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Nice article on TIPS
Old 07-09-2010, 07:02 AM   #1
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Nice article on TIPS

I think this is a pretty good article for those considering purchasing TIPS (especially TIPS ETF's) as a hedge against inflation. Basically, it emphasizes that shorter-term TIPS reduce one's exposure to rising real interest rates, which is likely as the economy recovers and demand for borrowing increases. This lower volatility with respect to changing real interest rates increases the correlation with inflation versus those with longer maturities (and greater duration with respect to changing real rates).

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Old 07-09-2010, 09:02 AM   #2
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With a specialized bond like TIP Securities, keeping maturities low is where the benefit of the inflation hedge is at its best. The other factors that affect bond price can be minimized in lower maturities. The primary reason an investor allocates into TIPS is to hedge against inflation. Low duration TIPS will benefit from increasing inflation (CPI) and the expectation of inflation increasing. Both of these factors will be directly affect these bondsí prices and lower maturities will allow the highest correlation to these factors that the investor is looking to access.
I would have said that two TIPS with the same coupon but different maturities will payout the same with regard to inflation.
Their market values will move around differently, but it's not clear to me that one will track inflation expectations better. Of course, if you hold to maturity, you never incur market value gains/losses.
If you hold the shorter maturities for a longer need, you have some reinvestment risk.

That seems somewhat different from the article. Any thoughts?

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Old 07-09-2010, 12:31 PM   #3
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Good article. Thanks for posting.

I think the author is saying that shorter-term TIPs will track actual CPI changes better.
And if I claim to be a wise man, it surely means that I don't know.
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Old 07-09-2010, 12:58 PM   #4
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The idea is good, but the article is unclear. From his example of the early 80s when CPI inflation rates fell, but interest rates rose, one would have to assume that what he really means is that short duration TIPS are better insulated from rises in real interest rates.

Which is what makes sense, as any TIPS will track CPI changes. But if real rates increase, coupons on new TIPS will also have to increase, and TIPS already extant will lose value, and that loss will be greater with longer duration TIPS.
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Old 07-09-2010, 03:07 PM   #5
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I don't quite understand what the article was getting at. Regular bonds already price in expected inflation. TIPS also give you any unexpected inflation.

So in the short term, there is rarely any unexpected inflation because crystal balls work rather well for the forthcoming year or so. In that sense, there is no point in purchasing shorter duration TIPS if a short-term nominal bond fund pays more.

This is one reason why you can use Larry Swedroe's duration shifting strategy. Go short if TIPS yields are low or get out of TIPS. You can see that yields are low by looking at this blue line for 10-year TIPS: St. Louis Fed: Series: DFII10, 10-Year Treasury Inflation-Indexed Security, Constant Maturity

If TIPS real yield is above 2.5% on the blue line, then you can go long. If real yields drop, you sell for a nice capital gain.

In the meantime, with real yields hovering about 1.3%, there is no point in owning any TIPS especially short-duration ones.
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Old 07-10-2010, 06:51 AM   #6
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I think the article needs a huge qualifier . . . "for assets allocated as liquid reserves, short-duration TIPS provide better inflation protection."

When held to maturity, the principal on all TIPS is perfectly correlated with CPI regardless of duration. So the better solution, IMHO, is to asset, liability match your TIPS portfolio. Your 5-yr money should be in 5-yr TIPS, 30-yr money in 30-yr TIPS, etc. etc. Holding 100% short-duration seems to forsake a pretty steep yield curve without a whole lot of obvious benefit.

(I also don't understand the need for a TIPS fund when you can buy them at auction and get the same price as institutional investors, without commission and without management fees.)
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Old 07-10-2010, 09:06 AM   #7
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It seems to me that Ha is correct in that for any given change in inflation expectations, the longer maturity TIPS will have the greater change in market value. What's not clear to me is the claim that means the short maturities "track inflation better". I guess my uncertainty deals with investment horizon.

G4G goes directly at my concern. If I'm a retiree buying TIPS because I want to protect my 2022 (for example) withdrawals from inflation losses, then I want a 2022 maturity. It will "track inflation" better for my spending.

But that approach requires buying a whole ladder, not something I can do at auction (unless I planned really well). I'll admit that I haven't looked at what it would take to construct a ladder through a broker. So far, I've owned a fund (Vanguard index), thinking that the actual market value fluctuations are small relative to my investment goals.

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