Do TIPS work? How do we know?

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Frank2012
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Do TIPS work? How do we know?

Post by Frank2012 » Sat Dec 14, 2019 11:16 am

Treasury Inflation-Protected Securities (TIPS) are Treasury bonds whose principal amount is adjusted for inflation. TIPS were first auctioned in January 1997. Since 1997, interest rates have gone down and inflation has been low.

So it seems to me that TIPS have never experienced an inflationary environment or a sudden, unexpected inflation spike; that being the case, how do we know that TIPS will act as a hedge against inflation?

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Re: Do TIPS work? How do we know?

Post by willthrill81 » Sat Dec 14, 2019 11:21 am

Because the rules regarding how they will function are exactly laid out by and backed by the U.S. Treasury.

That being said, TIPS only 'hedge' the funds used to buy the TIPS, not the rest of your portfolio.
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Re: Do TIPS work? How do we know?

Post by Call_Me_Op » Sat Dec 14, 2019 11:44 am

willthrill81 wrote:
Sat Dec 14, 2019 11:21 am
That being said, TIPS only 'hedge' the funds used to buy the TIPS, not the rest of your portfolio.
This is a critical point lost on many people. This fact makes TIPS a poor hedge against inflation for the overall portfolio unless most of the portfolio is invested in TIPS.
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Re: Do TIPS work? How do we know?

Post by Frank2012 » Sat Dec 14, 2019 11:49 am

Call_Me_Op wrote:
Sat Dec 14, 2019 11:44 am
willthrill81 wrote:
Sat Dec 14, 2019 11:21 am
That being said, TIPS only 'hedge' the funds used to buy the TIPS, not the rest of your portfolio.
This is a critical point lost on many people. This fact makes TIPS a poor hedge against inflation for the overall portfolio unless most of the portfolio is invested in TIPS.
Call_Me_Op and willthrill81, thank you for the posts. Very illuminating and something for me to ponder.

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Re: Do TIPS work? How do we know?

Post by FactualFran » Sat Dec 14, 2019 12:09 pm

Frank2012 wrote:
Sat Dec 14, 2019 11:16 am
Treasury Inflation-Protected Securities (TIPS) are Treasury bonds whose principal amount is adjusted for inflation. TIPS were first auctioned in January 1997. Since 1997, interest rates have gone down and inflation has been low.
TIPS worked for me. I used them for the portion of my portfolio that I wanted to be sure increased at the rate of the CPI-U. I bought 10-year TIPS at auction for a few years starting in 2000. The maturity values were as expected. The auction yield of TIPS generally increased from the first auction in 1997 to an auction in 2000.

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Re: Do TIPS work? How do we know?

Post by 3funder » Sat Dec 14, 2019 12:14 pm

I don't feel the need to invest in them, but I don't have anything against them either. In theory, I suppose they should work in the event that we experience inflationary surprises.
Last edited by 3funder on Sat Dec 14, 2019 12:16 pm, edited 2 times in total.

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Re: Do TIPS work? How do we know?

Post by Prudence » Sat Dec 14, 2019 12:15 pm

Call_Me_Op wrote:
Sat Dec 14, 2019 11:44 am
willthrill81 wrote:
Sat Dec 14, 2019 11:21 am
That being said, TIPS only 'hedge' the funds used to buy the TIPS, not the rest of your portfolio.
This is a critical point lost on many people. This fact makes TIPS a poor hedge against inflation for the overall portfolio unless most of the portfolio is invested in TIPS.
Right. That's why I have always wondered why many folks say they have 15% (or whatever) position in TIPS just in case there is unexpected inflation.

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Re: Do TIPS work? How do we know?

Post by kadye » Sat Dec 14, 2019 12:24 pm

I read elsewhere that the historical correlation between TIPS and CPI has been very very low. Can someone please illuminate us why this is?

If I buy a $1k zero coupon TIPS (I don't know if this is doable, I haven't bought TIPS before, but assuming it is doable), then I thought this will compound grow with CPI. No?

