Which TIPS offer the best inflation protection?

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Ocean77
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Which TIPS offer the best inflation protection?

Post by Ocean77 »

I'm trying to figure out if there is a difference in inflation protection between short, medium and long term TIPS, or if they will all respond alike to unexpected inflation.

I googled this topic already but came up empty. I also found an older thread here (viewtopic.php?f=10&t=312059) and read through the whole thing, but it is still not clear to me. Some posters there said that short and long term TIPS will respond the same way to inflation, while others write that long term TIPS will respond stronger, whiteout giving an explanation.

Also, in the latest edition of the "Gone Fishin' Portfolio", the author A. Green recommends long term TIPS because they are supposed to respond stronger to an inflation uptick, but also provides no explanation.

I realize of course that long term TIPS will expose the investor to interest rate risk. But let's say for the sake of argument that interest rates would remain steady, and only inflation would pick up. Would a short term TIPS fund show the same increase in price as a long term TIPS fund? Or will there be a difference? If so, how much difference? I'm trying to gauge how much benefit (if any) a long term TIPS fund would offer in terms of inflation protection, to potentially make up for the interest rate risk.
Northern Flicker
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Re: Which TIPS offer the best inflation protection?

Post by Northern Flicker »

If interest rates don't change at all and inflation stays positive, the only difference in return would be from differences in yield. But it is hard to imagine interest rates staying fixed if inflation accelerates. And real rates could drop even if noninal rates rise, so the part of TIPS return driven by changes in rates is quite unpredictable.
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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Ocean77
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Re: Which TIPS offer the best inflation protection?

Post by Ocean77 »

Northern Flicker wrote: Wed Jul 21, 2021 10:35 pm If interest rates don't change at all and inflation stays positive, the only difference in return would be from differences in yield. But it is hard to imagine interest rates staying fixed if inflation accelerates. And real rates could drop even if noninal rates rise, so the part of TIPS return driven by changes in rates is quite unpredictable.
Thank you! I understand that. But the question I was interested in is specifically the inflation price adjustment aspect of the TIPS, not the yield. I realize that interest rates can and will change and this will of course affect the return one gets from TIPS. But if we leave that aside and look at only the inflation adjustment, is that affected by the TIPS bond duration? The actual adjustment I understand is done periodically by the issuer (Treasury), and is based on the CPI in a certain period. But the market surely prices these adjustments in already, as soon as the market anticipates a certain inflation rate. Would the price adjustment be different for short vs long TIPS, or not? There might be some mathematical model for this, or some historical data that separates out the return components in TIPS for short and long durations, but I didn't find either, hence my post.
ChiGuy
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Re: Which TIPS offer the best inflation protection?

Post by ChiGuy »

I too am very confused about this topic. I know Vanguard's Target Date Income Fund uses short-term TIPS & their research papers that I've seen on inflation protection discuss short-term TIPS, BUT WITHOUT explaining why short-term TIPS are preferable to intermediate or long-term TIPS.
okwriter
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Re: Which TIPS offer the best inflation protection?

Post by okwriter »

Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
tonyclifton
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Re: Which TIPS offer the best inflation protection?

Post by tonyclifton »

I don’t think there is one best option as it depends on your timeline for short, intermediate or long term needs.

I read this book and found it to be very helpful:
Explore TIPS: A Practical Guide to Investing in Treasury Inflation-Protected Securities
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#Cruncher
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Re: Which TIPS offer the best inflation protection?

Post by #Cruncher »

Ocean77 wrote: Thu Jul 22, 2021 1:33 am... the question I was interested in is specifically the inflation price adjustment aspect of the TIPS ... is that affected by the TIPS bond duration?
No. Over any time period the inflation adjustment to principal is exactly the same percentage for all TIPS. For example, here is a comparison of the principal increase for calendar year 2020 for the 5-Year TIPS maturing 4/15/2021 and the 30-Year TIPS maturing 2/15/2049:

