Asymmetric risk with nominal vs. inflation-linked bonds

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willthrill81
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Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

We've seen a lot of discussion pertaining to the performance of TBM and TIPS over the last year, which is understandable since TBM has experienced its biggest nominal drawdown in its history and inflation is at the highest levels seen in over 40 years. Many investors have chosen to retain their nominal bond holdings, especially TBM, while many others have chosen to (hopefully, permanently) move part or all their fixed income to TIPS.

An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.

My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.

With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.

But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.

Therefore, absent deflation, it is indisputable that nominal Treasuries are riskier than TIPS when it comes to funding future consumption in real dollars. But there's another way to consider this that further demonstrates the same point.

If we assume that inflation is highly unlikely to average below 0% over a given decade, we can assume then that the best possible real returns of 10 year nominal Treasuries is their starting nominal yield of 2.65%. But there is no limit to how low the real returns of 10 year nominal Treasuries can be. In other words, 10 year Treasuries have very long left-tail risk. With TIPS held to maturity, their real return is, again, known with precision at the time of purchase.

Some claim that nominal bonds like 10 year Treasuries, funds like TBM, etc. have a higher expected real return than do TIPS. This is debatable since TIPS have a slight return premium over Treasuries due to their slightly lower liquidity. But in any event, any such higher expected return of nominal Treasuries over TIPS appears to be widely agreed upon to be very small and possibly zero.

Therefore, due to the uncertainty surrounding future inflation, there is uncertainty regarding the future real returns of nominal Treasuries (and nominal bonds, such as TBM), whereas there is no uncertainty regarding the real returns of TIPS as these are known at the time of purchase. Given that the expected benefit of nominal Treasuries compared to TIPS is no more than tiny, I contend that the risks faced by nominal Treasuries (and other nominal bonds) compared to those of TIPS are asymmetric and tilted significantly in favor of TIPS. Nominal Treasuries and other bonds are exposed to significant risks that are absent from TIPS, and those risks are not accompanied by a corresponding expectation of higher returns.

While it's true that nominal Treasuries are preferred in the presence of deflation, TIPS have some, though not as much, protection in that regard also since, upon maturity, the bearer will be paid the greater of their adjusted principal or their original principal. However, given that inflation has been a far bigger historic risk to investors than has deflation, I do not believe the better performance of nominal Treasuries to justify the uncertainty regarding their future inflation-adjusted value.
Last edited by willthrill81 on Mon Aug 01, 2022 10:03 am, edited 1 time in total.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by squirrel1963 »

Rather unsurprisingly I agree with you, hopefully this thread won't be side tracked with arguments about nominal liabilities vs real liabilities. I'm also looking forward to read other's comments.

Historically inflation has always been very hazardous to health, it's easy to see that inflation comes with many years in a sequence (sequence of returns risk), while deflationary episodes seem to have been rather isolated.
For my case I'm not worried enough to insist in buying at auction to get a low inflation factor, I just avoided inflation factors higher than 1.3 in building my TIPS ladder and I think that's enough.

I'm not even sure what would happen to the economy if we had several consecutive years of significant deflation.

I believe it is safe to assume that deflation is an acceptable risk and that the deflation protection offered by TIPS is good enough.

So I'm happily sacrificing unknown future real yields of nominals in exchange for the guaranteed downward protection of TIPS. Small price to pay IMHO to sleep well at night. Thinking about it in abstract, it's about the marginal value of a deflated dollar versus the marginal negative value of an inflated dollar.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

squirrel1963 wrote: Fri Jul 29, 2022 10:32 pm I'm not even sure what would happen to the economy if we had several consecutive years of significant deflation.
It's my understanding that the Federal Reserve has basically said that they are targeting 2% inflation in order to stay as far away from deflation as they comfortably can.

I agree that long-term deflation seems to be far less likely to occur than long-term, unexpected inflation, and TIPS offer good deflation protection, just not as good as that of nominals.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by bridge2benefits »

willthrill81 wrote: Fri Jul 29, 2022 10:12 pm An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.

My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.

With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.

But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.
Agree completely. I've been puzzled for a while that this isn't commonly accepted wisdom here. Some possible explanations:

1. Most people don't think or plan in terms of holding their bonds to maturity.
2. Most people focus on nominal returns instead of real returns.
3. It's easier to trade bonds before they mature (via bond funds) than to hold them to maturity.
4. Financial reporting emphasizes changes in bond Net Asset Value, encouraging trading of bonds.
5. Financial reporting focuses on institutional trader's perspective on bonds, instead of a retiree's perspective.
6. Recency bias due to bond funds increasing in Net Asset Value for 40 years due to falling rates, encouraging trading of bonds.
7. Recency bias due to low inflation for 40 years.
8. Thinking of nominals vs. inflation protected bonds as a coin flip due to lack of awareness of the asymmetric risk you describe.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by billaster »

willthrill81 wrote: Fri Jul 29, 2022 10:46 pm The Federal Reserve has basically said that they are targeting 2% inflation in order to stay as far away from deflation as they comfortably can.
No, the Federal Reserve is not so much worried about deflation. They are worried about having enough breathing room to lower rates in the event of a recession. If you are already at zero, you've got no place to go except quantitative easing which is not very effective.

There are many economists who argue that having 3% or 4% inflation as a stable target would be safer long term, allowing more room before hitting the zero lower bound.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by squirrel1963 »

bridge2benefits wrote: Fri Jul 29, 2022 11:38 pm
willthrill81 wrote: Fri Jul 29, 2022 10:12 pm An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.

My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.

With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.

