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Why not 100% TIPS for Bond portfolio?
Old 05-06-2011, 02:44 PM   #1
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Why not 100% TIPS for Bond portfolio?

Call it Buckets, Asset Allocation, whatever. But when I finally ER I envision having my funds in Stock (Vanguard Total), Cash (for short term living expenses) and Bonds.
Right now I'm in Vanguard Total Bond. Since, in theory and/or practice TIPS have inflation protection, and otherwise would move in price the same way as other Bonds do, it seems TIPS are the better way to go.
I'm still new in researching this, so maybe I'm missing something. Any comments/help?
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Old 05-06-2011, 02:59 PM   #2
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TIPs have been lousy performers. The certainty of parity with inflation has come at a high price relative to the Total Bond Market. I have decided to stick with bond funds with a short-term weighting. I can live on cash and short term bonds til equities catch up to inflation.

Just me. We'll see what the gurus say.
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Old 05-06-2011, 03:19 PM   #3
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Quote:
Originally Posted by Rich_in_Tampa View Post
TIPs have been lousy performers. The certainty of parity with inflation has come at a high price relative to the Total Bond Market.
I'm not sure that is true. Here are the performances (YTD, 1yr, 5yr, and 10yr) for the respective Vanguard funds:

Inflation Protected Securities: 4.63%, 7.77%, 6.46%, 6.70%
Total Bond Market Fund: 2.18%, 5.17%, 6.24%, 5.45%

"Past performance, blah, blah, blah"
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Old 05-06-2011, 03:26 PM   #4
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Originally Posted by mystang52 View Post
I'm still new in researching this, so maybe I'm missing something. Any comments/help?
There is nothing wrong with allocating 100% of your fixed income portfolio to TIPS. It lacks diversification, which could be beneficial in several instances. TIPS are priced with a certain inflation expectation, if inflation ends up being lower than that, normal bonds will perform better. On the other hand, if inflation is higher than expected (something of particular concern to retirees) that 100% TIPS portfolio is going to look pretty sweet.

The strategy also misses whatever credit spreads are available in the investment grade market (and misses the credit risk too) and lacks international diversification, which many people feel is valuable.

Having said all of that, I think it's a fine strategy. I'm not putting that trade on myself as I feel TIPS yields at the moment are significantly below long-term real yields that have historically been available in the bond market. But if we get real yields closer to 2.5-3% I could move in that direction in a big way.
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Old 05-06-2011, 03:37 PM   #5
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With TIPS you get coupon + inflation - taxes. With a 25% tax bracket, a coupon rate of 1% and 3% inflation, you break even after inflation.

Holding a TIPS fund, the value can decline if real rates rise, credit quality falls or inflation expectations rise. Holding a TIPS ladder reduces the appearance of loss but you still are exposed to a potential loss if you sell instead of redeeming.

Historically, short term treasuries have tracked best vs inflation and have the highest positive correlation, higher than TIPS. If you intend to use your fixed income to rebalance with equities or want guaranteed liquidity without loss, short term treasuries are much safer.

No guru, and I do agree with Rich.
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Old 05-06-2011, 03:38 PM   #6
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But if we get real yields closer to 2.5-3% I could move in that direction in a big way.
<dreams of 3% real yield in a TIP>

That would be beep beep back up the truck for me at least. Would make retirement calculations dirt simple.
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Old 05-06-2011, 03:42 PM   #7
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It's worth pointing out that you pay taxes on both the inflation compensation and real portions of the coupon on nominal bonds as well. So the fact that you pay taxes on the inflation adjustment in TIPS is no different from how nominal treasuries are treated.
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Old 05-06-2011, 03:44 PM   #8
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<dreams of 3% real yield in a TIP>