Code: Select all

        Term    5 Years   30 Years
First issued  4/29/2016  2/28/2019
     Matures  4/15/2021  2/15/2049
Index ratio
  Jan 1 2020    1.08582    1.02269
  Jan 1 2021    1.09865    1.03478
Principal (per $1,000 bond)
  Jan 1 2020  $1,085.82  $1,022.69
  Jan 1 2021  $1,098.65  $1,034.78
    Increase     $12.83     $12.09
  % increase      1.18%      1.18%
  
Oct 2019 CPI    257.346
Oct 2020 CPI    260.388
  % increase      1.18%
During the year the principal of both TIPS increased the same 1.18% which is the same as the increase in the Consumer Price Index from October 2019 to October 2020. If you're interested in how the CPI is used to compute the index ratios which determine the principal, refer to the first two paragraphs of the "Background" on the left side of this web page.

Edited 3:55 PM to add the following:
The table below adds price and market value to the principal value above. When this is done we can see that while principal does correlate to inflation the same for all TIPS, market value does not.

Code: Select all

        Term    5 Years   30 Years
     Matures  4/15/2021  2/15/2049
Principal
  Jan 1 2020  $1,085.82  $1,022.69
  Jan 1 2021  $1,098.65  $1,034.78
  % increase      1.18%      1.18%
Ask Price
 Dec 31 2019   99.84375  111.81250
 Dec 31 2020  100.46875  140.93750
  % increase       0.6%      26.0%
Market Value
 Dec 31 2019      1,084      1,143
 Dec 31 2020      1,104      1,458
  % increase       1.8%      27.5%
The yield of the 30-year TIPS fell from +0.560% on 12/31/2019 to -0.379% one year later on 12/31/2020. Since the duration is so long, this caused the price to rise 26%. The price of the 5-year TIPS on the other hand, rose less than 1%. (It was so near maturity on 12/31/2020 that its price would be near 100 regardless of its yield.) So we can see that while the 5-year's market value is closely correlated to the 1.2% increase in the CPI, the 30-year's market value is not. (See the table at the bottom of the 12/31/2019 and 12/31/2020 updates to my Consistent Yield thread for the prices and yields.)
Last edited by #Cruncher on Thu Jul 22, 2021 2:56 pm, edited 1 time in total.
TurtleBeatsHare
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Re: Which TIPS offer the best inflation protection?

Post by TurtleBeatsHare »

Your hypothetical assumes that interest rates remain steady while inflation picks up. In that scenario, you should expect to see similar performance in TIPS because, as others have noted, the inflation adjustment mechanism is tied off the principal and is the same for long and short TIPS. But this scenario is extremely unlikely because interest rates (certainly nominal and likely real) tend to correlate with inflation because orthodox policy is that the Federal Reserve will raise interest rates in response to inflation. In practice, there’s a correlation between interest rates and inflation, which means that long TIPS imo tend to be less effective at guarding against inflation,
which creates interest rate increases, but more effective at being a ballast against equities, IF you assume a negative correlation between bonds and stocks, which has been the case for the last 30/40 years, but has not been the case historically.

I’d also add that commodities/commodity companies
tend to be an even better hedge against inflation than short term TIPS. The Vanguard paper that’s linked above—if it’s the one that I think it is—shows that commodities and short TIPS have the strongest negative correlations to inflation, but that the commodities have larger magnitudes.

Edit: The paper above wasn’t the one I was remembering. Here it is: https://advisors.vanguard.com/insights/ ... PSCmbtInfl
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FIREchief
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Re: Which TIPS offer the best inflation protection?

Post by FIREchief »

I truly believe that our experts here on the forum have a better understanding of TIPS than whoever writes those papers for Vanguard.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.
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Re: Which TIPS offer the best inflation protection?

Post by Northern Flicker »

Ocean77 wrote: Thu Jul 22, 2021 1:33 am
Northern Flicker wrote: Wed Jul 21, 2021 10:35 pm If interest rates don't change at all and inflation stays positive, the only difference in return would be from differences in yield. But it is hard to imagine interest rates staying fixed if inflation accelerates. And real rates could drop even if noninal rates rise, so the part of TIPS return driven by changes in rates is quite unpredictable.
Thank you! I understand that. But the question I was interested in is specifically the inflation price adjustment aspect of the TIPS, not the yield.
I answered that question in the quoted text. If the only difference when interest rates stay fixed is yield, then the inflation corrections would be the same.

