TIPS: Buy Bond or Bond FUND? Pros & Cons please!

[Jane_Doe]

Hi, all!

I am interested in using TIPS as a good chunk of our AA once we finally sell out on our RE holdings.

Can anyone give the pros and cons on holding TIP funds (the way I am leaning as of now) vs. actually holding the bonds directly (which sounds more complicated to me).

To further clarify, I like using Vanguard so that is the fund I would use (VAIPX) and would be using this as a good part of our income stream. Also, all funds will be in TAXABLE accounts for whiat it's worth.

Thanks for any help!

Jane

 

[wabmester]

The differences between holding individual TIPS and TIPS funds are sort of like the differences between Democrats and Republicans -- very small, but people seem to get excited about the small differences.

Basically, by buying individual bonds, you have more control over maturity, duration, yield, etc. So, if those things excite you, buy individual bonds.

You also get "guaranteed" preservation of capital as long as you hold the bonds to maturity, but this is somewhat of an illusion since there is an opportunity cost to holding a low-yield bond in a high-yield environment. Some people (including me) find it comforting to know exactly what their returns will be over time and having the luxury of ignoring NAV fluctuations. But, in the end, it's really the total return (income stream + capital gain/loss + principal) that matters.

TIPS are pretty liquid. TIPS are cheap to buy (no fee via Treasury auctions). TIPS have no default risk. So, for people who are comfortable buying individual bonds, funds don't offer many of their traditional benefits for TIPS.

Funds are easier (and cheaper) to sell. It's easier to reinvest the interest with funds. Funds pay out the inflation adjustment in their dividends. And you don't need to know much about bonds to buy funds (although, I like to understand the underlying investments as well as I can). And for these benefits, you have to pay a small annual fee (a mere 0.11% in the case of VAIPX).

 

[brewer12345]

Hmmm, how about a mix of the two? The main diference between the two options is that it is a lot easier to buy or sell a small chunk of the fund than it is to do with bonds. So buy maybe 75% of the amount you want in directly held bonds at the next auction(s) and buy the rest in the form of the fund. That way you can rebalance easily out of the fund, but get lower costs and the other benefits of directly held bonds for most of your position.

 

[Jane_Doe]

Thanks, Wab & Brewer!

Both of your answers make sense to me - I am trying to form a plan to implement and sometimes all of this can be overwhelming. I know I will have time upon ER to spend on portfolio so buying and holding the "real" thing for the bulk of it and funds for liquidity and rebalancing sounds good.

I know I personally need to "keep it simple, sweetheart" for my "plan". I don't want to have to learn complicated math calculations to be able to "run" my portfolio. I continue to read and try to learn more, but some of this can REALLY be mind boggling!

Thanks for the help. I will eventually put my plan on here for critiquing but I am not ready yet. We are starting the process of selling our business - if that goes well we will be semi RE this spring! Yahoo!

Have a great day!

Jane

 

[brewer12345]

Jane, not to complicate things for you, but if you choose to directly hold TIPS you will need to decide which TIPS you want to buy. I would suggest looking at 5 year and 10 year maturities and picking a split.

 

[WilliamG]

Hi Jane - I'm not an expert on TIPS but I believe the fund will provide more ongoing income than the individual bonds since the fund pays out some of the inflation growth and you have to wait on it in the bonds. You said that this will be a good part of your income stream, so this may have some bearing on your choice.... bill

 

[Rich_by_the_Bay]

Say your cash reserve includes a hefty chunk of TIPS. In noninflationary times they act like any other low interest account and can be tapped like cash (assuming they are in mutual funds). In return for a lousy yield compared to some other kinds of bonds, they provide protection if and when inflation outpaces short term or even intermediate term yield.

Sound right? Any sanity checks on how much to hold in TIPS? I was thinking about 2 years of expenses as part of my 7-year income bucket.

 

[FIRE'd@51]

Say your cash reserve includes a hefty chunk of TIPS. In noninflationary times they act like any other low interest account and can be tapped like cash (assuming they are in mutual funds).

