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TIPS Fund vs Rising Rates/Inflation?
Old 02-28-2011, 09:14 AM   #1
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TIPS Fund vs Rising Rates/Inflation?

Inflation and interest rates generally move in the same direction, but not exactly. How will the Vanguard TIPS fund perform relative to other Intermediate term funds if interest rates spike sooner than inflation, or later?

Or, can I buy individual TIPS from VG with a relatively short maturity, like 1-3 years? Is that a (generally) good policy?

I've rebalanced a significant chunk of our investments out of equities, but still struggling with where to keep them. A modest amount of market timing doesn't scare me ("You don't need a weatherman to see which way the wind is blowing"), but trying to get precise about it is certainly beyond my ability.
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Old 02-28-2011, 10:02 AM   #2
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Good question and I'd like to see some responses from people who are more bond-literate people than me.

I know that TIPS weren't around in 1970's and 80's so we can't see what actually happened. My simple-minded view is that coupons on newly issued TIPS are going to be close to the expected real interest rate (assuming the Treasury wants to sell them around par), if regular Treasuries have increasing real yields, coupons go up on new TIPS and market prices of existing TIPS fall. If regular Treasuries have falling real yields, the opposite.

I'm tempted to do a normal yield-to-maturity calc on just the coupon portion of the TIPS and say that is a close approximation of market price moves, but I'm not sure about the details.

I have said for my own investing that even if I don't know the precise amount of market risk, it looks well within my risk tolerance.
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Old 02-28-2011, 10:42 AM   #3
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The nice thing about individual TIPS is that you can afford to take some maturity risk. While, for most bonds, I would not extend maturities beyond intermediate term because of the inflation risk, TIPS do not carry such risk and therefore I am much more willing to extend the maturities on them. Sure, the prices of long term TIPS can fluctuate widely but:

1) If you hold your TIPS to maturity you are guaranteed to get your principal back adjusted for inflation.*
2) the income generated by TIPS will increase with inflation over time hence giving you a constant purchasing power between now and the bond's maturity.*

With that in mind, I don't really care how my TIPS perform day-to-day and how interest rates impact their value in the short term.

Personally I moved away from TIPS funds. Funds have some advantages, but to me they have one big disadvantage: they do not throw a predictable amount of income like individual TIPS do. Therefore, TIPS funds might be appropriate for total return investors, but I do not believe they are appropriate for income investors.

*Of course, for this to work, CPI has to be close enough to your personal inflation rate and you have to believe that CPI is not rigged.
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Old 02-28-2011, 11:27 AM   #4
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Personally I moved away from TIPS funds. Funds have some advantages, but to me they have one big disadvantage: they do not throw a predictable amount of income like individual TIPS do. Therefore, TIPS funds might be appropriate for total return investors, but I do not believe they are appropriate for income investors
I believe that this is a very important distinction that all of us should make explicitly, so we fully understand what our goals and requirements are. It applies not only to TIPS and TIPS funds, but to other mutual funds and other types of securities.

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Old 02-28-2011, 01:55 PM   #5
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I believe that this is a very important distinction that all of us should make explicitly, so we fully understand what our goals and requirements are. It applies not only to TIPS and TIPS funds, but to other mutual funds and other types of securities.

Ha
Yes, that's my big gripe with bond funds.
How difficult is it to buy individual TIPS in a Vanguaqrd IRA?
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Old 02-28-2011, 02:06 PM   #6
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Yes, that's my big gripe with bond funds.
How difficult is it to buy individual TIPS in a Vanguaqrd IRA?
Can't answer for Vanguard, but for folks with their IRA's at Schwab who might be interested, TIP purchases are extremely easy and commission free when participating in Treasury auctions.

I got myself on the gov't email list for TIPS auctions. I go to my Schwab account the day before the auction and bring up the info which includes the coupon rate. If I want to participate, I fill out the number I want and the next day I find out what I paid by noon or so.

You can also buy secondary market TIPS through Schwab. There is a commission on these however.
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Old 02-28-2011, 02:09 PM   #7
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Yes, that's my big gripe with bond funds.
How difficult is it to buy individual TIPS in a Vanguaqrd IRA?
It's super easy if you buy on the second market. I have never gone through the auction process myself, so I can't comment on that.
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Old 02-28-2011, 07:24 PM   #8
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I believe that this is a very important distinction that all of us should make explicitly, so we fully understand what our goals and requirements are. It applies not only to TIPS and TIPS funds, but to other mutual funds and other types of securities.

Ha
I understand that some retirees want the sense of an income stream that is locked up for a few years. I've always been a total return type myself. If I have to sell some bonds or even equity that's fine.

Short term bonds have performed well (over a period of years) when rates rise and in an inflationary environment. They're also easy to sell for spending needs. So my choice for that part of the portfolio would be Vanguard Short Term Investment Grade (VFSUX ... what a call name ).

If you look at the time period 1950 to 1980 when rates were generally rising, cash or short term bonds were the place to be. TIPS are great but the current real rates are well below historical levels so I'm not sold on them at these rates. See Larry Swedroe's blog for some TIPS numbers and good discussion.
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Old 02-28-2011, 07:55 PM   #9
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Don't mutual funds offer you the option of automatically redeeming a fixed dollar amount of shares each month and depositing that amount to your checking account? I don't know that they do --- I'm just asking. If they do, then I see no real difference between "income investors" and "value investors", if your investment vehicle is a mutual fund.
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Old 02-28-2011, 09:20 PM   #10
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Inflation and interest rates generally move in the same direction, but not exactly. How will the Vanguard TIPS fund perform relative to other Intermediate term funds if interest rates spike sooner than inflation, or later?
TIPS are kind of their own animal, and while their price moves normally correlate positively with those of vanilla bonds, they don't have to. It's possible for TIPS to lose value as regular treasuries rally, and vice versa. And we saw that during the early stages of the 2008 crash. Treasuries rallied strongly but TIPS got smoked, especially vintage TIPS with large inflation adjustments built into their principal. In that case, not even all TIPS acted the same. 10 year on the run TIPS didn't fall nearly as hard as 10 year old 20 year TIPS, even though both had roughly the save duration.

As far as predicting the future, what will matter is how rates rise, if they rise. If we're expecting an increase in real rates then TIPS may fair worse than regular treasuries. If we're expecting inflation to rise and real rates to stay more or less the same, then TIPS will outperform.

My thought is that real rates are about 200bp lower than normal, and inflation expectations are about 50bp lower than normal. So when we eventually get the 10yr back to 6%, most of that move is going to come from an expansion of real rates.
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Old 03-01-2011, 10:28 AM   #11
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Don't mutual funds offer you the option of automatically redeeming a fixed dollar amount of shares each month and depositing that amount to your checking account? I don't know that they do --- I'm just asking. If they do, then I see no real difference between "income investors" and "value investors", if your investment vehicle is a mutual fund.
I'm retired and use my monthly distributions as a minor rebalancing tool. Two years ago, had some individual bonds from another account that were maturing, used them for living expenses but didn't touch the equities. That turned out to be a good thing.
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Old 03-01-2011, 10:34 AM   #12
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You can also buy secondary market TIPS through Schwab. There is a commission on these however.
I've bought individual TIPS through Schwab. There is no direct commission, but presumably it's built into the bid-ask spread or buy/sell prices. If one plans (as I do) to hold all to maturity, one need only consider the YTM at their sell price and decide if it's attractive enough to make the purchase.
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