There was, however, a little hidden subtlety in my answer where I said as long as inflation stays positive. If you buy a TIPS (on the secondary market) that is seasoned with some accumulated inflation correction, and there is net deflation over the remaining life of the TIPS, the principal will decrease even if inflation stays flat, and the deflation put at maturity will only ensure that redemption value is not lower than the principal at original issue-- ie it would be less than the principal you purchased.
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: Which TIPS offer the best inflation protection?

Post by Northern Flicker »

FIREchief wrote: Thu Jul 22, 2021 11:40 am I truly believe that our experts here on the forum have a better understanding of TIPS than whoever writes those papers for Vanguard.
I don't think that is true. I'm pretty sure the Vanguard investigators/authors understand that there can be different objectives of a TIPS portfolio. They are looking at the problem of tracking CPI over shorter periods for portfolios that, unlike TIPS ladders, are expected to provide daily or at least regular liquidity, so that short-term market value matters.
My postings are my opinion, and never should be construed as a recommendation to buy, sell, or hold any particular investment.
dbr
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Re: Which TIPS offer the best inflation protection?

Post by dbr »

As already pointed out all TIPS present exactly the same offset or indexing for inflation. What "inflation protection" is supposed to mean, I have no idea. People should stop using that term because it is too ambiguous as to what exactly is wanted. And, yes, I know the name is Treasury Inflation Protected Security(s).

There are lots of reason any given investor would prefer one duration in TIPS over another, or even to hold individual TIPS or a TIPS ladder, but those reasons have nothing to do with inflation indexing of the bond principal.

I don't think people at Vanguard writing up studies on this are less knowledgeable than people posting here, but in my opinion they have a gift for confounding simple ideas and producing confusion.
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Re: Which TIPS offer the best inflation protection?

Post by GaryA505 »

okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
Also, Vanguard uses short-term TIPS in their target date funds.
"Get most of it right and don't make any big mistakes."
dbr
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Re: Which TIPS offer the best inflation protection?

Post by dbr »

okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
It's different from that and worse than that. Correlation with inflation is an artificial and irrational measure of "inflation protection." The reason longer TIPS don't correlate well to inflation is that they have more duration risk that causes variability in return and therefore reduces the correlation to the one factor. But that has nothing to do with how well the investment is indexed to inflation. That paper really pisses me off because instead of informing people it confuses people. Also, all TIPS are indexed to expected and unexpected inflation.

Stock are badly correlated with inflation but also have a high probability of continuing to have a positive expected return. TIPS can and do have negative expected real return at any point. However, what is the expected return and what is the variability of return when real and/or nominal interest rates change (which includes when the rate of inflation changes) would be two different things.
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Re: Which TIPS offer the best inflation protection?

Post by BJJ_GUY »

dbr wrote: Thu Jul 22, 2021 2:04 pm
okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
It's different from that and worse than that. Correlation with inflation is an artificial and irrational measure of "inflation protection." The reason longer TIPS don't correlate well to inflation is that they have more duration risk that causes variability in return and therefore reduces the correlation to the one factor. But that has nothing to do with how well the investment is indexed to inflation. That paper really pisses me off because instead of informing people it confuses people. Also, all TIPS are indexed to expected and unexpected inflation.

Stock are badly correlated with inflation but also have a high probability of continuing to have a positive expected return. TIPS can and do have negative expected real return at any point. However, what is the expected return and what is the variability of return when real and/or nominal interest rates change (which includes when the rate of inflation changes) would be two different things.
How are TIPS indexed to unexpected inflation? CPI is a trailing measure. Nothing specifically is indexed to unexpected inflation with TIPS
dbr
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Re: Which TIPS offer the best inflation protection?