But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.
Agree completely. I've been puzzled for a while that this isn't commonly accepted wisdom here. Some possible explanations:

1. Most people don't think or plan in terms of holding their bonds to maturity.
2. Most people focus on nominal returns instead of real returns.
3. It's easier to trade bonds before they mature (via bond funds) than to hold them to maturity.
4. Financial reporting emphasizes changes in bond Net Asset Value, encouraging trading of bonds.
5. Financial reporting focuses on institutional trader's perspective on bonds, instead of a retiree's perspective.
6. Recency bias due to bond funds increasing in Net Asset Value for 40 years due to falling rates, encouraging trading of bonds.
7. Recency bias due to low inflation for 40 years.
8. Thinking of nominals vs. inflation protected bonds as a coin flip due to lack of awareness of the asymmetric risk you describe.
I wonder if people get confused by the reported yield on TIPS funds? For intermediate TIPS, looking at the current information pages in Vanguard and Schwab I see:

Vanguard VIPSX : 0.14%
Schwab SCHP : 12.44%

That's quite a difference even considering that their duration is a bit different.

How many people actually read the footnotes to find out that Vanguard reports real yield instead of nominal yield? It's confusing at best even if you know it.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Northern Flicker »

I don't disagree, but risk should be evaluated as overall portfolio risk.
My postings are my opinion, and never should be construed as a recommendation to buy, sell, or hold any particular investment.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by FoundingFather »

We have the majority of our fixed income in I Bonds for many of the reasons you outlined. I like that I Bonds and TIPS have both inflation and deflation protection. Nominals, on the other hand, are great during deflation but do quite a bit worse during inflation. I would rather my fixed income be well adapted for either situation.

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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by gips »

willthrill81 wrote: Fri Jul 29, 2022 10:12 pm
While it's true that nominal Treasuries are preferred in the presence of deflation, TIPS have some, though not as much, protection in that regard also since, upon maturity, the bearer will be paid the greater of their adjusted principal or their original principal. However, given that inflation has been a far bigger historic risk to investors than has deflation, I do not believe the better performance of nominal Treasuries to justify the uncertainty regarding their future inflation-adjusted value.
We are in a time of high inflation and tips look attractive now but I don’t think one can state with certainty that tips have always or will always be superior to nominals.

here is an article I read some time ago by larry swedoe which argues that allocation to nominals vs tips should be informed by the inflation risk premium of nominals:

https://www.advisorperspectives.com/art ... inal-bonds

best,
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by marcopolo »

bridge2benefits wrote: Fri Jul 29, 2022 11:38 pm
willthrill81 wrote: Fri Jul 29, 2022 10:12 pm An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.

My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.

With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.

But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.
Agree completely. I've been puzzled for a while that this isn't commonly accepted wisdom here. Some possible explanations:

1. Most people don't think or plan in terms of holding their bonds to maturity.
2. Most people focus on nominal returns instead of real returns.
3. It's easier to trade bonds before they mature (via bond funds) than to hold them to maturity.
4. Financial reporting emphasizes changes in bond Net Asset Value, encouraging trading of bonds.
5. Financial reporting focuses on institutional trader's perspective on bonds, instead of a retiree's perspective.
6. Recency bias due to bond funds increasing in Net Asset Value for 40 years due to falling rates, encouraging trading of bonds.
7. Recency bias due to low inflation for 40 years.

8. Thinking of nominals vs. inflation protected bonds as a coin flip due to lack of awareness of the asymmetric risk you describe.

That is interesting.
It seems to me the recency bias is more prevalent in all the threads all of a sudden popping up extolling the virtues of TIPS, just coincidentally after unexpected inflation has shown up. I know many have been advocating inflation protected fixed income for sometime. But, there has definitely been a lot recent uptick in interest in those products.

I have roughly 50% our fixed income assets in TIPs, and have had that for some time, long before they have become the product du jour.

I take this diversification approach because I don't know if, when, or how much, unexpected inflation will show up.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Northern Flicker »

bridge2benefits wrote: 6. Recency bias due to bond funds increasing in Net Asset Value for 40 years due to falling rates, encouraging trading of bonds.
Not for 40 years, obviously, but that has actually benefited TIPS more than nominal treasuries.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Dude2 »

Considering the portfolio as a whole, and in keeping with the general approach to invest primarily in stocks and bonds, the often mentioned approach is to take risk on the stock side -- that is the side that has shown its ability to compensate the investor for the risk. From that viewpoint, then of course we should choose TIPS over nominals. This isn't recency bias. We've all been saying it all along.

You may not buy into the risk on the equity side argument though. The fundamental characteristics of stocks and bonds are different. The less faith you have in stocks, the more risk you may be willing to take on the bond side. For that you want your risk to be compensated. You want to invest in bonds as smartly as possible, i.e. to get a unit of reward for each unit of risk. However, you wouldn't call it investing if you only sought the very least reward possible. Clearly TIPS are at the far end of the risk/reward spectrum.

There may be a line where you'd prefer short term bond index, for example, over TIPS because you can get a widely more diverse set of bonds in your basket. Economic factors will wax and wane, but over the long run you'd still expect the risk to be rewarded, and at least you would have minimized exposure to unexpected inflation.

In other words, when there isn't unexpected inflation, you'd be right to believe you are going to do far better not being exclusively in TIPS. That's my devil's advocate type of comment, but the conclusion we usually come to in these discussions is that the difference is minimal. Stock rewards dwarf bond rewards so greatly that take the risk on the equity side wins. Therefore, why not be 100% TIPS. I could not agree more, either today or ten years ago.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by CraigTester »

Good post and no surprise that I agree with you.

IMHO, the primary reason TIPS are not already the “default”, is because they were only invented in 1997.