Edit: see this for an example for the correlation

viewtopic.php?p=4890812#p4890532
Last edited by kadye on Sat Dec 14, 2019 7:54 pm, edited 1 time in total.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 12:25 pm

I get in theory how TIPS function but they can be a complex investment.

We invested in Vanguards TIPS fund over 10 years ago. We sold and consolidated with Total Bond. In hindsight simplifying was a good decision. I believe Taylor Larimore also sold his TIPS and consolidated with Total Bond.

TIPS also lost value during the financial crisis when the bond component was needed most. Total Bond rose. My understanding is this had something to do with liquidity and the collapse of Lehman Brothers. Still one expects Treasury bonds to be an anchor to a portfolio!

In terms of unexpected inflation protection, TIPS provide that to only that piece of a portfolio. I think investors may sometimes confuse this.
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Re: Do TIPS work? How do we know?

Post by nisiprius » Sat Dec 14, 2019 12:28 pm

Frank2012 wrote:
Sat Dec 14, 2019 11:16 am
Treasury Inflation-Protected Securities (TIPS) are Treasury bonds whose principal amount is adjusted for inflation. TIPS were first auctioned in January 1997. Since 1997, interest rates have gone down and inflation has been low.

So it seems to me that TIPS have never experienced an inflationary environment or a sudden, unexpected inflation spike; that being the case, how do we know that TIPS will act as a hedge against inflation?
Because they are directly tied to the CPI. If the CPI spikes, TIPS spike. And there is even a part of the agreement saying that if the CPI gets changed in a way that is deleterious to TIPS holders, the Secretary of the Treasury is obligated to find an alternative index that isn't. (Though I admit I wonder if that would really happen).

The only way they could not "work" would be if the Treasury defaulted on them. Certainly that could happen, but that is no different from any other Treasury security. We plan on the assumption that nothing is any safer from default than Treasury securities.
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Re: Do TIPS work? How do we know?

Post by 2pedals » Sat Dec 14, 2019 12:32 pm

Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf

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Re: Do TIPS work? How do we know?

Post by Frank2012 » Sat Dec 14, 2019 12:37 pm

2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.

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Re: Do TIPS work? How do we know?

Post by FactualFran » Sat Dec 14, 2019 12:44 pm

kadye wrote:
Sat Dec 14, 2019 12:24 pm
I read elsewhere that the historical correlation between TIPS and CPI has been very very low. Can someone please illuminate us why this is?
Without knowing exactly what you read elsewhere, it is not possible to determine whether what you read elsewhere is accurate.

On possibility is that because 1) the principle of TIPS is adjusted using the CPI-U from a few months before the adjustment and 2) month-to-month changes in the CPI-U can have a very low correlation, there can be a very low correlation between the principle of TIPS and the most recent CPI-U.

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Re: Do TIPS work? How do we know?

Post by Prudence » Sat Dec 14, 2019 12:46 pm

abuss368 wrote:
Sat Dec 14, 2019 12:25 pm
I get in theory how TIPS function but they can be a complex investment.

We invested in Vanguards TIPS fund over 10 years ago. We sold and consolidated with Total Bond. In hindsight simplifying was a good decision. I believe Taylor Larimore also sold his TIPS and consolidated with Total Bond.

TIPS also lost value during the financial crisis when the bond component was needed most. Total Bond rose. My understanding is this had something to do with liquidity and the collapse of Lehman Brothers. Still one expects Treasury bonds to be an anchor to a portfolio!

In terms of unexpected inflation protection, TIPS provide that to only that piece of a portfolio. I think investors may sometimes confuse this.
Going forward, one can avoid the liquidity issue experienced in the financial crisis by buying the bonds not the mutual fund. If one must buy the fund, I would go with ST TIPS fund, not IT or LT.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 12:48 pm

nisiprius wrote:
Sat Dec 14, 2019 12:28 pm
Frank2012 wrote:
Sat Dec 14, 2019 11:16 am
Treasury Inflation-Protected Securities (TIPS) are Treasury bonds whose principal amount is adjusted for inflation. TIPS were first auctioned in January 1997. Since 1997, interest rates have gone down and inflation has been low.