You need to be a bit careful here, since TIPS (and TIPS mutual funds) exhibit substantial volatility with respect to changes in real interest rates. They should not be viewed as a cash substitute.

 

[renferme]

take a look at Vanguard's TIPs fund - horrible return this year.
They are not for me.

 

[brewer12345]

take a look at Vanguard's TIPs fund - horrible return this year.
They are not for me.

Is this the reverse of performance chasing?

 

[flipstress]

You need to be a bit careful here, since TIPS (and TIPS mutual funds) exhibit substantial volatility with respect to changes in real interest rates. They should not be viewed as a cash substitute.

But what if one also has Treasury bonds of an equal amount to the TIPS, with the Treasury bonds giving benefits in a deflationary environment while the TIPS is for protection in an inflationary environment?

I was indeed thinking of using TIPS and Treasury bonds for my non-equity holdings, as cash substitutes--close to 50% for each and holding little cash. So if I had 70% in equities, I would have 15% in TIPS and 15% in Treasury bonds.

 

[brewer12345]

But what if one also has Treasury bonds of an equal amount to the TIPS, with the Treasury bonds giving benefits in a deflationary environment while the TIPS is for protection in an inflationary environment?

I was indeed thinking of using TIPS and Treasury bonds for my non-equity holdings, as cash substitutes--close to 50% for each and holding little cash.

Holding little cash. period, or holding little cash as part of the permanent portfolio? I think the former is a questionable idea.

 

[flipstress]

Holding little cash. period, or holding little cash as part of the permanent portfolio? I think the former is a questionable idea.

Right now, while saving for retirement, I am holding little in cash.

I haven't thought it out much, but in retirement, I was thinking of maintaining an asset allocation that goes 70% in equities, 15% in TIPS, and 15% in Treasury bonds, or a more conservative 60%-20%-20%. I was thinking of just withdrawing 4% from each asset type each month but perhaps a better way would be to withdraw the whole sum at the beginning of each year and put it in cash or cash equivalents, or maybe even withdraw two years worth (8%) and put this in cash or cash equivalents.

Maybe this should be another thread but in any case, I appreciate the TIPS and TIPS funds insights because I couldn't decide which to use.

 

[brewer12345]

Ah, gotcha. I thought you were talking about an in-retirement portfolio. If you are still accumulating, that is different. Minimal cash makes more sense.

I would suggest you think about more asset classes than just equity and treasuries if you are going to re-do your allocation.

 

[flipstress]

Will do--thanks.

I have some REIT in the Vanguard Index fund, and hopefully some Precious Metals and/or commodities in the future. I'm afraid to venture into corporate bonds.

 

[astromeria]

I think individual TIPS are perfect for the cash/income bucket for someone in or close to retirement. My husband will almost certainly be retired (and I'm already retired) when the 5-year TIPS I bought this year mature. I feel more secure with individual TIPS (or I-Bonds) in a cash/income bucket than I do bond funds--who the heck knows what bond funds will do! But I know exactly what TIPS and I-Bonds will do: match inflation, and then some (and I even know what "then some" will be!). They feel like CDs to me, another investment option I'm very comfortable with, but with the added bonuses of inflation adjustment and no state tax (an issue in South Carolina, where income over ~$12k pays 7% state income tax).

 

[JohnEyles]

Will do--thanks.

I have some REIT in the Vanguard Index fund, and hopefully some Precious Metals and/or commodities in the future. I'm afraid to venture into corporate bonds.

What's wrong with corporate bonds held as part of a highly-regarded low-expense
broad-based ETF like AGG ? Seems a little undiversified to have ALL your
fixed-income in Treasuries.

As far as cash, I have a good-sized HELOC and figure I don't need any more cash
than for living expenses (I'm in retirement). Does this make sense Brewer ?

Bought a bunch of GLD the other day, but want more. Any opinions on gold
prices ? (Looks like the share price of GLD is the per-oz price of gold divided
by 10, but I can't see that actually stated anywhere).

