Are TIPS really a good inflation hedge? Pros and Cons

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

Post by GAAP » Thu Nov 14, 2019 7:22 pm

garlandwhizzer wrote:
Tue Nov 12, 2019 2:10 pm
CULater wrote in the original post:
IMO this is an excellent piece that explains the uses of TIPs, Commodities, Gold, etc., for inflation protection. Each has its own niche of effectiveness but none is perfect in all inflationary situations. A good read IMO if you want to understand your choices for inflation protection and what might work best in your own situation.

Garland Whizzer
This paper specifically addresses unexpected inflation. I've had trouble quantifying just how often that occurs, and therefore what degree of protection is required for the unexpected event instead of general ongoing high inflation.

The simplest definition of unexpected would be anything more that what exists today (ie, steady state). By that definition, I don't think we've ever had a continuous period longer than 5 years (1966-70). Adding even a small margin to that definition shrinks the risk pretty quickly. I've tried Linear Moving Averages up to five years, but found again that the simplest case works best also. With those results, a 5-year rolling TIPS ladder or a short-term fund would pretty much cover that particular risk. Based on that, I'm using three years of expected withdrawals to define my TIPS allocation.

Does anyone have a better idea of just how much unexpected inflation protection has been necessary in the past -- and may be needed in the future?

On a parallel note, just how much deflation protection is necessary? That risk also seems hard to quantify.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by dbr » Fri Nov 15, 2019 8:56 am

It is not as if TIPS are not also indexed for expected inflation. The question is whether or not that is something an investor wants compared to the behavior of other investments that are not explicitly adjusted for inflation. I like the idea of holding some assets that explicitly remove inflation risk at any rate of inflation. One recognizes this is not a hedge for a whole portfolio unless the whole portfolio is TIPS. It would seem to make some sense that any investment in bonds should be in inflation indexed bonds though not many people actually do that. The advocates of bond ladders for an LMP approach certainly would not put that in nominal bonds whatever the actual expectations or un-expectations for inflation might be.

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

Post by willthrill81 » Tue Nov 26, 2019 11:57 am

dbr wrote:
Fri Nov 15, 2019 8:56 am
It is not as if TIPS are not also indexed for expected inflation. The question is whether or not that is something an investor wants compared to the behavior of other investments that are not explicitly adjusted for inflation. I like the idea of holding some assets that explicitly remove inflation risk at any rate of inflation. One recognizes this is not a hedge for a whole portfolio unless the whole portfolio is TIPS. It would seem to make some sense that any investment in bonds should be in inflation indexed bonds though not many people actually do that. The advocates of bond ladders for an LMP approach certainly would not put that in nominal bonds whatever the actual expectations or un-expectations for inflation might be.
I'm inclined to agree. IMHO, the cost of TIPS' 'insurance' seems to be very low right now, low enough to be a no-brainer compared to nominal bonds.
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GAAP
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by GAAP » Tue Nov 26, 2019 1:36 pm

willthrill81 wrote:
Tue Nov 26, 2019 11:57 am
dbr wrote:
Fri Nov 15, 2019 8:56 am
It is not as if TIPS are not also indexed for expected inflation. The question is whether or not that is something an investor wants compared to the behavior of other investments that are not explicitly adjusted for inflation. I like the idea of holding some assets that explicitly remove inflation risk at any rate of inflation. One recognizes this is not a hedge for a whole portfolio unless the whole portfolio is TIPS. It would seem to make some sense that any investment in bonds should be in inflation indexed bonds though not many people actually do that. The advocates of bond ladders for an LMP approach certainly would not put that in nominal bonds whatever the actual expectations or un-expectations for inflation might be.
I'm inclined to agree. IMHO, the cost of TIPS' 'insurance' seems to be very low right now, low enough to be a no-brainer compared to nominal bonds.
Compared to equivalent Treasuries, certainly. I'm not so convinced about all nominal bonds -- especially if you desire a global allocation. I'm also curious how TIPS compare to inflation protected bonds from other countries, but too lazy to actually investigate.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by HawkeyePierce » Tue Nov 26, 2019 1:59 pm

Seems to me that the sweet spot for TIPS is as near-term liability matching, say over the next 5-10 of an investor's horizon.

