Rick Ferri's TIPS interest rate hell: is it time to unload?

Lbill · Post by **Lbill** » Sun Jul 17, 2011 7:58 am

As I recall, Rick Ferri wrote a piece the describes the "perfect storm" for TIPS: rising real interest rates not linked to inflation. In this scenario, rising rates will bring about principal losses that are not offset by inflation-based principal adjustments, or even downward principal adjustments if there is outright deflation. It's looking more and more as if this is possible due to downgrades of U.S. Treasury debt due to the threat or actual default. Having acquired a boatload of TIPS in my retirement portfolio, I'm getting more than a bit concerned about this, and wondering if I should unload. What do others think? Especially like to hear from Rick and Larry Swedroe.

Aptenodytes · Post by **Aptenodytes** » Sun Jul 17, 2011 8:06 am

If you hold to maturity you don't need to worry about your scenario. In general I would think the sensible way to use TIPS is to hold until maturity.

tipswatcher · Post by **tipswatcher** » Sun Jul 17, 2011 8:10 am

Rick Ferri wrote a piece the describes the "perfect storm" for TIPS: rising real interest rates not linked to inflation.

I agree that would be very bad for TIPS mutual funds. Not so much for TIPS held to maturity, which would just have a bit lower interest rate than new issues.

If you are laddering TIPS and holding to maturity, a rise in interest rates would be a good thing. I would put more into TIPS if the base rate were higher.

DaveS · Post by **DaveS** » Sun Jul 17, 2011 8:17 am

I would not unload the "boat." but if you did what would you get that is less risky? Your scenario of rapidly rising rates without an increase in inflation is not too likely. Possible but not the highest probability. That is why you want to be diversified. You do have other investments don't you? Dave

grayfox · Post by **grayfox** » Sun Jul 17, 2011 8:17 am

Lbill wrote:As I recall, Rick Ferri wrote a piece the describes the "perfect storm" for TIPS: rising real interest rates not linked to inflation. In this scenario, rising rates will bring about principal losses that are not offset by inflation-based principal adjustments, or even downward principal adjustments if there is outright deflation. It's looking more and more as if this is possible due to downgrades of U.S. Treasury debt due to the threat or actual default. Having acquired a boatload of TIPS in my retirement portfolio, I'm getting more than a bit concerned about this, and wondering if I should unload. What do others think? Especially like to hear from Rick and Larry Swedroe.

So you are saying that the yield in TIPS will increase because of credit risk premium being added to TIPS yield. Well the bond market doesn't seem to be worrying about default of TIPS. See 5-year TIPS chart:

<img src="http://research.stlouisfed.org/fredgraph.png?g=19z">

5-Year TIPS Chart

On the other hand, it might make sense to sell any 5-year TIPS because the yield is negative. Why take a guaranteed real loss?

Rick Ferri · Post by **Rick Ferri** » Sun Jul 17, 2011 8:18 am

During 2009, I wrote an article for Forbes titled The Dark Side of TIPS. It described a scenario where real interest rates rise while inflation falls. Real interest rates are the difference between inflation and the nominal rate of return on Treasuries. This scenario is possible if the world loses confidence in the ability of the USA to pay its debts, and in turn, creates a dramatic slowdown in the world economy and falling prices (deflation). TIPS would lose in this scenario.

I don't believe their is a high probability of the dark side scenario. More likely, Treasury will print as much money as we need to pay our debts, thereby creating an inflationary scenario. This scenario would make TIPS attractive.

Take your pick. IMO, a 20% position in TIPS is prudent in your bond portfolio. That's what I own (full disclosure).

Rick Ferri

yobria · Post by **yobria** » Sun Jul 17, 2011 8:32 am

tipswatcher wrote:I agree that would be very bad for TIPS mutual funds. Not so much for TIPS held to maturity, which would just have a bit lower interest rate than new issues.

I don't see how holding the TIPS yourself vs having your fund hold the TIPS would be a free lunch in such a scenario. Prices would behave the same way.

Nick

ofcmetz · Post by **ofcmetz** » Sun Jul 17, 2011 8:38 am

yobria wrote:
tipswatcher wrote:I agree that would be very bad for TIPS mutual funds. Not so much for TIPS held to maturity, which would just have a bit lower interest rate than new issues.
I don't see how holding the TIPS yourself vs having your fund hold the TIPS would be a free lunch in such a scenario. Prices would behave the same way.

Nick

If individuals were held to maturity then at least you get a return of principle. In a bond fund that's not the case since the fund is always buying and selling bonds and the NAV could be completely different when you sell.

I think that's what he's talking about.