Post by dbr »

BJJ_GUY wrote: Thu Jul 22, 2021 2:22 pm
dbr wrote: Thu Jul 22, 2021 2:04 pm
okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
It's different from that and worse than that. Correlation with inflation is an artificial and irrational measure of "inflation protection." The reason longer TIPS don't correlate well to inflation is that they have more duration risk that causes variability in return and therefore reduces the correlation to the one factor. But that has nothing to do with how well the investment is indexed to inflation. That paper really pisses me off because instead of informing people it confuses people. Also, all TIPS are indexed to expected and unexpected inflation.

Stock are badly correlated with inflation but also have a high probability of continuing to have a positive expected return. TIPS can and do have negative expected real return at any point. However, what is the expected return and what is the variability of return when real and/or nominal interest rates change (which includes when the rate of inflation changes) would be two different things.
How are TIPS indexed to unexpected inflation? CPI is a trailing measure. Nothing specifically is indexed to unexpected inflation with TIPS
The definition of indexing is that the principle value is incremented by the most recent (yes trailing average) measure of periodic inflation, whether that inflation had been expected or not. No one tries to increase the face value of the bond today based on a guess what the inflation rate will be in the future, nor is it necessary to do that as long as the increment is continuously and cumulatively applied, which it is. The TIPS Inflation Index Ratio is calculated daily but I am not sure how far back the rolling period is.

It is probably better for people to just see what the investment does and not feature so much what is "protected" or isn't protected.
Angst
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Re: Which TIPS offer the best inflation protection?

Post by Angst »

Ocean77 wrote: Wed Jul 21, 2021 10:28 pm I'm trying to figure out if there is a difference in inflation protection between short, medium and long term TIPS, or if they will all respond alike to unexpected inflation.
Ocean77 wrote: Wed Jul 21, 2021 10:28 pm I realize of course that long term TIPS will expose the investor to interest rate risk. But let's say for the sake of argument that interest rates would remain steady, and only inflation would pick up. Would a short term TIPS fund show the same increase in price as a long term TIPS fund? Or will there be a difference?
As has already been discussed by others, there's no difference as this is a purely academic question. Of course in the real world we have to deal with duration and with our expectations as to when we'll need to access certain funds, and even Vanguard's ST TIPS fund is subject to duration risks. Buying a TIPS at auction for a 5, 10 or 30 year duration liability is the most elegant real world solution, to a very specific problem, while it's already been pointed out that purchasing individual TIPS in the secondary market entails some additional risk of losing accrued inflation to deflation. It's a messy real world out here. Then again, the most complete inflation protection obtainable today with the current real yield curve being negative throughout all maturities, is I Bonds. There are a few caveats with them too of course, affecting some of us a lot less than others.
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Re: Which TIPS offer the best inflation protection?

Post by BJJ_GUY »

dbr wrote: Thu Jul 22, 2021 2:35 pm
BJJ_GUY wrote: Thu Jul 22, 2021 2:22 pm
dbr wrote: Thu Jul 22, 2021 2:04 pm
okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
It's different from that and worse than that. Correlation with inflation is an artificial and irrational measure of "inflation protection." The reason longer TIPS don't correlate well to inflation is that they have more duration risk that causes variability in return and therefore reduces the correlation to the one factor. But that has nothing to do with how well the investment is indexed to inflation. That paper really pisses me off because instead of informing people it confuses people. Also, all TIPS are indexed to expected and unexpected inflation.

Stock are badly correlated with inflation but also have a high probability of continuing to have a positive expected return. TIPS can and do have negative expected real return at any point. However, what is the expected return and what is the variability of return when real and/or nominal interest rates change (which includes when the rate of inflation changes) would be two different things.
How are TIPS indexed to unexpected inflation? CPI is a trailing measure. Nothing specifically is indexed to unexpected inflation with TIPS
The definition of indexing is that the principle value is incremented by the most recent (yes trailing average) measure of periodic inflation, whether that inflation had been expected or not. No one tries to increase the face value of the bond today based on a guess what the inflation rate will be in the future, nor is it necessary to do that as long as the increment is continuously and cumulatively applied, which it is. The TIPS Inflation Index Ratio is calculated daily but I am not sure how far back the rolling period is.