TIPS would protect your near-term spending power from unexpected inflation, since that's exactly what they're designed to do. Equities would (hopefully) protect your long-term spending power from unexpected inflation, but since that cycle can take a decade or more you'd rely on TIPS in the meantime.

If I was nearing the decumulation phase I could imagine moving 5-10 years worth of expenses into TIPS then leaving the rest of the portfolio in equities. Every year sell some equities and buy another 10-year TIPS to give yourself a rolling inflation-protected bond ladder.

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

Post by willthrill81 » Tue Nov 26, 2019 3:07 pm

GAAP wrote:
Tue Nov 26, 2019 1:36 pm
willthrill81 wrote:
Tue Nov 26, 2019 11:57 am
dbr wrote:
Fri Nov 15, 2019 8:56 am
It is not as if TIPS are not also indexed for expected inflation. The question is whether or not that is something an investor wants compared to the behavior of other investments that are not explicitly adjusted for inflation. I like the idea of holding some assets that explicitly remove inflation risk at any rate of inflation. One recognizes this is not a hedge for a whole portfolio unless the whole portfolio is TIPS. It would seem to make some sense that any investment in bonds should be in inflation indexed bonds though not many people actually do that. The advocates of bond ladders for an LMP approach certainly would not put that in nominal bonds whatever the actual expectations or un-expectations for inflation might be.
I'm inclined to agree. IMHO, the cost of TIPS' 'insurance' seems to be very low right now, low enough to be a no-brainer compared to nominal bonds.
Compared to equivalent Treasuries, certainly. I'm not so convinced about all nominal bonds -- especially if you desire a global allocation. I'm also curious how TIPS compare to inflation protected bonds from other countries, but too lazy to actually investigate.
I'm not one to desire international bonds when their yield is significantly lower than that of the U.S.'s, so I'm disinclined to do such an investigation either.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by abuss368 » Tue Nov 26, 2019 7:29 pm

GAAP wrote:
Tue Nov 26, 2019 1:36 pm
Compared to equivalent Treasuries, certainly. I'm not so convinced about all nominal bonds -- especially if you desire a global allocation. I'm also curious how TIPS compare to inflation protected bonds from other countries, but too lazy to actually investigate.
I remember watching a Jack Bogle interview where he discussed inflation in other countries and international bonds. He clearly explained that he earns U.S. Dollars, saves U.S. Dollars, invests U.S. Dollars, and spends U.S. Dollars.
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GAAP
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by GAAP » Wed Nov 27, 2019 2:56 pm

abuss368 wrote:
Tue Nov 26, 2019 7:29 pm
GAAP wrote:
Tue Nov 26, 2019 1:36 pm
Compared to equivalent Treasuries, certainly. I'm not so convinced about all nominal bonds -- especially if you desire a global allocation. I'm also curious how TIPS compare to inflation protected bonds from other countries, but too lazy to actually investigate.
I remember watching a Jack Bogle interview where he discussed inflation in other countries and international bonds. He clearly explained that he earns U.S. Dollars, saves U.S. Dollars, invests U.S. Dollars, and spends U.S. Dollars.
Fair enough. However, I'm retired, not tied to a particular country and married to someone with triple citizenship. We do talk about going ex-pat periodically. If we actually did move out of the country, then I would be looking at replacing my small TIPS allocation with an appropriate choice from our new home.

We're getting off topic here, but hedged international bonds effectively remove a lot of the currency concern, and may have better returns at times. They are also not tied to a particular economy, and provide diversification against problems in a single economy.

An inflation-indexed bond from fill-in-the-blank-foreign-country could potentially provide a better return than other bond choices currently available here. I don't know that one does or that none of them do. Until we decide to move offshore, it's not something I'm bothering to investigate.
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by abuss368 » Wed Nov 27, 2019 5:20 pm

GAAP wrote:
Wed Nov 27, 2019 2:56 pm
abuss368 wrote:
Tue Nov 26, 2019 7:29 pm
GAAP wrote:
Tue Nov 26, 2019 1:36 pm
Compared to equivalent Treasuries, certainly. I'm not so convinced about all nominal bonds -- especially if you desire a global allocation. I'm also curious how TIPS compare to inflation protected bonds from other countries, but too lazy to actually investigate.
I remember watching a Jack Bogle interview where he discussed inflation in other countries and international bonds. He clearly explained that he earns U.S. Dollars, saves U.S. Dollars, invests U.S. Dollars, and spends U.S. Dollars.
Fair enough. However, I'm retired, not tied to a particular country and married to someone with triple citizenship. We do talk about going ex-pat periodically. If we actually did move out of the country, then I would be looking at replacing my small TIPS allocation with an appropriate choice from our new home.