Mitchell777 · Post by **Mitchell777** » Sun Jul 17, 2011 8:46 am

Rick - Do you own the 20% TIPS bond allocation in a TIPS fund or individual TIPS, if you are willing to say - Thank you

Rick Ferri · Post by **Rick Ferri** » Sun Jul 17, 2011 9:00 am

Mitchell777 wrote:Rick - Do you own the 20% TIPS bond allocation in a TIPS fund or individual TIPS, if you are willing to say - Thank you

I own the Vanguard TIPS Fund. It's low cost, diversified, and I don't have to deal with interest reinvestment.

yobria · Post by **yobria** » Sun Jul 17, 2011 9:39 am

ofcmetz wrote:If individuals were held to maturity then at least you get a return of principle. In a bond fund that's not the case since the fund is always buying and selling bonds and the NAV could be completely different when you sell.

Yes, can't say that would dissuade me from holding a TIPS fund. If the fund does have to sell for a loss due to rising rates, it's going to reinvest at those higher rates. No free lunch in holding to maturity vs selling at a loss and buying securities with yields to make up for it.

I guess if you needed an exact amount of principal back on a certain date this might be a concern, but not for a typical investor, who accumulates then draws down over a period of decades.

Nick

fredflinstone · Post by **fredflinstone** » Sun Jul 17, 2011 9:48 am

I am currently revising my IPS. The revised version will tell me to devote 100 percent of my retirement accounts to long-duration TIPS and to hold those TIPS to maturity.

If long-term real interest rates rise, I will be delighted because the TIPS I buy in the future will offer a higher yield than the ones I can buy now. At the same time, the TIPS I own now will continue to pump out interest (about 2 percent real).

If long-term real interest rates decline, I will not be delighted, but at least I can take comfort in knowing that the market value of the TIPS I currently own has increased.

In the past, I have shown no ability whatsoever to predict moves in real interest rates, so I am real reluctant to get into any kind of cutesy market timing here, a la Larry Swedroe. (He doesn't call it market timing, but in my view if your decision to buy TIPS is based on the yield, then market timing is what it is.)

If I had to guess I would say long-term TIPS yields are more likely to decline than increase. The real yield curve seems quite steep to me. I cannot understand why so many people in their 30s and 40s own intermediate-duration TIPS when longer-duration TIPS offer much higher yields.

tipswatcher · Post by **tipswatcher** » Sun Jul 17, 2011 9:54 am

I don't see how holding the TIPS yourself vs having your fund hold the TIPS would be a free lunch in such a scenario.

Personal opinion: When I buy a TIPS to hold to maturity, I look it as 'guaranteed' asset for the next 5, 10 or 30 years. It pays x.x% interest, plus the inflation adjustment to principal. When the term is up, I get my money and decide if I want to reinvest. I usually do.

Those TIPS I bought back in 1999 had base rates around 4.0%, and their market value rose nicely over the years, but it didn't matter. I was holding to maturity.

The more-recent TIPS are paying much lower rates. I buy and hold. I don't care if the 'market' value goes down -- it probably will. I will hold.

Yes, I'd like higher base rates, so if the base rate went up, I'd be a little more aggressive buying TIPS.

So a TIPS to me is more like a bank CD. I know what I am getting.

I have owned TIPS mutual funds in the past, but not today. I'd definitely look at them if the base-rate increases to more 'normal' levels.

jon-nyc · Post by **jon-nyc** » Sun Jul 17, 2011 12:12 pm

I'm hoping for another buying opportunity so I can fill some gaps in the ladder I'm building. In fact I sold some other bonds in my IRAs to have some powder ready.

I should say I'm not that convinced the debt ceiling showdown will generate the buying opportunity I'm hoping for, but if it does I'll be ready.

Rick Ferri · Post by **Rick Ferri** » Sun Jul 17, 2011 12:17 pm

<img src="http://research.stlouisfed.org/fredgraph.png?g=19z">

5-Year TIPS Chart

Yep, TIPS were cheap in late 2008. But then, so was everything else.

Well, I shouldn't say that because nominal Treasuries were rallying strongly at the time. What's interesting about this chart is that the market for TIPS dried up, which exposed another weakness in TIPS versus nominal Treasuries. They have liquidity risk.

Rick Ferri

DickBenson · Post by **DickBenson** » Sun Jul 17, 2011 12:57 pm

Rick Ferri wrote:IMO, a 20% position in TIPS is prudent in your bond portfolio.

What type of bonds do you recommend for the other 80% of your bond portfolio?

Dick

Rick Ferri · Post by **Rick Ferri** » Sun Jul 17, 2011 1:02 pm

I own 60% in the Vanguard Total Bond Market index fund, 20% in the Vanguard Corporate High Yield Fund, and 20% in the Vanguard TIPS fund. This 60/20/20 allocation is rebalanced annually.