And my only personal hesitation with more widely using them is concern over how liquid they are in times of financial stress. I’ve “heard” (but not personally experienced), they were difficult to sell at the height of the subprime crisis.

Does anyone on this thread have any direct experience with this concern?

(This is arguably not an issue if just planning to hold until maturity, but sometimes plans can change).
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Dude2 »

I think that it is Doc who has told his story of the 2008 era issues he experienced. The summary, was that with stocks and TIPS dropping like a rock, if he stuck to his rebalancing plan he would be selling his TIPS and realizing major losses. He quickly abandoned his approach after that crisis. This all tends to drive us to a concept in which we don't sell our TIPS to rebalance, i.e. to more use them as LMP type assets where duration matches need versus using them for ballast. This is clearly a good point. The more TIPS and stocks are correlated, the worse for a rebalancing plan. Then again, most probably consider 2008/2009 a 5 sigma event.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Svensk Anga »

I agree with the thesis laid out in the OP. I just find it curious that the major fund houses, in designing their target date funds, have provided only a minor allocation to TIPS. None at all may be justified in the early accumulation years, when fixed income is a minor part of the portfolio, but once one gets to the distribution years and very heavy fixed income allocations, I would think TIPS should dominate. Or at least 50/50.

Stocks are often described as offering inflation protection. But this is true only in the longer term. A retiree may suffer severe sequence risk if high inflation shows up and he holds mostly longish duration nominal bonds. I'm thinking here of the 1970's. Inflation ramped up to the 1981 peak, but stocks went net nowhere from, IIRC, 1973 to 1982. (Dow hit 1000 in the early 70's, declined in the 74/75 bear market and did not get back to that level until 1982 or 83. But that is just price return, ignoring dividends that were more substantial than current fashion.)

I adopted the TIPS heavy fixed income allocation starting about 2012 when I was getting serious about retirement planning. Bill Bernstein made the case for a TIPS ladder in his pamphlet "Ages of the Investor" and I accepted adopted his program. Part of the deal is delaying SS to 70, so as to get the maximum in inflation-adjusted reliable income. One's sequence risk on fixed income is then dominated by the years between retirement and age 70. It may not take a huge commitment to TIPS to fund that gap.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Svensk Anga »

CraigTester wrote: Sat Jul 30, 2022 4:09 am
And my only personal hesitation with more widely using them is concern over how liquid they are in times of financial stress. I’ve “heard” (but not personally experienced), they were difficult to sell at the height of the subprime crisis.
The flip side of this is that times of financial stress are the time to be a TIPS buyer. Treasury prices would likely be spiking in a rush to safety. TIPS prices may be falling due to the liquidity issue, providing an excellent rebalancing opportunity. This occurred in 2008 and very briefly in early 2020. The relative return prospects quickly become very different, assuming that the precipitating crisis will soon pass.

I wonder if we didn't just see a minor example of this in the late June runup in TIPS real yields. Mr. Market got worried that Fed actions would precipitate a recession, so TIPS yields had to go up to compensate for possible deflation/disinflation. Recession fears may now be receding and TIPS yields have since fallen.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by panhead »

willthrill81 wrote: Fri Jul 29, 2022 10:12 pm My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.

With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.

But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.

Therefore, absent deflation, it is indisputable that nominal Treasuries are riskier than TIPS when it comes to funding future consumption in real dollars. But there's another way to consider this that further demonstrates the same point.
Earlier in my investing career I had drank the boglehead kool aid at the time which was to invest in 50% TBM and 50% TIPS fund. I didn't really understand tips at the time, and when I looked at the negative yield, I didn't understand what it meant. I eventually abandoned this and went with total bond.

As I learned more about TIPS (and ibonds) I saw them as being very useful as a bridge to social security at age 70, basically creating ones own mini-pension equal to age 70 social security to maximize the annuity benefit, but smooth purchasing power before and after SS eligibility at 70. I became convinced the best way to do this was to buy individual tips duration matched to my needs. I came to this conclusion several years ago and began studying and learning more about tips and ibonds at the time. Since I'm not yet retired, I didn't see a sense of urgency as I figured my salary was an acceptable inflation hedge.

Now, I am starting to set up this ladder, and of course TIPS maturing during a large part of my desired ladder don't exist yet, but that's ok, it can be worked around.

I'm not sure I want to go all-in on TIPS, but I am a big believer in their use when held as individual issues and held to maturity to match future spending (such as a ladder to SS). I think they my also be very useful to hold as a lump sum to purchase an annuity later in life (age >70-ish). That being said, I also think a dose of nominal bunds in a fund is useful for rebalancing along the journey, as we have seen in certain circumstances (doc) that there can be liquidity issues with TIPS which can cause issues.

Where does this leave my thinking? Currently I'm going to build a ladder to SS using TIPS. This ladder will serve to replace my age 70 social security and not supplement it, so it will end when I turn 70. Beyond that, my thinking could evolve to increasing and extending the tips ladder to ensure real spending floor well beyond age 70, but for now I'm content using stocks/nominal bonds and rebalancing between them.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by bridge2benefits »

Northern Flicker wrote: Sat Jul 30, 2022 3:40 am
bridge2benefits wrote: 6. Recency bias due to bond funds increasing in Net Asset Value for 40 years due to falling rates, encouraging trading of bonds.
Not for 40 years, obviously, but that has actually benefited TIPS more than nominal treasuries.
Good point, thanks. I guess what I was trying to get at is if people view nominals and TIPS as assets to buy and flip before they mature, it may distract from the simpler comparison of "if I buy this and hold to maturity, what will I get?"