It is probably better for people to just see what the investment does and not feature so much what is "protected" or isn't protected.
This sounds like you're agreeing with me then? Did I misread what you initially said, or are you changing your mind (about saying that TIPS are indexed to expected and unexpected inflation)?

TIPS are indexed to actual inflation (as measured by CPI), so actually not indexed to expected inflation (and obviously not unexpected inflation either).
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MahoningValley
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Re: Which TIPS offer the best inflation protection?

Post by MahoningValley »

The only comprehensive discussion of TIPS and I Bonds has been by David Enna @TIPSwatch.com. His blog goes back to 2011.
dbr
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Re: Which TIPS offer the best inflation protection?

Post by dbr »

BJJ_GUY wrote: Thu Jul 22, 2021 3:41 pm
dbr wrote: Thu Jul 22, 2021 2:35 pm
BJJ_GUY wrote: Thu Jul 22, 2021 2:22 pm
dbr wrote: Thu Jul 22, 2021 2:04 pm
okwriter wrote: Thu Jul 22, 2021 5:04 am Vanguard has a paper on this: The Long and Short of TIPS.

They find that short-term TIPS has a greater correlation with short-term unexpected inflation compared to intermediate and long TIPS. So they advocate shortening TIPS duration.

Personally I don't find this convincing - shouldn't you care more about long-term rather than short-term unexpected inflation? That paper seems to advocate for stocks for this purpose.
It's different from that and worse than that. Correlation with inflation is an artificial and irrational measure of "inflation protection." The reason longer TIPS don't correlate well to inflation is that they have more duration risk that causes variability in return and therefore reduces the correlation to the one factor. But that has nothing to do with how well the investment is indexed to inflation. That paper really pisses me off because instead of informing people it confuses people. Also, all TIPS are indexed to expected and unexpected inflation.

Stock are badly correlated with inflation but also have a high probability of continuing to have a positive expected return. TIPS can and do have negative expected real return at any point. However, what is the expected return and what is the variability of return when real and/or nominal interest rates change (which includes when the rate of inflation changes) would be two different things.
How are TIPS indexed to unexpected inflation? CPI is a trailing measure. Nothing specifically is indexed to unexpected inflation with TIPS
The definition of indexing is that the principle value is incremented by the most recent (yes trailing average) measure of periodic inflation, whether that inflation had been expected or not. No one tries to increase the face value of the bond today based on a guess what the inflation rate will be in the future, nor is it necessary to do that as long as the increment is continuously and cumulatively applied, which it is. The TIPS Inflation Index Ratio is calculated daily but I am not sure how far back the rolling period is.

It is probably better for people to just see what the investment does and not feature so much what is "protected" or isn't protected.
This sounds like you're agreeing with me then? Did I misread what you initially said, or are you changing your mind (about saying that TIPS are indexed to expected and unexpected inflation)?

TIPS are indexed to actual inflation (as measured by CPI), so actually not indexed to expected inflation (and obviously not unexpected inflation either).
Yes, we agree. The issue of language here might be best summed up by saying that "indexed to unexpected inflation" means that when the unexpected inflation actually shows up then the TIPS will surely be indexed to it.

The discussion that is going on about expected and unexpected inflation really applies to nominal bonds where estimates of future interest rates might affect what people are willing to pay for a bond today. Expectations for future inflation would affect that and unexpected inflation would be a monkey wrench in the works. TIPS simply compensate the nominal dollar value of the security for whatever inflation comes to pass whether someone had expected that to happen or not.
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Ocean77
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Re: Which TIPS offer the best inflation protection?

Post by Ocean77 »

Thank you all for the very informative posts! What I take from the discussion so far is that the price change of TIPS that is due just to the inflation adjustment would be same for all TIPS, no matter what the duration is. So assuming there is no interest rate change, all TIPS should respond to an unexpected inflation increase in the same way (with the same price change as percent of NAV).