So it seems to me that TIPS have never experienced an inflationary environment or a sudden, unexpected inflation spike; that being the case, how do we know that TIPS will act as a hedge against inflation?
Because they are directly tied to the CPI. If the CPI spikes, TIPS spike. And there is even a part of the agreement saying that if the CPI gets changed in a way that is deleterious to TIPS holders, the Secretary of the Treasury is obligated to find an alternative index that isn't. (Though I admit I wonder if that would really happen).

The only way they could not "work" would be if the Treasury defaulted on them. Certainly that could happen, but that is no different from any other Treasury security. We plan on the assumption that nothing is any safer from default than Treasury securities.
If inflation spikes do TIPS spike only if inflation increases over and above expected inflation. Expected inflation is built into the interest rate of all bonds correct?
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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 12:50 pm

Prudence wrote:
Sat Dec 14, 2019 12:46 pm
abuss368 wrote:
Sat Dec 14, 2019 12:25 pm
I get in theory how TIPS function but they can be a complex investment.

We invested in Vanguards TIPS fund over 10 years ago. We sold and consolidated with Total Bond. In hindsight simplifying was a good decision. I believe Taylor Larimore also sold his TIPS and consolidated with Total Bond.

TIPS also lost value during the financial crisis when the bond component was needed most. Total Bond rose. My understanding is this had something to do with liquidity and the collapse of Lehman Brothers. Still one expects Treasury bonds to be an anchor to a portfolio!

In terms of unexpected inflation protection, TIPS provide that to only that piece of a portfolio. I think investors may sometimes confuse this.
Going forward, one can avoid the liquidity issue experienced in the financial crisis by buying the bonds not the mutual fund. If one must buy the fund, I would go with ST TIPS fund, not IT or LT.
A few years ago Vanguard removed the intermediate term fund in the Target Retirement fund and add the short term fund. The reasoning was the short term fund better aligned with inflation.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success." || Buy Total Stock until it hurts. Then find a way to buy even more!

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Re: Do TIPS work? How do we know?

Post by 2pedals » Sat Dec 14, 2019 12:50 pm

Frank2012 wrote:
Sat Dec 14, 2019 12:37 pm
2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.
How can they not? They earn an interest rate in addition to the measured-inflation Consumer Price Index (CPI).

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Re: Do TIPS work? How do we know?

Post by willthrill81 » Sat Dec 14, 2019 12:51 pm

Frank2012 wrote:
Sat Dec 14, 2019 12:37 pm
2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.
Since TIPS are explicitly linked to CPI by the Treasury, why do you believe that this is possible, unless perhaps you believe that CPI is a poor measure of inflation?
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Re: Do TIPS work? How do we know?

Post by columbia » Sat Dec 14, 2019 12:54 pm

How have TIPS fared - in terms of return above inflation - compared to corporate bonds?

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 1:02 pm

TIPS are linked to the CPI.
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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 1:03 pm

columbia wrote:
Sat Dec 14, 2019 12:54 pm
How have TIPS fared - in terms of return above inflation - compared to corporate bonds?
I do not believe TIPS would have returns above inflation. The bonds can rise or lower in value.
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Re: Do TIPS work? How do we know?

Post by bberris » Sat Dec 14, 2019 1:06 pm

Call_Me_Op wrote:
Sat Dec 14, 2019 11:44 am
willthrill81 wrote:
Sat Dec 14, 2019 11:21 am
That being said, TIPS only 'hedge' the funds used to buy the TIPS, not the rest of your portfolio.
This is a critical point lost on many people. This fact makes TIPS a poor hedge against inflation for the overall portfolio unless most of the portfolio is invested in TIPS.
I guess so, but the alternative is a leveraged inflation bet. It's like saying my house insurance doesn't protect my car.
Gold, everyone's favorite inflation hedge, has only just matched inflation as well. So it did not protect the rest of the portfolio either.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 1:15 pm

I wish that TIPS provided monthly dividends like most bond funds any Treasuries in general.
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Re: Do TIPS work? How do we know?