And it's when we make that "hold to maturity" comparison that the asymmetric advantage of TIPS over nominals becomes apparent.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by bridge2benefits »

Svensk Anga wrote: Sat Jul 30, 2022 5:40 am I agree with the thesis laid out in the OP. I just find it curious that the major fund houses, in designing their target date funds, have provided only a minor allocation to TIPS. None at all may be justified in the early accumulation years, when fixed income is a minor part of the portfolio, but once one gets to the distribution years and very heavy fixed income allocations, I would think TIPS should dominate. Or at least 50/50.
Yes, this has always been surprising to me as well - to use Rick Ferri's language, I would expect 100% TIPS to be the "center of gravity" for a retiree, and then the discussion would go from there about how much nominals to mix in, depending on the situation.

In terms of retirement funds holding mostly nominals, there is one interesting exception that I'm aware of (via this forum) - the DFA Retirement Income Fund:
https://us.dimensional.com/funds/dimens ... ncome-fund
I adopted the TIPS heavy fixed income allocation starting about 2012 when I was getting serious about retirement planning. Bill Bernstein made the case for a TIPS ladder in his pamphlet "Ages of the Investor" and I accepted adopted his program. Part of the deal is delaying SS to 70, so as to get the maximum in inflation-adjusted reliable income. One's sequence risk on fixed income is then dominated by the years between retirement and age 70. It may not take a huge commitment to TIPS to fund that gap.
This is exactly what I do as well. I'm convinced that delaying Social Security and building a TIPS ladder for the bridge years is a very effective way to reduce sequence of returns risk.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

gips wrote: Sat Jul 30, 2022 2:38 am here is an article I read some time ago by larry swedoe which argues that allocation to nominals vs tips should be informed by the inflation risk premium of nominals:
In the years since, it's become fairly apparent that the inflation risk premium of nominals has been more than offset by the illiquidity premium of TIPS.

Even before the relatively recent inflation manifested itself, TIPS had had higher returns than nominals. From 2001-2020, TBM returned 2.54% real, while TIPS returned 3.08%. And obviously, since 2001, TIPS have blown nominals out of the water (by bond standards).

Consequently, I don't understand why splitting one's fixed income 50/50 between nominals and TIPS makes sense. I suppose its built on Swensen's notion of being at least 50% 'right' whether realized inflation is above or below the breakeven inflation rate. But that completely ignores the asymmetric risk of nominals and the fact that their purported inflation risk premium has manifested itself in the form of higher overall returns.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by ScubaHogg »

I completely agree with the OP. I actually think he is understating the asymmetry. Absolutely horrible deflation might be measured in the 10-20% range. The sum total deflation in the Great Depression was like 25%.

Inflation on the other hand has virtually no upper bound.

1000% inflation? We have examples of it.
10,000% inflation? We have examples of it

Even experiencing something as realistic (by historical standards) as 15% unexpected inflation for a decade plus could decimate a nominal bond portfolio
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

ScubaHogg wrote: Sat Jul 30, 2022 8:59 am I completely agree with the OP. I actually think he is understating the asymmetry. Absolutely horrible deflation might be measured in the 10-20% range. The sum total deflation in the Great Depression was like 25%.

Inflation on the other hand has virtually no upper bound.

1000% inflation? We have examples of it.
10,000% inflation? We have examples of it

Even experiencing something as realistic (by historical standards) as 15% unexpected inflation for a decade plus could decimate a nominal bond portfolio
Thanks for mentioning that. The benefits of nominals in deflation are far overblown, IMHO. When we look at the history of financial markets around the world over the last 100+ years, it's clear that inflation has been a far bigger and far more likely risk than deflation.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

Northern Flicker wrote: Sat Jul 30, 2022 1:36 am I don't disagree, but risk should be evaluated as overall portfolio risk.
That's a good point, though portfolios with TIPS funds rather than TBM funds haven't suffered since their inception in the early 2000s.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by gips »

willthrill81 wrote: Sat Jul 30, 2022 8:54 am
gips wrote: Sat Jul 30, 2022 2:38 am here is an article I read some time ago by larry swedoe which argues that allocation to nominals vs tips should be informed by the inflation risk premium of nominals:
In the years since, it's become fairly apparent that the inflation risk premium of nominals has been more than offset by the illiquidity premium of TIPS.

Even before the relatively recent inflation manifested itself, TIPS had had higher returns than nominals. From 2001-2020, TBM returned 2.54% real, while TIPS returned 3.08%. And obviously, since 2001, TIPS have blown nominals out of the water (by bond standards).

Consequently, I don't understand why splitting one's fixed income 50/50 between nominals and TIPS makes sense. I suppose its built on Swensen's notion of being at least 50% 'right' whether realized inflation is above or below the breakeven inflation rate. But that completely ignores the asymmetric risk of nominals and the fact that their purported inflation risk premium has manifested itself in the form of higher overall returns.
perhaps tbm is the wrong benchmark. look at the chart in this article with attention to the winner column:

https://tipswatch.com/tips-vs-nominal-treasurys/

“We just completed a decade-long period of inflation running at less than 2.0%. In general TIPS have out-performed nominal Treasurys when the inflation-breakeven rate dropped below 2.0%, especially for 10-year TIPS. But the next decade could be entirely different. Never predict the future decade based on the performance of the past decade.”
Last edited by gips on Sat Jul 30, 2022 9:20 am, edited 3 times in total.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by dodecahedron »

willthrill81 wrote: Sat Jul 30, 2022 9:06 am
ScubaHogg wrote: Sat Jul 30, 2022 8:59 am I completely agree with the OP. I actually think he is understating the asymmetry. Absolutely horrible deflation might be measured in the 10-20% range. The sum total deflation in the Great Depression was like 25%.

Inflation on the other hand has virtually no upper bound.

