 year TIPS bond and the 10 year nominal US Treasury the gap between their yields is the breakeven inflation rate.

That is in effect the expected inflation rate.

If inflation turns out to have been lower than that over 10 years then you have won by owning the straight US Treasury bond.

If higher then there was unexpected inflation and you won by investing in the TIPS bond

When we talk about expected inflation we mean baked into current bond yields (nominal bond yields).

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

Post by Silence Dogood » Wed Sep 18, 2019 8:47 am

nisiprius wrote:
Mon Sep 16, 2019 7:54 am
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.
Excellent post, nisiprius! As a (relatively) young person/investor, I consider myself very fortunate to have learned so much from you.

I'd also like to point out that, while not the stated concern in the original post, Series I Savings bonds also offer protection during deflationary periods.

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

Post by Silence Dogood » Wed Sep 18, 2019 8:49 am

nisiprius wrote:
Mon Sep 16, 2019 7:54 am
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.
Can you elaborate on this? I thought that the whole point of people advocating for the "gold standard" is because it is meant to prevent inflation?

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