Post by willthrill81 » Sat Dec 14, 2019 1:18 pm

bberris wrote:
Sat Dec 14, 2019 1:06 pm
Gold, everyone's favorite inflation hedge, has only just matched inflation as well. So it did not protect the rest of the portfolio either.
The average real return of gold has indeed been small compared to that of stocks and bonds, but during the high inflation period of the late 1970s and early 1980s, gold soared while stocks slid and nominal bonds tanked.

From 1977-1981, a 50/50 mix of TSM and intermediate-term Treasuries had a real return of -2.27%. But a 20% allocation to gold and 40/40 TSM and ITT had a real return of 1.90%. So gold did help to protect the rest of the portfolio against unexpected inflation.

But whether that will happen again if unexpected inflation shows up is unknown, of course.
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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 1:23 pm

What is the current size of the TIPS market compared to the financial crisis?
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Re: Do TIPS work? How do we know?

Post by Frank2012 » Sat Dec 14, 2019 1:32 pm

willthrill81 wrote:
Sat Dec 14, 2019 12:51 pm
Frank2012 wrote:
Sat Dec 14, 2019 12:37 pm
2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.
Since TIPS are explicitly linked to CPI by the Treasury, why do you believe that this is possible, unless perhaps you believe that CPI is a poor measure of inflation?
I don't know whether or not CPI is a good measure of inflation...but I know that many experts have been debating this for awhile:

https://www.investopedia.com/articles/0 ... eindex.asp

If CPI is a lagging indicator of inflation, then I don't see how TIPS are much of a hedge or protection against inflation....

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Re: Do TIPS work? How do we know?

Post by nisiprius » Sat Dec 14, 2019 1:45 pm

willthrill81 wrote:
Sat Dec 14, 2019 1:18 pm
bberris wrote:
Sat Dec 14, 2019 1:06 pm
Gold, everyone's favorite inflation hedge, has only just matched inflation as well. So it did not protect the rest of the portfolio either.
The average real return of gold has indeed been small compared to that of stocks and bonds, but during the high inflation period of the late 1970s and early 1980s, gold soared while stocks slid and nominal bonds tanked.

From 1977-1981, a 50/50 mix of TSM and intermediate-term Treasuries had a real return of -2.27%. But a 20% allocation to gold and 40/40 TSM and ITT had a real return of 1.90%. So gold did help to protect the rest of the portfolio against unexpected inflation.

But whether that will happen again if unexpected inflation shows up is unknown, of course.
But we really should not forget the worst period of inflation in the history of the CPI, the early 1920s:

Image

It occurred despite the United States being on the gold standard.

So, during that time, an investment in gold could not have protected you because an investment in gold was the same as currency, and both lost over half their buying power within a space of a few years.

(As best I understand it, gold advocates define "inflation" in such a way that what happened in 1920 was not "inflation;" it did not matter that Ford's auto workers $5/day wage only bought half of what it had. But that was not "inflation" because because they could have bought just as much gold with that $5 as before.)
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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 1:48 pm

nisiprius wrote:
Sat Dec 14, 2019 1:45 pm
willthrill81 wrote:
Sat Dec 14, 2019 1:18 pm
bberris wrote:
Sat Dec 14, 2019 1:06 pm
Gold, everyone's favorite inflation hedge, has only just matched inflation as well. So it did not protect the rest of the portfolio either.
The average real return of gold has indeed been small compared to that of stocks and bonds, but during the high inflation period of the late 1970s and early 1980s, gold soared while stocks slid and nominal bonds tanked.

From 1977-1981, a 50/50 mix of TSM and intermediate-term Treasuries had a real return of -2.27%. But a 20% allocation to gold and 40/40 TSM and ITT had a real return of 1.90%. So gold did help to protect the rest of the portfolio against unexpected inflation.

But whether that will happen again if unexpected inflation shows up is unknown, of course.
But we really should not forget the worst period of inflation in the history of the CPI, the early 1920s:

Image

It occurred despite the United States being on the gold standard.

So, during that time, an investment in gold could not have protected you because an investment in gold was the same as currency, and both lost over half their buying power within a space of a few years.