 

[brewer12345]

John, I think keeping a yaer's worth of expenses around in cash/short term FI is probably a good idea for retirees. The fine print allows banks to yank a HELOC at their sole discretion. You would have access to a margin loan if you have a taxable brokerage account, but cash or short terms are not easily replacable. OTOH, something like AGG is liquid and low volatility, so it might serve as a replacement for cash.

I've no clue on gold prices, but I am starting to consider adding a small (3% or so) allocation to GDX (gold miners ETF). It gives you levered exposure to gold prices, so you get the hedging benefits without putting up too much capital.

 

[FinanceDude]

John, I think keeping a yaer's worth of expenses around in cash/short term FI is probably a good idea for retirees. The fine print allows banks to yank a HELOC at their sole discretion. You would have access to a margin loan if you have a taxable brokerage account, but cash or short terms are not easily replacable. OTOH, something like AGG is liquid and low volatility, so it might serve as a replacement for cash.

I've no clue on gold prices, but I am starting to consider adding a small (3% or so) allocation to GDX (gold miners ETF). It gives you levered exposure to gold prices, so you get the hedging benefits without putting up too much capital.

Good sound advice. I keep one years expenses in rolling one year treasuries, and another year in various and sundry other FI instruments, depending on yield. Treaury yields have come up a lot in the last two years.......

I dislike CD's.....too mnay rules and penalty clauses.........

 

[JohnEyles]

Good sound advice. I keep one years expenses in rolling one year treasuries ...

Yes, I think I'll keep $60K in six laddered 6-month T'Bills.

I dislike CD's.....too mnay rules and penalty clauses.........

Agreed. T'Bills probably do better in a state with significant taxes like mine.
Plus it's kinda fun to see what auction price you end up with each time.

 

[flipstress]

What's wrong with corporate bonds held as part of a highly-regarded low-expense
broad-based ETF like AGG ? Seems a little undiversified to have ALL your
fixed-income in Treasuries.

I don't know how to evaluate individual corporate bonds. I also read David Swensen's book "Unconventional Success..." and he lays out the disadvantages or drawbacks to corporate bonds, which I take to include bond funds. Of course, I don't remember them Hmmm, let me try--something about the bonds being tailored to benefit the issuing party more and I'm not sure about this--high correlation with stocks anyway? My understanding was that corporate bonds are not for unsophisticated investors like me.

I do intend to have a ladder of TIPS and short-term to mid-term Treasury bonds.

 

[JohnEyles]

My understanding was that corporate bonds are not for unsophisticated investors like me.

Yes, which is exactly the point of using a mutual fund or ETF.

 

[brewer12345]

A high grade ond index like AGG or the VG total bond market index fund holds high grade (A to AAA ated) medium term bonds, including corporates, mortgage backeds, and treasuries. Very plain-vanilla stuff you are unlikely to see experience a loss except for interest rate fluctuations. Even then, you'd need a real big rise in rates to see a loss.

 

[bamsphd]

I like a 5 year TIPS ladder, each rung worth 4% of my portfolio
at the time of purchase. That is my "great depression" insurance.
I add 4% in a Vanguard short term fund for the unexpected major
expense, and 0.5% to 4% in a Money Market for liquidity.

The rest of my portfolio goes into Equities, though I sometimes think
about adding a slice of long term zero coupon bonds for excitement.
I have not done that yet, in part because of the current yield curve.

 

[ESRBob]

Jane,
One thing-- you need to be careful holding TIPS (or TIPS funds) in your taxable account: the inflation-adjustment portion of the bond price is calculated as taxable income to you each year, which can be a drag. You don't actually get the money until you redeem your TIPS, but you have to pay ordinary income tax on it each year, just the same.

If you have the ability, it is easier to hold these things in a tax-advantaged account. It at least saves you needing to do that math and come up with those taxes on unrealized paper gains each year.