I realize of course that my assumption of no interest rate change is very hypothetical. But I asked specifically to find out if there is a benefit to long term TIPS as far as inflation protection goes. Since long term TIPS have more interest rate risk (if the rates do change), I figured there may be some trade-off with long term TIPS (more inflation protection, at the expense of more interest rate risk). Looks like this is not the case. So if one is after inflation protection only and does not want to be exposed to much interest rate risk (or conversely benefit from falling rates), it looks like short term TIPS would be the way to go.
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Re: Which TIPS offer the best inflation protection?

Post by simple man »

Isnt the most likely difference on TIP funds the inflation index they are using? It seems to me that inflation indices can be altered depending on what is causing inflation at any give time? Also, I sometimes see inflation reported "without including X and Y" - which are major hits to the pocketbook. So the index tracked is the big issue here....CPI this or CPI that.
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Re: Which TIPS offer the best inflation protection?

Post by vectorizer »

Angst wrote: Thu Jul 22, 2021 2:39 pm ... Buying a TIPS at auction for a 5, 10 or 30 year duration liability is the most elegant real world solution, to a very specific problem, while it's already been pointed out that purchasing individual TIPS in the secondary market entails some additional risk of losing accrued inflation to deflation.
I've been buying 10 year TIPS at auction each July for a few years now, intending to hold to maturity as an inflation-protected supplement to SS. Avoids secondary market risk and I won't care about price swings. The first TIPS bond matures in the year I first take SS. My order was priced today at $111.99. Yikes! TIPS are stupid-expensive now ... luckily I'm stupid enough to keep buying them, because what else can one do to get explicit inflation protection? (IBonds aren't an option because of dollar limit and I need them in my IRA.)
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Re: Which TIPS offer the best inflation protection?

Post by BigJohn »

I read a lot of these posts on TIPS as well as the VG paper and other research sources several year ago when I made the decision to move 50% of my bond allocation to TIPS. I’m no bond expert but the conclusion I came to was this. If I was comfortable with intermediate term nominal bonds, they should be replace with intermediate term TIPS. For the portion of my bonds that I keep short term, I replace with short term TIPS. This made sense to me as both are indexed to the same inflation measure and have similar duration risk. Maybe an overly simplistic view but it works for me :beer
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Re: Which TIPS offer the best inflation protection?

Post by BJJ_GUY »

simple man wrote: Thu Jul 22, 2021 5:10 pm Isnt the most likely difference on TIP funds the inflation index they are using? It seems to me that inflation indices can be altered depending on what is causing inflation at any give time? Also, I sometimes see inflation reported "without including X and Y" - which are major hits to the pocketbook. So the index tracked is the big issue here....CPI this or CPI that.
TIPS all reference the same consumer price index. It's not about what the fund selects, but rather the underlying securities.

As for your point about the CPI itself, there is plenty of reason to be skeptical about the efficacy as an inflation gauge -- and some may even be cynical enough to identify a conflict of interest between who can manipulate the CPI and who pays the coupons on the bonds indexed to that measure. Leaving the latter point alone, I believe it's more than fair to raise the issues that you did, they are real problems.
dbr
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Re: Which TIPS offer the best inflation protection?

Post by dbr »

Ocean77 wrote: Thu Jul 22, 2021 4:56 pm Thank you all for the very informative posts! What I take from the discussion so far is that the price change of TIPS that is due just to the inflation adjustment would be same for all TIPS, no matter what the duration is. So assuming there is no interest rate change, all TIPS should respond to an unexpected inflation increase in the same way (with the same price change as percent of NAV).

They also respond to an expected inflation increase in exactly the same way. But more accurately the response is not to changes in inflation but simply to inflation itself. If there is no increase in inflation the bonds are still marked up periodically by whatever that constant value of inflation might be. Whether or not a constant rate of inflation was what was expected or not, I couldn't say.

I realize of course that my assumption of no interest rate change is very hypothetical. But I asked specifically to find out if there is a benefit to long term TIPS as far as inflation protection goes. Since long term TIPS have more interest rate risk (if the rates do change), I figured there may be some trade-off with long term TIPS (more inflation protection, at the expense of more interest rate risk). Looks like this is not the case. So if one is after inflation protection only and does not want to be exposed to much interest rate risk (or conversely benefit from falling rates), it looks like short term TIPS would be the way to go.