As best I understand it, gold advocates define "inflation" in such a way that what happened in 1920 was not "inflation."
That is interesting and I did not know that. Thank you for sharing.
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Re: Do TIPS work? How do we know?

Post by stlutz » Sat Dec 14, 2019 1:58 pm

abuss368 wrote:
Sat Dec 14, 2019 12:48 pm
If inflation spikes do TIPS spike only if inflation increases over and above expected inflation. Expected inflation is built into the interest rate of all bonds correct?
Kinda sorta in a way but not really. Expected inflation is one component among many in fixed income pricing. The rate of interest above (or below) inflation has varied substantially across time. For example, 6% Treasury yields in 1999 vs. sub 2% yields today aren't a reflection of a decline in the "expected" rate of inflation of 4%. Inflation expectations have declined some over the past 20 years, but nowhere close to 4%. It's actually a fairly recent (i.e. last 50 years) phenomenon that interest rates and inflation have had any relationship at all to each other.

The yield difference between nominal bonds and TIPS is one measure of "expected inflation" (there are others as well). And it's an imperfect one because the pricing of TIPS vs. nominal bonds involves other factors as well.

Right now, the 10 year nominal bond yields 1.82%. The 10 Year TIPS yields .12%. So, one could say that 1.7% is the expected inflation rate for the next 10 years, although the more technical terms would simply be "breakeven" inflation.

For the investor, they will do better holding TIPS if inflation is higher over the next 10 years, say 2%. They will do better with nominals if it's lower--say 1.5%.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 2:10 pm

stlutz wrote:
Sat Dec 14, 2019 1:58 pm
abuss368 wrote:
Sat Dec 14, 2019 12:48 pm
If inflation spikes do TIPS spike only if inflation increases over and above expected inflation. Expected inflation is built into the interest rate of all bonds correct?
Kinda sorta in a way but not really. Expected inflation is one component among many in fixed income pricing. The rate of interest above (or below) inflation has varied substantially across time. For example, 6% Treasury yields in 1999 vs. sub 2% yields today aren't a reflection of a decline in the "expected" rate of inflation of 4%. Inflation expectations have declined some over the past 20 years, but nowhere close to 4%. It's actually a fairly recent (i.e. last 50 years) phenomenon that interest rates and inflation have had any relationship at all to each other.

The yield difference between nominal bonds and TIPS is one measure of "expected inflation" (there are others as well). And it's an imperfect one because the pricing of TIPS vs. nominal bonds involves other factors as well.

Right now, the 10 year nominal bond yields 1.82%. The 10 Year TIPS yields .12%. So, one could say that 1.7% is the expected inflation rate for the next 10 years, although the more technical terms would simply be "breakeven" inflation.

For the investor, they will do better holding TIPS if inflation is higher over the next 10 years, say 2%. They will do better with nominals if it's lower--say 1.5%.
Thanks!
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Re: Do TIPS work? How do we know?

Post by danielc » Sat Dec 14, 2019 2:22 pm

Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(

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Re: Do TIPS work? How do we know?

Post by danielc » Sat Dec 14, 2019 2:27 pm

kadye wrote:
Sat Dec 14, 2019 12:24 pm
If I buy a $1k zero coupon TIPS (I don't know if this is doable, I haven't bought TIPS before, but assuming it is doable), then I thought this will compound grow with CPI. No?
Unfortunately no. Not only are there no zero coupon TIPS, but you even pay yearly tax on the adjusted principal. No compounding. However, I-Bonds do have compounding (i.e. they are tax-deferred) so you might want to look into those, but they also tend to pay lower real rates than TIPS.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 2:30 pm

danielc wrote:
Sat Dec 14, 2019 2:22 pm
Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(
Correct. I believe this called phantom income. The adjustment to principal is taxes even though the income is not received.
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Re: Do TIPS work? How do we know?

Post by stlutz » Sat Dec 14, 2019 2:34 pm

Frank2012 wrote:
Sat Dec 14, 2019 1:32 pm
If CPI is a lagging indicator of inflation, then I don't see how TIPS are much of a hedge or protection against inflation....
I guess I'm not quite sure what you're looking for.