We're getting off topic here, but hedged international bonds effectively remove a lot of the currency concern, and may have better returns at times. They are also not tied to a particular economy, and provide diversification against problems in a single economy.

An inflation-indexed bond from fill-in-the-blank-foreign-country could potentially provide a better return than other bond choices currently available here. I don't know that one does or that none of them do. Until we decide to move offshore, it's not something I'm bothering to investigate.
Thank you for the update. Makes sense.
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learning_head
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by learning_head » Thu Nov 28, 2019 7:58 am

nisiprius wrote:
Mon Sep 16, 2019 7:54 am
A TIPS contracts to pay out precisely-known-in-advance inflation-adjusted ("real") amounts of money on specific dates, most of it at maturity. That is, measured in real terms, you know the exact amount you will be getting on specific future dates. Since most of it is paid out at maturity, it is at the very least a way to preserve purchasing power--precisely.

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

You can argue that the Treasury might default, or that you don't trust the CPI as a measure of purchasing power, or that that isn't what you mean by a "hedge." OK. (People also raise phony issues--e.g. income tax is levied on nominal return, not real return, as if that weren't true for all investments).
Hi Nisi,

I am about to raise the phony issue :-)

I believe what you just said is that nothing, other than TIPS and I-bonds will (to quote you) "pay out precisely-known-in-advance inflation-adjusted ("real") amounts of money on specific dates", except, if in taxable account, it won't be inflation adjusted precisely because of taxes... except it does not matter because taxes affect everything else too.

Imagine an I bond "maturing" in 30 years where prices tripled over time and imagine that by that time you are in 50% marginal federal tax rate, either because of a tax law change for your situation or it might be possible even today (e.g. the way some benefits work out, like Social Security taxation, which multiplies your marginal rate by 1.5 factor in many cases).

So now your dollar doubled while prices tripled.

This is NOT an inflation-adjusted "real" amount you talked about. You just lost 1/3 of your purchasing power. Oops... this does not seem like a phony issue now.

And sure, other investments would get taxed too. But that does not make your TIPS or I-bond investment in taxable account any more protected from CPI.

The correct statement IMO is then with TIPS and I-bonds in taxable account you are SURE to lose your purchasing power by some amount related to your tax rate (unless it's 0), but otherwise, the increase in value is MOST tied to CPI. Other options would have much more variation vs CPI.

P.S. Formula for I-bond on how much you'd lose to taxes goes something like this: 1 - [ (1+Inf*(1-t))/(1+Inf) ], where Inf is cumulative inflation over the years and "t" is your marginal tax rate. In my above example, Inf = 200%, t = 50%.

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

Post by digit8 » Fri Nov 29, 2019 1:18 pm

learning_head wrote:
Thu Nov 28, 2019 7:58 am

Imagine an I bond "maturing" in 30 years where prices tripled over time and imagine that by that time you are in 50% marginal federal tax rate, either because of a tax law change for your situation or it might be possible even today (e.g. the way some benefits work out, like Social Security taxation, which multiplies your marginal rate by 1.5 factor in many cases).

So now your dollar doubled while prices tripled.
If I'm imaging that, I'm imagining being in the middle of a national situation where returns on my investments have become very low on my list of problems(my same response to the "why don't you invest in physical gold? Money might become worthless" scenarios).
"You can't latte yourself to bankruptcy. The bladder won't allow it." | -Katherine Porter

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

Post by learning_head » Fri Nov 29, 2019 1:37 pm

digit8 wrote:
Fri Nov 29, 2019 1:18 pm
learning_head wrote:
Thu Nov 28, 2019 7:58 am

Imagine an I bond "maturing" in 30 years where prices tripled over time and imagine that by that time you are in 50% marginal federal tax rate, either because of a tax law change for your situation or it might be possible even today (e.g. the way some benefits work out, like Social Security taxation, which multiplies your marginal rate by 1.5 factor in many cases).