The benefit to longer durations is that on average the expected return is more. As another poster has pointed out, if your choice in nominal bonds were for intermediate duration, then it would probably be logical to hold intermediate TIPS. If you have decided on short TIPS you should probably ask if that is how you invest in nominal bonds. A measure of the difference is that the current real interest rate at five years is -1.75%, rate at ten years is -1.01%, the rate at twenty years is -.53%, and the rate at thirty years is -0.29%. This is fairly flat right now and can be much steeper.
Topic Author
Ocean77
Posts: 427
Joined: Wed Oct 23, 2019 3:20 pm

Re: Which TIPS offer the best inflation protection?

Post by Ocean77 »

dbr wrote: Thu Jul 22, 2021 7:05 pm
Ocean77 wrote: Thu Jul 22, 2021 4:56 pm Thank you all for the very informative posts! What I take from the discussion so far is that the price change of TIPS that is due just to the inflation adjustment would be same for all TIPS, no matter what the duration is. So assuming there is no interest rate change, all TIPS should respond to an unexpected inflation increase in the same way (with the same price change as percent of NAV).

They also respond to an expected inflation increase in exactly the same way. But more accurately the response is not to changes in inflation but simply to inflation itself. If there is no increase in inflation the bonds are still marked up periodically by whatever that constant value of inflation might be. Whether or not a constant rate of inflation was what was expected or not, I couldn't say.

I realize of course that my assumption of no interest rate change is very hypothetical. But I asked specifically to find out if there is a benefit to long term TIPS as far as inflation protection goes. Since long term TIPS have more interest rate risk (if the rates do change), I figured there may be some trade-off with long term TIPS (more inflation protection, at the expense of more interest rate risk). Looks like this is not the case. So if one is after inflation protection only and does not want to be exposed to much interest rate risk (or conversely benefit from falling rates), it looks like short term TIPS would be the way to go.

The benefit to longer durations is that on average the expected return is more. As another poster has pointed out, if your choice in nominal bonds were for intermediate duration, then it would probably be logical to hold intermediate TIPS. If you have decided on short TIPS you should probably ask if that is how you invest in nominal bonds. A measure of the difference is that the current real interest rate at five years is -1.75%, rate at ten years is -1.01%, the rate at twenty years is -.53%, and the rate at thirty years is -0.29%. This is fairly flat right now and can be much steeper.
Thank you! The expected higher return at longer durations is a good point. But at current rates probably nothing to get really excited about. I'd be more worried about the interest rate risk, should rates rise. My nominal bonds are mostly short term for the same reason.

As for "expected inflation", I think that would already be priced into the TIPS, no? Even if the actual mark up in price by the Treasury did not occur yet, the market would already have discounted that. So if I were to purchase those TIPS now, then the mark up due to expected inflation would not be part of the return I would receive.
dbr
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Joined: Sun Mar 04, 2007 9:50 am

Re: Which TIPS offer the best inflation protection?

Post by dbr »

Ocean77 wrote: Fri Jul 23, 2021 12:04 pm
As for "expected inflation", I think that would already be priced into the TIPS, no? Even if the actual mark up in price by the Treasury did not occur yet, the market would already have discounted that. So if I were to purchase those TIPS now, then the mark up due to expected inflation would not be part of the return I would receive.
I don't relate to this expected vs unexpected inflation. The return in a period is derived from the interest paid on the marked up value, gain in value from any markup applied (which comes from actual inflation whether or not expected or not expected by someone), and the gain or loss in market price of the bonds. It wouldn't occur to me to say that the mark up is not part of the return because it was already paid for in the beginning of period price.

Of course if the markup involved unexpected inflation then the markup would be part of the return. The definition of return is not that convoluted.
Topic Author
Ocean77
Posts: 427
Joined: Wed Oct 23, 2019 3:20 pm

Re: Which TIPS offer the best inflation protection?