1000% inflation? We have examples of it.
10,000% inflation? We have examples of it

Even experiencing something as realistic (by historical standards) as 15% unexpected inflation for a decade plus could decimate a nominal bond portfolio
Thanks for mentioning that. The benefits of nominals in deflation are far overblown, IMHO. When we look at the history of financial markets around the world over the last 100+ years, it's clear that inflation has been a far bigger and far more likely risk than deflation.
Indeed!
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Joey Jo Jo Jr »

This would be hard to argue if TIPS and nominals were the only two assets in existence. But the reality, so far at least, has been that equities plus nominals have had less max drawdown, volatility, and market correlation than equities plus TIPS.

You can debate whether that will be true going forward, but I don’t think you can debate that there is simply no debate about which to use in a portfolio. I would also note that the experts appear to favor more nominals during accumulation (heavier in equities) and shifting to TIPS as you get closer to retirement (heavier in fixed income).
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by ScubaHogg »

Joey Jo Jo Jr wrote: Sat Jul 30, 2022 9:27 am This would be hard to argue if TIPS and nominals were the only two assets in existence. But the reality, so far at least, has been that equities plus nominals have had less max drawdown, volatility, and market correlation than equities plus TIPS.
Perhaps not sure on the market correlation bit. And equities plus tips have had a higher return

Using the max available amount of data (2001-present) on Portfolio Visualizer a 50/50 US Equity/TIPS has beaten both the 50/50 split for US Equity/Intermediate treasuries and US Equity/TBM. And during a time of generally falling rates, which should disadvantage TIPS.

https://bit.ly/3POXsCs

And even where equities plus nominals have won it’s only been by a little. If big inflation comes nominals will get wrecked. Thus the asymmetry.
Pierre-Simon Laplace’s original phrase for expected value was “mathematical hope.”
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by nigel_ht »

What is the recommendation in Aug 2022 if one is still mostly in TBM?

Assume it’s all in tax deferred with vanguard…
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by JohnDoh »

bridge2benefits wrote: Sat Jul 30, 2022 8:28 am
Svensk Anga wrote: Sat Jul 30, 2022 5:40 am I agree with the thesis laid out in the OP. I just find it curious that the major fund houses, in designing their target date funds, have provided only a minor allocation to TIPS. None at all may be justified in the early accumulation years, when fixed income is a minor part of the portfolio, but once one gets to the distribution years and very heavy fixed income allocations, I would think TIPS should dominate. Or at least 50/50.
Yes, this has always been surprising to me as well - to use Rick Ferri's language, I would expect 100% TIPS to be the "center of gravity" for a retiree, and then the discussion would go from there about how much nominals to mix in, depending on the situation.

In terms of retirement funds holding mostly nominals, there is one interesting exception that I'm aware of (via this forum) - the DFA Retirement Income Fund:
https://us.dimensional.com/funds/dimens ... ncome-fund
I adopted the TIPS heavy fixed income allocation starting about 2012 when I was getting serious about retirement planning. Bill Bernstein made the case for a TIPS ladder in his pamphlet "Ages of the Investor" and I accepted adopted his program. Part of the deal is delaying SS to 70, so as to get the maximum in inflation-adjusted reliable income. One's sequence risk on fixed income is then dominated by the years between retirement and age 70. It may not take a huge commitment to TIPS to fund that gap.
This is exactly what I do as well. I'm convinced that delaying Social Security and building a TIPS ladder for the bridge years is a very effective way to reduce sequence of returns risk.
This page is perhaps more informative about Dimensional's approach. See esp. the PDF report under "Resources":
https://us.dimensional.com/target-date- ... come-funds
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by PicassoSparks »

I’m getting increasingly convinced that I didn’t really understand bonds well enough when I started investing, but since time in the market beats timing the market, I was better off making some kind of asset allocation, even if it was the wrong one.

The puzzle for me now is: If inflation protected securities are so much better than nominals, why hasn’t the efficient bond market changed suit?
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

nigel_ht wrote: Sat Jul 30, 2022 9:54 am What is the recommendation in Aug 2022 if one is still mostly in TBM?

Assume it’s all in tax deferred with vanguard…
I'm not recommending anything per se, but there doesn't seem to be any disputing that TBM is inherently riskier than TIPS either in terms of funding future real consumption or historic portfolio performance during periods of both low and high inflation, and TIPS have not lowered returns either. In terms of an advantage for nominals, apart from a long-term deflationary situation, I for one don't see any.

If one decided to switch, the consequent action is very simple: sell TBM and buy TIPS, which is easy with funds.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

PicassoSparks wrote: Sat Jul 30, 2022 10:07 am The puzzle for me now is: If inflation protected securities are so much better than nominals, why hasn’t the efficient bond market changed suit?
That's a very good question, and I don't have a good answer.

The fact that the breakeven inflation rate on 10 year TIPS is only 2.48% is baffling to me, especially given current inflation. That's basically 7% inflation in year 1 and 2% inflation in years 2-10.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Robot Monster »

squirrel1963 wrote: Fri Jul 29, 2022 11:56 pm I wonder if people get confused by the reported yield on TIPS funds?
Jason Zweig wrote a 2021 Wall Street Journal article, "Don’t Believe the Inflated Yields on Inflation-Protected Bond Funds":
An 8% return on government bonds? Only a nutty calculation can make it so...These funds that purport to fight inflation are, ironically, inflating their own reported yields.
Near the end of the article:
Right now, “the market is experiencing very high month-over-month inflation, and a calculation that annualizes inflation accretion may reflect an overstated view of expected yield,” says a Vanguard spokesman. “Our practice has been to avoid that adjustment, which results in SEC yields on Vanguard funds with TIPS exposure appearing lower than other firms. Conversely, during periods where monthly inflation is negative, our SEC yield may look higher.” The firm feels this approach represents its TIPS funds’ real yield consistently and accurately, he says.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by steve r »