If I ask you, "What is the temperature right now in Chicago?", one might pull up their weather app and read me out a number. But, there are actually a whole bunch of temperatures in Chicago. What it is by the lakeshore differs from what it is at O'Hare. So which is correct? Or should I take an average across the entire city? Should that average be weighted by population density? I can get more an more complex/absurd with what my perfect measure of the Chicago temperature is.

There are multiple measures of inflation--all with their own quirks. If you are going to have a security like TIPS, you have to pick one. Government programs are mostly indexed to CPI, taxes are mostly indexed to a lower measure, "chained CPI". There is also the GDP deflator. There is the producer price index (PPI). There is also MIT's billion prices project. Etc. Etc.

It may well be the case that your TIPS bond will index by 2.5% and you think it should be 2.8% and somebody else might say it should be 2.2%. Such is life. But at the end of the day, if inflation increased substantially, the CPI would do so as would the principal and interest payments on your TIPS bond.

Then there is the question of whether you are looking at the long term or the short term. Like any other bond, the prices of TIPS change from day to day as interest rates change. If the real yield on TIPS increased from .1% today to 2% a year from now, the price of existing TIPS bonds will decline, meaning that TIPS would trail inflation in 2020. Over time the higher interest payments would make up that difference. So, if you look at a 20 year period (e.g. a typical retirement), TIPS will return coupons plus CPI inflation. If all you care about is what happens in 2020, TIPS very well may not "work". If you care about the next 20 years, they will "work" very well.

And that is not unique to inflation-indexed bonds. If I have $100 today and I absolutely need to have $100 a years from now and not $97 or $103, then Vanguard Total Bond is not a good investment, as it's price does fluctuate. For this situation, a savings account is a better choice.

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Re: Do TIPS work? How do we know?

Post by stlutz » Sat Dec 14, 2019 2:36 pm

danielc wrote:
Sat Dec 14, 2019 2:22 pm
Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(
This is not unique to TIPS. Taxes on all investment income are based on nominal and not real dollars.

Your own home is an exception since the gain on the first $250/$500K (depending on marital status) is usually exempt from federal tax.

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 2:39 pm

stlutz wrote:
Sat Dec 14, 2019 2:36 pm
danielc wrote:
Sat Dec 14, 2019 2:22 pm
Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(
This is not unique to TIPS. Taxes on all investment income are based on nominal and not real dollars.

Your own home is an exception since the gain on the first $250/$500K (depending on marital status) is usually exempt from federal tax.
Correct. With TIPS held in a taxable account though any adjustment to principal is taxed whether paid or not in cash. That is the difference where nominal bonds are paying out the income which is taxed.
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Re: Do TIPS work? How do we know?

Post by danielc » Sat Dec 14, 2019 2:40 pm

columbia wrote:
Sat Dec 14, 2019 12:54 pm
How have TIPS fared - in terms of return above inflation - compared to corporate bonds?
Not well . According to Portfolio Visualizer (see here) since 2003 (longest timeframe available) corporate bonds have returned 5.53% and TIPS only 4.07%, and corporates had a slightly better Sharpe ratio. This doesn't take into account the tax advantage of TIPS (they're exempt from state tax) so YMMV.

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Re: Do TIPS work? How do we know?

Post by not4me » Sat Dec 14, 2019 2:40 pm

I don't intend to hijack this thread & in someone's explanation it likely will help this thread anyway.

I'll start with the following which may need to be corrected. 1st, TIPS are adjusted based on CPI-U Non-seasonally adjusted. 2nd, Social Security cola is adjusted based on CPI-W. 3rd, there has been discussion about changing social security to using "chained CPI". 4th, there is an "experimental" CPI-E (for elderly) that has been tracked but limited in its application so far. Additionally, at one point the Social Security Trust fund was the largest holder of US Treasuries. I assume we got here by a evolutionary process and budget drivers.