So now your dollar doubled while prices tripled.
If I'm imaging that, I'm imagining being in the middle of a national situation where returns on my investments have become very low on my list of problems(my same response to the "why don't you invest in physical gold? Money might become worthless" scenarios).
So you are scared that much of 3.73% average annual inflation? Or you think it's such an unthinkable scenario?

In case you did not know, prices more than quadrupled between 1970 and 2000 in US. In that time frame, I-bonds, if they existed, would have lost close to a third of purchasing power with 40% marginal federal tax rate.

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

Post by dodecahedron » Fri Nov 29, 2019 1:48 pm

learning_head wrote:
Thu Nov 28, 2019 7:58 am
nisiprius wrote:
Mon Sep 16, 2019 7:54 am
A TIPS contracts to pay out precisely-known-in-advance inflation-adjusted ("real") amounts of money on specific dates, most of it at maturity. That is, measured in real terms, you know the exact amount you will be getting on specific future dates. Since most of it is paid out at maturity, it is at the very least a way to preserve purchasing power--precisely.

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

You can argue that the Treasury might default, or that you don't trust the CPI as a measure of purchasing power, or that that isn't what you mean by a "hedge." OK. (People also raise phony issues--e.g. income tax is levied on nominal return, not real return, as if that weren't true for all investments).
Hi Nisi,

I am about to raise the phony issue :-)

I believe what you just said is that nothing, other than TIPS and I-bonds will (to quote you) "pay out precisely-known-in-advance inflation-adjusted ("real") amounts of money on specific dates", except, if in taxable account, it won't be inflation adjusted precisely because of taxes... except it does not matter because taxes affect everything else too.

Imagine an I bond "maturing" in 30 years where prices tripled over time and imagine that by that time you are in 50% marginal federal tax rate, either because of a tax law change for your situation or it might be possible even today (e.g. the way some benefits work out, like Social Security taxation, which multiplies your marginal rate by 1.5 factor in many cases).

So now your dollar doubled while prices tripled.

This is NOT an inflation-adjusted "real" amount you talked about. You just lost 1/3 of your purchasing power. Oops... this does not seem like a phony issue now.
This is why I hold my TIPS inside my Roth IRA. And by the way, TIPS also hedge against tax increases in sales & excise taxes (because those taxes are included in the computation of CPI.)

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

Post by digit8 » Fri Nov 29, 2019 3:49 pm

learning_head wrote:
Fri Nov 29, 2019 1:37 pm
So you are scared that much of 3.73% average annual inflation? Or you think it's such an unthinkable scenario?

In case you did not know, prices more than quadrupled between 1970 and 2000 in US. In that time frame, I-bonds, if they existed, would have lost close to a third of purchasing power with 40% marginal federal tax rate.
I think that's an idea that goes into a lot of assumptions about decisions that would have been made if IBonds had been invented earlier, or will be made in the future. Going deeper would probably need to touch on politics sufficiently to get this locked.
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learning_head
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Re: Are TIPS really a good inflation hedge? Pros and Cons

Post by learning_head » Fri Nov 29, 2019 11:41 pm

digit8 wrote:
Fri Nov 29, 2019 3:49 pm
learning_head wrote:
Fri Nov 29, 2019 1:37 pm
So you are scared that much of 3.73% average annual inflation? Or you think it's such an unthinkable scenario?

In case you did not know, prices more than quadrupled between 1970 and 2000 in US. In that time frame, I-bonds, if they existed, would have lost close to a third of purchasing power with 40% marginal federal tax rate.
I think that's an idea that goes into a lot of assumptions about decisions that would have been made if IBonds had been invented earlier, or will be made in the future. Going deeper would probably need to touch on politics sufficiently to get this locked.
Are you assuming that policy decision makers CAN either prevent or effectively control inflation going forward?

Are you assuming that IBond market is large enough for them to care?

I personally don't think either of these assumptions are anywhere close to being accurate.

But if you do, I don't think you need to care about inflation at all, and your investment decisions are much easier than the rest of us :-)

In any case, your statement that we'd be down to some complete deterioration of society if my example were true is clearly NOT the case. A worse scenario happened in recent past in this very country.

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