Rick Ferr

abuss368 · Post by **abuss368** » Sun Jul 17, 2011 1:24 pm

Wouldn't it be nice if someday Vanguard included both TIPS and High Yield in the Total Bond Market fund? A "one stop shop" bond fund for your US allocation (i.e. ignoring foreign bonds for the moment).

I realize the index would probably have to be adjusted.

Bongleur · Post by **Bongleur** » Sun Jul 17, 2011 2:16 pm

>More likely, Treasury will print as much money as we need to pay our debts, thereby creating an inflationary scenario.
>

Does Treasury have the authority to print more without a rise in the debt ceiling? Which means the politicians must decide?

dmcmahon · Post by **dmcmahon** » Sun Jul 17, 2011 2:50 pm

fredflinstone wrote: If long-term real interest rates rise, I will be delighted because the TIPS I buy in the future will offer a higher yield than the ones I can buy now. At the same time, the TIPS I own now will continue to pump out interest (about 2 percent real).

If long-term real interest rates decline, I will not be delighted, but at least I can take comfort in knowing that the market value of the TIPS I currently own has increased.

Ditto this. I have no plans to do anything with my TIPS. If real rates rise, I'll be cheering, even if it means the "NAV" of my TIPS bonds "declines" in response.

Valuethinker · Post by **Valuethinker** » Sun Jul 17, 2011 2:52 pm

Rick Ferri wrote:What's interesting about this chart is that the market for TIPS dried up, which exposed another weakness in TIPS versus nominal Treasuries. They have liquidity risk.

Rick Ferri

If they are used in collateralized transactions (Repos) by a bank called Lehman Brothers.

It's not at all clear that scenario would be repeated.

Generally TIPS are relatively thinly traded vs. US Treasuries: only 10% of all US Treasury Bonds are TIPS, and most buyers and 'buy and hold': institutions with long term liability profiles like pension funds and insurance companies.

Nonetheless there is no certainty the extraordinary events of late 2008 would be repeated in the TIPS market.

In retrospect, it may well have been 'deal of the century' for buyers.

FNK · Post by **FNK** » Sun Jul 17, 2011 3:34 pm

Bongleur wrote:>More likely, Treasury will print as much money as we need to pay our debts, thereby creating an inflationary scenario.
>

Does Treasury have the authority to print more without a rise in the debt ceiling? Which means the politicians must decide?

The constitution binds the entire government to make payments on public debt no matter what. All the other programs must be authorized.

Bongleur · Post by **Bongleur** » Sun Jul 17, 2011 9:41 pm

FNK wrote:
Bongleur wrote:>More likely, Treasury will print as much money as we need to pay our debts, thereby creating an inflationary scenario.
>

Does Treasury have the authority to print more without a rise in the debt ceiling? Which means the politicians must decide?
The constitution binds the entire government to make payments on public debt no matter what. All the other programs must be authorized.

More complicated than that; anyway you are begging the question. If Treasury receipts are less than all scheduled payments, may they print money beyond the Debt Ceiling?

Public Debt is only one kind of government debt; its not all the debt owed.

MWCA · Post by **MWCA** » Sun Jul 17, 2011 9:44 pm

TIPS funds ytd have done quite well. Unload to what?

FNK · Post by **FNK** » Tue Jul 19, 2011 6:33 pm

Bongleur wrote: More complicated than that; anyway you are begging the question. If Treasury receipts are less than all scheduled payments, may they print money beyond the Debt Ceiling?

Public Debt is only one kind of government debt; its not all the debt owed.

So sweet to have people use "begging the question" correctly.

As far as I understand it (and IANAL), a constitutional amendment overrides a law and requires printing money for things that the constitution requires. However, everything else the government does would shut down.

Bongleur · Post by **Bongleur** » Tue Jul 19, 2011 6:37 pm

How can Treasury print money if there is no money to pay the salaries of the people doing the printing?

Catch-22 !!!!!

FNK · Post by **FNK** » Tue Jul 19, 2011 6:54 pm

Dang! Got them! Must set computers on auto-print before they leave.

On the other hand, there's 8000 metric tons of gold and 700 billion barrels of oil to dump on the markets.

DartThrower · Post by **DartThrower** » Wed Jul 20, 2011 1:18 pm

It's the Fed that can print money, not Treasury. The Treasury can get money by taxing, by borrowing from various lenders or by borrowing from the Fed itself.

Hence QE1, QE2 etc.

Bongleur · Post by **Bongleur** » Wed Jul 20, 2011 5:41 pm

But IIRC the Mint is part of the Treasury Dept, and they actually to the printing !!!

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Rick Ferri's TIPS interest rate hell: is it time to unload?

Rick Ferri's TIPS interest rate hell: is it time to unload?

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Re: Rick Ferri's TIPS interest rate hell: is it time to unlo