So, my questions would be:
1) Does anyone know if the Social Security trust fund, either now or previously, has owned TIPS?
2) How much difference, over time, would there be to a retiree between the measures of CPI? That is, how would TIPS adjustments track with social security colas? and/or how might tips work in relation to cpi-e or chained cpi?

Looking for possible impacts in tips liquidity if government made greater use and/or whether tips 'protection' is redundant with SS colas.

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Re: Do TIPS work? How do we know?

Post by danielc » Sat Dec 14, 2019 2:42 pm

stlutz wrote:
Sat Dec 14, 2019 2:36 pm
danielc wrote:
Sat Dec 14, 2019 2:22 pm
Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(
This is not unique to TIPS. Taxes on all investment income are based on nominal and not real dollars.
I know this is not unique to TIPS. That's also why regular bonds fail too, even though they often have coupons higher than inflation ---- once you add taxes, you're still screwed. As I said earlier, as far as I can tell the only asset class that does not have a negative expected real return after encountering taxes is stocks :-(

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 2:46 pm

That has always been a counter to investing in TIPS. That is if one does not believe they are exposed to unexpected inflation risks, or reducing the risks, by receiving annual COLA (or higher increases) in wages, social security is COLA adjusted, holding a large allocation to RETs (such as David Swensen recommenced), and a large allocation to stocks.
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Re: Do TIPS work? How do we know?

Post by 2pedals » Sat Dec 14, 2019 2:47 pm

Frank2012 wrote:
Sat Dec 14, 2019 1:32 pm
willthrill81 wrote:
Sat Dec 14, 2019 12:51 pm
Frank2012 wrote:
Sat Dec 14, 2019 12:37 pm
2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.
Since TIPS are explicitly linked to CPI by the Treasury, why do you believe that this is possible, unless perhaps you believe that CPI is a poor measure of inflation?
I don't know whether or not CPI is a good measure of inflation...but I know that many experts have been debating this for awhile:

https://www.investopedia.com/articles/0 ... eindex.asp

If CPI is a lagging indicator of inflation, then I don't see how TIPS are much of a hedge or protection against inflation....
These debates are like watching a cage fight of economists. You don't care who wins. The only thing that matters is how can you protect yourself from unexpected inflation and if this very safe and low risk investment is something you want. Maybe you don't want something that protects you from the CPI index but this is different than asking the question, "Does TIPS work? How do we know?" You don't get to choose what metrics are used for inflation when picking a treasury bond from the US.

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Re: Do TIPS work? How do we know?

Post by Elysium » Sat Dec 14, 2019 2:48 pm

danielc wrote:
Sat Dec 14, 2019 2:40 pm
columbia wrote:
Sat Dec 14, 2019 12:54 pm
How have TIPS fared - in terms of return above inflation - compared to corporate bonds?
Not well . According to Portfolio Visualizer (see here) since 2003 (longest timeframe available) corporate bonds have returned 5.53% and TIPS only 4.07%, and corporates had a slightly better Sharpe ratio. This doesn't take into account the tax advantage of TIPS (they're exempt from state tax) so YMMV.
That really depends on the duration of TIPS bonds used. A 60/40 portfolio of US TSM & Long Term TIPS would have had better Sharpe ratio than a similar portfolio of US TSM / Interm-Term Investment Grade bonds. Short / Interm-Term TIPS would have fared slightly lower.

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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 2:51 pm

kadye wrote:
Sat Dec 14, 2019 12:24 pm
I read elsewhere that the historical correlation between TIPS and CPI has been very very low. Can someone please illuminate us why this is?

If I buy a $1k zero coupon TIPS (I don't know if this is doable, I haven't bought TIPS before, but assuming it is doable), then I thought this will compound grow with CPI. No?
Yes, as long as the inflation adjustments are reinvested, which is automatic with directly-held TIPS, next year's inflation adjustment (it happens more than annually) will be on top of this year's.

That's what compounding is.

PJW

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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 2:56 pm

Frank2012 wrote:
Sat Dec 14, 2019 12:37 pm
2pedals wrote:
Sat Dec 14, 2019 12:32 pm
Be careful with what your definition of "do TIPS work" is.