Post by Ocean77 »

dbr wrote: Fri Jul 23, 2021 3:19 pm
Ocean77 wrote: Fri Jul 23, 2021 12:04 pm
As for "expected inflation", I think that would already be priced into the TIPS, no? Even if the actual mark up in price by the Treasury did not occur yet, the market would already have discounted that. So if I were to purchase those TIPS now, then the mark up due to expected inflation would not be part of the return I would receive.
I don't relate to this expected vs unexpected inflation. The return in a period is derived from the interest paid on the marked up value, gain in value from any markup applied (which comes from actual inflation whether or not expected or not expected by someone), and the gain or loss in market price of the bonds. It wouldn't occur to me to say that the mark up is not part of the return because it was already paid for in the beginning of period price.

Of course if the markup involved unexpected inflation then the markup would be part of the return. The definition of return is not that convoluted.
I don't think it's that complicated. If between now and next week, the inflation expectation of the market goes up by 1% (i.e. due to economic news), TIPS prices will rise in response. Somebody who buys TIPS today (before the change) will realize that increase as a return on this investment. While somebody who buys the TIPS next week after the news will not.
TurtleBeatsHare
Posts: 26
Joined: Fri Jun 25, 2021 2:01 pm

Re: Which TIPS offer the best inflation protection?

Post by TurtleBeatsHare »

Ocean77 wrote: Thu Jul 22, 2021 4:56 pm Thank you all for the very informative posts! What I take from the discussion so far is that the price change of TIPS that is due just to the inflation adjustment would be same for all TIPS, no matter what the duration is. So assuming there is no interest rate change, all TIPS should respond to an unexpected inflation increase in the same way (with the same price change as percent of NAV).

I realize of course that my assumption of no interest rate change is very hypothetical. But I asked specifically to find out if there is a benefit to long term TIPS as far as inflation protection goes. Since long term TIPS have more interest rate risk (if the rates do change), I figured there may be some trade-off with long term TIPS (more inflation protection, at the expense of more interest rate risk). Looks like this is not the case. So if one is after inflation protection only and does not want to be exposed to much interest rate risk (or conversely benefit from falling rates), it looks like short term TIPS would be the way to go.
This is correct, but there is a very important BUT. TIPS are very effective at protecting against inflation risk for the portion of your portfolio invested in TIPS, but they don’t cover the non-TIPS portion of your portfolio because the inflation adjustment is calculated to offset the value loss to the TIPS principal. Put differently, if TIPS are 20% of your portfolio, then you’ve eliminated index-captured inflation risk to that 20% but still taken your inflation devaluation on the remaining 80% of the portfolio. If you want to protect the non-TIPS portion of your portfolio, you need an inflation hedge that increases in value more than inflation (as opposed to merely offsets it) to compensate for devaluation in the rest of your portfolio.

The only basic asset class (so ignoring derivatives, leveraged investments, or option-type trading and not considering sector funds) that has sufficient correlation with inflation and sufficient magnitude are commodities/commodity companies. While these correlate slightly less with inflation than short term TIPS, they correlate more than long term TIPS, domestic or international equities and real estate and
they have substantially more magnitude. As a result, they often increase in value during inflation by more than the inflation therefore a small percentage of your portfolio can hedge against inflation for a much larger percentage of your portfolio. But even this isnt foolproof—the current inflationary environment is driven by used cars, furniture and home prices (which aren’t included in either index) and so would not be captured in any commodity index—which tend to be evenly split between energy/raw materials/agriculture or are tilted to double weight energy—depending upon the index you use. I tend to think that’s okay for a personal investor because products outside the indices are usually avoidable purchases for a retiree, and therefore doesn’t need to hedge. Obviously it’s a different story for institutional investors, like pensions.

In any event, I think that a TIPS only strategy for inflation protection is simple, but not especially optimal. I’m probably a minority view on these forums; people here really like their TIPS, but they cannot provide inflation protection for the non-TIPS portion of the portfolio because of how the inflation adjustment is calculated (well, barring a situation where you bough the TIPS with leverage, in which case the inflation would devalue the debt). While they are good enough for investors who no longer need to care about return, I think a TIPS only strategy for hedging inflation sacrifices more return than necessary to hedge the inflationary risk.
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