Why not just make bond allocation 100% inflation-indexed?

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nomadgecko
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Why not just make bond allocation 100% inflation-indexed?

Post by nomadgecko » Tue May 08, 2012 11:52 am

I've just finished reading The Boglehead's Guide to Investing; enjoyed it, and learned several things. One question I have after is on what bonds my wife and I should have in our portfolio...

My wife and I are in the accumulating years, with an overall investment portfolio allocation of 75/25 equities/bonds. Currently our bond-only portfolio is 70/30 traditional/inflation-indexed. Our traditional bonds are in Total Bond Market fund and Intermediate Term Bond fund (in tax-advantaged accounts); our inflation-indexed bonds are in the Vanguard TIPS fund (tax-advantaged account) and in I-Bonds through TreasuryDirect.

I'm on board with our current overall allocation to 25% bonds. The chapter that discussed inflation eroding the purchasing power of bonds makes sense to me. Given this, why wouldn't I just go with 100% inflation-indexed bonds instead of the recommended 50/50 traditional/inflation-indexed bond allocation?

One argument I can think of is the zig-zag argument: inflation-indexed and traditional bonds may not move in lock-step - diversification.
A second argument I can think of is that I may not want all my bonds tied to US bonds (perhaps I'll want some corporate or MBS or muni's, etc.) - also diversification.

Any other considerations in making this decision?
Thanks!

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SSSS
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Re: Why not just make bond allocation 100% inflation-indexed

Post by SSSS » Tue May 08, 2012 12:02 pm

Nominal bonds already have future "expected" inflation priced into their interest rates. Inflation adjusted bonds will do better when inflation is higher than expected. Nominal bonds will do better when inflation is lower than expected.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by hsv_climber » Tue May 08, 2012 12:06 pm

SSSS wrote:Nominal bonds already have future "expected" inflation priced into their interest rates. Inflation adjusted bonds will do better when inflation is higher than expected. Nominal bonds will do better when inflation is lower than expected.
.. or deflation. Inflation-indexed bonds tend to do pretty bad during deflation.
( Especially if you'd look at the current ST TIPS coupon rates. )

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Re: Why not just make bond allocation 100% inflation-indexed

Post by Lbill » Tue May 08, 2012 1:31 pm

Swensen recommends a 50/50 split between nominal treasuries and TIPS. You might want to read what he has to say.
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fishndoc
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Re: Why not just make bond allocation 100% inflation-indexed

Post by fishndoc » Tue May 08, 2012 1:36 pm

Lbill wrote:Swensen recommends a 50/50 split between nominal treasuries and TIPS. You might want to read what he has to say.
1+ on that recommendation.

While the track record of TIPS is short, if you look back at what happened to them during 2008-2009, you see that, at least for that crisis, TIPS were positively correlated with equities - just what you do not want from your fixed income in a portfolio with a high equity allocation, as most accumulators have.

Treasuries during this period, actually increased in value as equities crashed (negative correlation), exactly what you hope for (and Swensen predicted).
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Re: Why not just make bond allocation 100% inflation-indexed

Post by magician » Tue May 08, 2012 2:42 pm

fishndoc wrote:While the track record of TIPS is short, if you look back at what happened to them during 2008-2009, you see that, at least for that crisis, TIPS were positively correlated with equities - just what you do not want from your fixed income in a portfolio with a high equity allocation, as most accumulators have.
What characteristic of TIPS was positively correlated with what characteristic of equities? It sounds likes prices of both, whereas when finance-types talk about correlation they generally mean correlation of returns.
fishndoc wrote:Treasuries during this period, actually increased in value as equities crashed (negative correlation), exactly what you hope for (and Swensen predicted). [Emphasis added]
Just because prices are moving in the opposite direction doesn't mean that the prices have a negative correlation. Between December, 2007 and May, 2012 the S&P 500 lost an average of 1.57% per year, while Vanguard's total bond market ETF BND gained an average of 5.67% per year, yet their correlation of prices was +0.32; their correlation of returns was also positive: +0.11.