Does TIPS protect against expected inflation? The answer is not so well. Stocks most likely will do a better job with that.
Does TIPS protect against unexpected inflation? The answer yes it does.

https://personal.vanguard.com/pdf/ISGCTIPS.pdf
But we've not had unexpected inflation since TIPS came into existence in 1997, so we've never seen how TIPS react to unexpected inflation. I'm not so sure that TIPS will offer any protection against unexpected inflation.
Are you asking about Yield to Maturity, YTM, or about current market price? If you expect the present market price to closely track realized inflation you will be disappointed. They do not. TIPS are subject to term risk just like any other bonds, and the longer the average duration the bigger the fluctuations in value will be.

It's just that TIPS respond to the real yield curve. Nominal bonds respond to the nominal yield curve. They do not reliably track each other.

PJW

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 3:00 pm

TIPS are impacted by the real yield curve.

Nominal bonds are impacted by the nominal yield curve.
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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 3:00 pm

abuss368 wrote:
Sat Dec 14, 2019 2:30 pm
danielc wrote:
Sat Dec 14, 2019 2:22 pm
Inside a taxable account I don't think TIPS are a good hedge against inflation at all. You pay tax on the adjustment of principal, so you still lose wealth, and the greater the inflation the faster you lose wealth. AFAICT the only asset that does not have a negative real return in taxable is stocks :-(
Correct. I believe this called phantom income. The adjustment to principal is taxes even though the income is not received.
Phantom income is a phantom problem. In order to keep the value of your investment up with inflation as it compounds you have to reinvest the portion that matches realized inflation. In directly-held TIPS it happens automatically. In a TIPS fund the inflation adjustments are paid out as distributions. To keep up one has to reinvest at least the portion of the distribution that reflects realized inflation.

Paid out money that's reinvested is no more available to pay income tax with than are adjustments to par value.

PJW

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Re: Do TIPS work? How do we know?

Post by abuss368 » Sat Dec 14, 2019 3:02 pm

Phantom income is reported separately on year end tax documents.
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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 3:03 pm

danielc wrote:
Sat Dec 14, 2019 2:40 pm
columbia wrote:
Sat Dec 14, 2019 12:54 pm
How have TIPS fared - in terms of return above inflation - compared to corporate bonds?
Not well . According to Portfolio Visualizer (see here) since 2003 (longest timeframe available) corporate bonds have returned 5.53% and TIPS only 4.07%, and corporates had a slightly better Sharpe ratio. This doesn't take into account the tax advantage of TIPS (they're exempt from state tax) so YMMV.
Are you talking about Yield to Maturity, YTM, or about day by day changes in market value? TIPS YTM is adjusted for inflation. If you expect their market values to track inflation closely you will be disappointed.

I think whether they work or not has to do with one's understanding of what they're meant to accomplish.

PJW

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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 3:04 pm

danielc wrote:
Sat Dec 14, 2019 2:27 pm
kadye wrote:
Sat Dec 14, 2019 12:24 pm
If I buy a $1k zero coupon TIPS (I don't know if this is doable, I haven't bought TIPS before, but assuming it is doable), then I thought this will compound grow with CPI. No?
Unfortunately no. Not only are there no zero coupon TIPS, but you even pay yearly tax on the adjusted principal. No compounding. However, I-Bonds do have compounding (i.e. they are tax-deferred) so you might want to look into those, but they also tend to pay lower real rates than TIPS.
That's incorrect. There is compounding. This year's par value adjustments (it happens more than annually) are on top of previous years'. That's what compounding is.

PJW

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Re: Do TIPS work? How do we know?

Post by Phineas J. Whoopee » Sat Dec 14, 2019 3:07 pm

not4me wrote:
Sat Dec 14, 2019 2:40 pm
...
1) Does anyone know if the Social Security trust fund, either now or previously, has owned TIPS?
...
The Social Security Trust Fund holds special Treasury securities specifically created for it to invest in. They work much like savings bonds you and I can buy. They are not CPI-adjusted.

PJW

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