bridge2benefits wrote: Sat Jul 30, 2022 8:28 am
Svensk Anga wrote: Sat Jul 30, 2022 5:40 am I agree with the thesis laid out in the OP. I just find it curious that the major fund houses, in designing their target date funds, have provided only a minor allocation to TIPS. None at all may be justified in the early accumulation years, when fixed income is a minor part of the portfolio, but once one gets to the distribution years and very heavy fixed income allocations, I would think TIPS should dominate. Or at least 50/50.
Yes, this has always been surprising to me as well - to use Rick Ferri's language, I would expect 100% TIPS to be the "center of gravity" for a retiree, and then the discussion would go from there about how much nominals to mix in, depending on the situation.

In terms of retirement funds holding mostly nominals, there is one interesting exception that I'm aware of (via this forum) - the DFA Retirement Income Fund:
https://us.dimensional.com/funds/dimens ... ncome-fund

..
Interesting observation on the Target Date funds. Perhaps a "status quo bias" from the old 60/40 portfolio. That said, TD funds have seemed to rush into international bonds.

Perhaps it is a reaction to what happened in Japan? IDK. I will say this, deflation is historically not as uncommon as many think. I believe it occurred around 100 years during the first 170 years of U.S. history (but not much since). Deflation was a big issue in the election of 1896.

Looking at the data Simba on a U.S. 60/40 portfolio, with all its limitations, going back only to 1985 with simulated TIPs part of the time. So, 1985 to 2021.

TIPs out perform in CAGR nominal (10.21 versus 9.99), but with higher measured risk and max drawdown. TIPs had a lower Sortino Ratio, and similar Sharp.

A similar result occurs if I replace TSM (US) with World Stocks or an 80/20 portfolio and a variety of others with US and World stocks.
Similar results if I use ITT as suggest by Larry Swedroe.

I can play with the dates and get a "tie."

The TDF comment really has me thinking / wondering.



Good thread.
The closer you come to holding the entire market portfolio the higher your expected return for the risk you take. William Sharpe |No Debt |Aggressive Target Date Fund (adding bonds), TIAA RE & Chill
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Da5id »

willthrill81 wrote: Sat Jul 30, 2022 8:54 am
gips wrote: Sat Jul 30, 2022 2:38 am here is an article I read some time ago by larry swedoe which argues that allocation to nominals vs tips should be informed by the inflation risk premium of nominals:
In the years since, it's become fairly apparent that the inflation risk premium of nominals has been more than offset by the illiquidity premium of TIPS.

Even before the relatively recent inflation manifested itself, TIPS had had higher returns than nominals. From 2001-2020, TBM returned 2.54% real, while TIPS returned 3.08%. And obviously, since 2001, TIPS have blown nominals out of the water (by bond standards).

Consequently, I don't understand why splitting one's fixed income 50/50 between nominals and TIPS makes sense. I suppose its built on Swensen's notion of being at least 50% 'right' whether realized inflation is above or below the breakeven inflation rate. But that completely ignores the asymmetric risk of nominals and the fact that their purported inflation risk premium has manifested itself in the form of higher overall returns.
I don't find a backtests with a single starting and ending point compelling in any context. I don't generally like arguments of the form "X has outperformed over the past N years" therefore you should only own X. You don't say that TIPs outperformance will persist forever explicitly, but it feels like that is the implication of backtests when folks present them.

As we've discussed in a different thread on this topic, I'm generally not a believer in free lunches. The idea that TIPs are both safer AND higher returning strikes me as something that, if true, probably won't last. My general feeling is that the break even currently feels low, but on the other hand I don't invest based on a feeling that the market has set prices incorrectly.

I also expect that owning 100% TIPs, 100% nominals, or some mix of the two will be good enough in an equity dominated portfolio even if some choices may be better than others. I own some of both and am OK with that.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by ScubaHogg »

PicassoSparks wrote: Sat Jul 30, 2022 10:07 am
The puzzle for me now is: If inflation protected securities are so much better than nominals, why hasn’t the efficient bond market changed suit?
Two guesses (guesses only)

1) the TIPS market just isn’t big enough for institutional investors

2) many institutions have nominal liabilities, so nominals bonds are fine

Third guess:

3) EMH is overblown. Said differently. It’s emH, not emT, and definitely not emL
Pierre-Simon Laplace’s original phrase for expected value was “mathematical hope.”
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by ScubaHogg »

Da5id wrote: Sat Jul 30, 2022 10:35 am
As we've discussed in a different thread on this topic, I'm generally not a believer in free lunches. The idea that TIPs are both safer AND higher returning strikes me as something that, if true, probably won't last.
It’s not necessarily a free lunch. You also have to ask, “safer for who?” They definitely aren’t safer for Institutions with nominal liabilities

That being said, inflation can be a very fat tailed event. Nominals could win for 99 years and give it all back in a year of horrible inflation. William Bernstein has some nice history of inflation.
Pierre-Simon Laplace’s original phrase for expected value was “mathematical hope.”
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Da5id »

ScubaHogg wrote: Sat Jul 30, 2022 10:47 am
Da5id wrote: Sat Jul 30, 2022 10:35 am
As we've discussed in a different thread on this topic, I'm generally not a believer in free lunches. The idea that TIPs are both safer AND higher returning strikes me as something that, if true, probably won't last.
It’s not necessarily a free lunch. You also have to ask, “safer for who?” They definitely aren’t safer for Institutions with nominal liabilities