Correlations are funny things.
Simplify the complicated side; don't complify the simplicated side.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by fishndoc » Tue May 08, 2012 5:10 pm

Well, in plain language: when "it" hit the fan in '08, equities and TIPS both declined in price, while Treasuries increased in price.
If one had a portfolio dominated by equities, you really needed those Treasuries.
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Re: Why not just make bond allocation 100% inflation-indexed

Post by nisiprius » Tue May 08, 2012 7:16 pm

To the original poster. On the one hand, 100% inflation indexed would not be crazy, as shown by the fact that Scott Burns has defined a "lazy portfolio"--intended for ordinary investors--called the "Margarita Portfolio:" 1/3 Total Stock (VTSMX), 1/3 Total International (VGTSX), 1/3 Vanguard Inflation-Protected Securities (VIPSX). On the other hand, I think of myself as a TIPS enthusiast, I bought my first TIPS in 1998, and my fixed income is more than 50% TIPS. But I don't have the nerve to depart too far from the beaten path, so I hold VBMFX as well. 2007 and 2008 were weird for TIPS, and the weird run-up in 2007 was just as troubling as the decline in 2008.
fishndoc wrote:Well, in plain language: when "it" hit the fan in '08, equities and TIPS both declined in price, while Treasuries increased in price. If one had a portfolio dominated by equities, you really needed those Treasuries.
In plain language, you are talking about direction, not magnitude. To suggest that equities and TIPS did the same thing is absurd. Equities (blue) dropped 50%. TIPS (orange) dropped 10%. And TIPS dropped less than corporates (green). It's true that Treasuries sailed straight through.

Notice, too, that on a growth chart, if you had put $10,000 into VIPSX on 6/18/2007, at no point during the worst of 2008-2009 did you ever see less than $10,000 in your account. True, you gave back previous earnings. True, the people in Treasuries and GNMAs had more than you. All I can say is: my wife and I were looking at our stock holdings, petrified, and frankly I didn't even notice that some of my bonds were down a bit. What I noticed was that they were keeping us afloat.

If you wanted to rebalance from bonds into stocks in early 2009, then, yes, the investor who rebalancing out of Treasuries did better than one in TIPS, who did better than one in corporates. But still, you didn't "need" Treasuries to benefit. Not matter what you were doing, it would hardly have been a disaster to be 100% in TIPS in 2008-2009.
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nomadgecko
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Re: Why not just make bond allocation 100% inflation-indexed

Post by nomadgecko » Wed May 09, 2012 9:09 am

All, as always thanks for taking the time for insightful comments and perspective.

I'm going to go with 50/50 nominal/inflation-indexed and call it a day.

Thank you.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by HonoluluGator » Wed May 09, 2012 11:38 am

nisiprius wrote:
Image

Thanks for that. A picture is worth 1000 words, and the chart really cleared up some misconceptions I had on bonds.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by dyangu » Wed May 09, 2012 4:07 pm

You also need to think about how well your personal expenditures correlate with components in the CPI-U. If your main goal is to save for college tuition or retire in Bermuda, you would care more about your nominal return than your real return.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by Munir » Wed May 09, 2012 4:30 pm

HonoluluGator wrote:
nisiprius wrote:
Image

Thanks for that. A picture is worth 1000 words, and the chart really cleared up some misconceptions I had on bonds.
From 2007 to 2012 all three bond funds ended up at the same point in the graph. If you stay the course and don't do any panic selling, all three evened out in that time period. Of course if you choose another time period, they may look different.

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Re: Why not just make bond allocation 100% inflation-indexed

Post by Beagler » Wed May 09, 2012 8:04 pm

YDNAL wrote: I want my stinking Fixed income to:
- have low-volatility
- pay dividend
- help me sleep at night
- allow me to buy a gallon of milk at the store.

Other than that, it's all theory and not George Washingtons in my wallet - I know, those GWs are worth only about Euro 0.6734 but Publix doesn't take Euros nor inflation-adjusted dollars.
“The only place where success come before work is in the dictionary.” Abraham Lincoln. This post does not provide advice for specific individual situations and should not be construed as doing so.

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