That being said, inflation can be a very fat tailed event. Nominals could win for 99 years and give it all back in a year of horrible inflation. William Bernstein has some nice history of inflation.
If they are clearly better for retail investors I also expect demand to pick up and that to impact the price, no? If they are (over the long term) worse for the lender (US and other national governments) I expect the deal to get worse. Though as of a few years ago they were better for the US government apparently.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by dodecahedron »

ScubaHogg wrote: Sat Jul 30, 2022 10:47 am
Da5id wrote: Sat Jul 30, 2022 10:35 am
As we've discussed in a different thread on this topic, I'm generally not a believer in free lunches. The idea that TIPs are both safer AND higher returning strikes me as something that, if true, probably won't last.
It’s not necessarily a free lunch. You also have to ask, “safer for who?” They definitely aren’t safer for Institutions with nominal liabilities

That being said, inflation can be a very fat tailed event. Nominals could win for 99 years and give it all back in a year of horrible inflation. William Bernstein has some nice history of inflation.
I agree about the fat tails. Curious about where to find Bernstein’s inflation history.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by ScubaHogg »

dodecahedron wrote: Sat Jul 30, 2022 11:02 am
ScubaHogg wrote: Sat Jul 30, 2022 10:47 am
Da5id wrote: Sat Jul 30, 2022 10:35 am
As we've discussed in a different thread on this topic, I'm generally not a believer in free lunches. The idea that TIPs are both safer AND higher returning strikes me as something that, if true, probably won't last.
It’s not necessarily a free lunch. You also have to ask, “safer for who?” They definitely aren’t safer for Institutions with nominal liabilities

That being said, inflation can be a very fat tailed event. Nominals could win for 99 years and give it all back in a year of horrible inflation. William Bernstein has some nice history of inflation.
I agree about the fat tails. Curious about where to find Bernstein’s inflation history.
The four part “Ages of the Investor” goes over some historical examples. And he references some books which cover more inflation history

https://www.amazon.com/Ages-Investor-Cr ... B008CM2T2A
Pierre-Simon Laplace’s original phrase for expected value was “mathematical hope.”
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by Escapevelocity »

I retired this year and went into retirement with only a small allocation to I Bonds and no TIPS. Now, I have about 25% of my fixed income in combination of I Bonds and TIPS (funds and individual). I would like to get this to around 50% and possibly more, but I'm afraid of mistiming the market and having buyer's remorse if the real yields of TIPS climb from the zero-ish level they are today.

Do additional I Bond purchases make sense if and when real yields on TIPS happen to be higher than the fixed interest rate on new or already held I Bonds?

Another aspect that I am having a hard time with is the interest rate risk of TIPS. I have a good understanding of the interest rate risk of varying duration nominals, but how does this translate to TIPS. Is holding a long duration TIP less risky than a long term treasury bond? Does it just come down to the risk of locking in a low real yield on TIPS and then having the real yields spike up? This seems less risky due to smaller volatility of real yields on TIPS right?
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by CletusCaddy »

Escapevelocity wrote: Sat Jul 30, 2022 11:39 am I retired this year and went into retirement with only a small allocation to I Bonds and no TIPS. Now, I have about 25% of my fixed income in combination of I Bonds and TIPS (funds and individual). I would like to get this to around 50% and possibly more, but I'm afraid of mistiming the market and having buyer's remorse if the real yields of TIPS climb from the zero-ish level they are today.

Do additional I Bond purchases make sense if and when real yields on TIPS happen to be higher than the fixed interest rate on new or already held I Bonds?

Another aspect that I am having a hard time with is the interest rate risk of TIPS. I have a good understanding of the interest rate risk of varying duration nominals, but how does this translate to TIPS. Is holding a long duration TIP less risky than a long term treasury bond? Does it just come down to the risk of locking in a low real yield on TIPS and then having the real yields spike up? This seems less risky due to smaller volatility of real yields on TIPS right?
Real yields may or may not be as volatile in the future but once you start worrying about that you are basically market timing.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by CletusCaddy »

In the long run I still think deflation is the bigger risk, not inflation. But I am in my 30s and others may not have the same timeline I do.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

steve r wrote: Sat Jul 30, 2022 10:23 am
bridge2benefits wrote: Sat Jul 30, 2022 8:28 am
Svensk Anga wrote: Sat Jul 30, 2022 5:40 am I agree with the thesis laid out in the OP. I just find it curious that the major fund houses, in designing their target date funds, have provided only a minor allocation to TIPS. None at all may be justified in the early accumulation years, when fixed income is a minor part of the portfolio, but once one gets to the distribution years and very heavy fixed income allocations, I would think TIPS should dominate. Or at least 50/50.
Yes, this has always been surprising to me as well - to use Rick Ferri's language, I would expect 100% TIPS to be the "center of gravity" for a retiree, and then the discussion would go from there about how much nominals to mix in, depending on the situation.

In terms of retirement funds holding mostly nominals, there is one interesting exception that I'm aware of (via this forum) - the DFA Retirement Income Fund:
https://us.dimensional.com/funds/dimens ... ncome-fund

..
Interesting observation on the Target Date funds. Perhaps a "status quo bias" from the old 60/40 portfolio. That said, TD funds have seemed to rush into international bonds.
That TDF funds have jumped on international bonds while virtually avoiding TIPS altogether makes zero sense to me.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by bridge2benefits »

JohnDoh wrote: Sat Jul 30, 2022 10:05 am
bridge2benefits wrote: Sat Jul 30, 2022 8:28 am Yes, this has always been surprising to me as well - to use Rick Ferri's language, I would expect 100% TIPS to be the "center of gravity" for a retiree, and then the discussion would go from there about how much nominals to mix in, depending on the situation.

In terms of retirement funds holding mostly nominals, there is one interesting exception that I'm aware of (via this forum) - the DFA Retirement Income Fund:
https://us.dimensional.com/funds/dimens ... ncome-fund
This page is perhaps more informative about Dimensional's approach. See esp. the PDF report under "Resources":
https://us.dimensional.com/target-date- ... come-funds
Thanks! And here's a related paper that user Fremdon Ferndock previously pointed us to: https://papers.ssrn.com/sol3/papers.cfm ... id=3881168
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

Da5id wrote: Sat Jul 30, 2022 10:35 am
willthrill81 wrote: Sat Jul 30, 2022 8:54 am
gips wrote: Sat Jul 30, 2022 2:38 am here is an article I read some time ago by larry swedoe which argues that allocation to nominals vs tips should be informed by the inflation risk premium of nominals:
In the years since, it's become fairly apparent that the inflation risk premium of nominals has been more than offset by the illiquidity premium of TIPS.

Even before the relatively recent inflation manifested itself, TIPS had had higher returns than nominals. From 2001-2020, TBM returned 2.54% real, while TIPS returned 3.08%. And obviously, since 2001, TIPS have blown nominals out of the water (by bond standards).

Consequently, I don't understand why splitting one's fixed income 50/50 between nominals and TIPS makes sense. I suppose its built on Swensen's notion of being at least 50% 'right' whether realized inflation is above or below the breakeven inflation rate. But that completely ignores the asymmetric risk of nominals and the fact that their purported inflation risk premium has manifested itself in the form of higher overall returns.
I don't find a backtests with a single starting and ending point compelling in any context. I don't generally like arguments of the form "X has outperformed over the past N years" therefore you should only own X. You don't say that TIPs outperformance will persist forever explicitly, but it feels like that is the implication of backtests when folks present them.
The historic data are what they are. I used all available annual data in the backtest and didn't cherry pick anything.

While I agree that a single ~20 year period is far from ideal when it comes to making generalized statements, it's all the data we have. And so far, the data are clear that TIPS have not had lower returns than Treasuries of similar maturity, the true benchmark, or even TBM, which effectively has a small amount of stock exposure via the corporate bonds that it holds. The returns might be very different going forward, I admit. But in my view, the relative returns of nominals and TIPS is an ancillary issue to the asymmetric risk of nominals.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

ScubaHogg wrote: Sat Jul 30, 2022 10:40 am
PicassoSparks wrote: Sat Jul 30, 2022 10:07 am
The puzzle for me now is: If inflation protected securities are so much better than nominals, why hasn’t the efficient bond market changed suit?
Two guesses (guesses only)

1) the TIPS market just isn’t big enough for institutional investors

2) many institutions have nominal liabilities, so nominals bonds are fine

Third guess:

3) EMH is overblown. Said differently. It’s emH, not emT, and definitely not emL
Bingo. Insurance companies' liabilities, for instance, are, AFAIK, 100% nominal. There are no CPI linked products such as SPIAs available on the market anymore. As such, nominal Treasuries make more sense for them from a liability matching perspective. And I agree that the EMH is only a hypothesis and certainly not a universal law; we've long known that there were exceptions to it at the very least.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by willthrill81 »

Escapevelocity wrote: Sat Jul 30, 2022 11:39 am Do additional I Bond purchases make sense if and when real yields on TIPS happen to be higher than the fixed interest rate on new or already held I Bonds?
Taxes can favor I bonds even if their real yield is lower than that of TIPS. The nominal interest on I bonds is tax-deferred, which can be a significant advantage, especially if you've already maxed out all your available tax-advantaged accounts. It's best to hold TIPS in tax-advantaged, particularly tax-deferred, accounts when possible.
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by bridge2benefits »

CletusCaddy wrote: Sat Jul 30, 2022 11:55 am In the long run I still think deflation is the bigger risk, not inflation. But I am in my 30s and others may not have the same timeline I do.
I understand how the risk of inflation manifests itself, but I have a harder time understanding the negative consequences of deflation.

In the case of inflation, if cumulative inflation is 50% over 10 years, and I started with $100, I only have 100/150 = 2/3 of my original purchasing power. This is obviously a serious risk.

In the case of deflation, if cumulative deflation is -50% over 10 years, and I started with $100, I have 100/50 = 2x my original purchasing power. This seems like a stroke of good fortune. What might lead us to instead view it as a risk?
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Re: Asymmetric risk with nominal vs. inflation-linked bonds

Post by squirrel1963 »

Robot Monster wrote: Sat Jul 30, 2022 10:17 am
squirrel1963 wrote: Fri Jul 29, 2022 11:56 pm I wonder if people get confused by the reported yield on TIPS funds?
Jason Zweig wrote a 2021 Wall Street Journal article, "Don’t Believe the Inflated Yields on Inflation-Protected Bond Funds":
An 8% return on government bonds? Only a nutty calculation can make it so...These funds that purport to fight inflation are, ironically, inflating their own reported yields.
Near the end of the article:
Right now, “the market is experiencing very high month-over-month inflation, and a calculation that annualizes inflation accretion may reflect an overstated view of expected yield,” says a Vanguard spokesman. “Our practice has been to avoid that adjustment, which results in SEC yields on Vanguard funds with TIPS exposure appearing lower than other firms. Conversely, during periods where monthly inflation is negative, our SEC yield may look higher.” The firm feels this approach represents its TIPS funds’ real yield consistently and accurately, he says.
I agree that Vanguard practice of reporting real yield is the correct one, I'm just wondering if it confusing?
Certainly the 30 day SEC yield has to be analyzed in its context as always, it'd be nice if they were also to report 180 day yield for instance.
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