That would be beep beep back up the truck for me at least. Would make retirement calculations dirt simple.
If you look historically at 10-year treasury yields less CPI 2.5-3% is about the average. We're currently in an extremely low rate environment so those yields look astronomically high. But remember, it wasn't that long ago we had an overnight interest rate of 5%. I don't expect we'll be staying at zero forever.
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Old 05-06-2011, 03:47 PM   #9
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Historically, short term treasuries have tracked best vs inflation and have the highest positive correlation, higher than TIPS.
This may be true if you're tracking market prices, but the principal value of TIPS correlates perfectly with inflation (as defined by CPI). Therefore, a held-to-maturity portfolio will track perfectly with inflation as well. Nominal treasury bonds, short-term or otherwise, will not.
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Old 05-06-2011, 03:48 PM   #10
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Originally Posted by DoraM View Post
<dreams of 3% real yield in a TIP>

That would be beep beep back up the truck for me at least. Would make retirement calculations dirt simple.
That might be enough for me to get off the fence and go all in on TIPS, currently evenly weighted with short term treasuries/intermediate treasuries/TIPS cuz I just don't know...

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Old 05-06-2011, 03:51 PM   #11
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If you look historically at 10-year treasury yields less CPI 2.5-3% is about the average. We're currently in an extremely low rate environment so those yields look astronomically high. But remember, it wasn't that long ago we had an overnight interest rate of 5%. I don't expect we'll be staying at zero forever.
If you ever got to a 4% real yield on a TIP you could set up your portfolio 100% TIPs with a 4% SWR and have zero worries....would never need to look at the market again (at least for the duration of the TIP).

I view a default on TIPs as being very close to an end of the world as we know it scenario.
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Old 05-06-2011, 03:57 PM   #12
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Originally Posted by Gone4Good View Post
This may be true if you're tracking market prices, but the principal value of TIPS correlates perfectly with inflation (as defined by CPI). Therefore, a held-to-maturity portfolio will track perfectly with inflation as well. Nominal treasury bonds, short-term or otherwise, will not.
G4G, market prices are the only prices that matter. If you need to sell at some point, they matter very much.

If you want to build a ladder with maturities scheduled to coincide with your cash needs, TIPS will give you the result I indicated above, which may be greater than or less than current value + CPI over time, because it depends on taxes and inflation adjustments.
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Old 05-06-2011, 03:58 PM   #13
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Originally Posted by DoraM View Post
If you ever got to a 4% real yield on a TIP you could set up your portfolio 100% TIPs with a 4% SWR and have zero worries....would never need to look at the market again (at least for the duration of the TIP).
As MichaelB points out above, tax leakage could be a problem if you're trying to draw the entire real yield. You pay taxes on both the real and inflation adjustment. If inflation rises significantly, the tax bill could swamp the real compensation.

Example: With a 4% real yield, 15% inflation, and a 25% tax rate your tax bill would exceed the 'real' portion of your yield. Of course you'd probably still be better off than almost any other investor.
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Old 05-06-2011, 03:58 PM   #14
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If you ever got to a 4% real yield on a TIP you could set up your portfolio 100% TIPs with a 4% SWR and have zero worries....would never need to look at the market again (at least for the duration of the TIP).

I view a default on TIPs as being very close to an end of the world as we know it scenario.
Of course, TIPS once had that rate - but demand was not overwhelming. Go figure.
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Old 05-06-2011, 04:02 PM   #15
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If you want to build a ladder with maturities scheduled to coincide with your cash needs, TIPS will give you the result I indicated above, which may be greater than or less than current value + CPI over time, because it depends on taxes and inflation adjustments.
Aren't you comparing after tax returns on TIPS with before tax returns on treasuries? Not exactly a fair comparison, in my view. ST treasuries may track inflation before tax, but suffer the same problems as TIPS after tax. The only difference is that I can own longer duration TIPS without fear of having actual inflation wipe out the before-tax portion of my yield that was supposed to be 'real.' Tax treatment for the two securities is exactly the same. One is not tax advantaged relative to the other.
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Old 05-06-2011, 04:02 PM   #16
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Here is an article that sums up my feeling. Basically, unless I see a 2.5% fixed portion, I would not touch them because they are taxed and the very honest and citizen-first thinking government of ours gets to set the CPI. Two strikes already before you even step to the plate.


Holding TIPS will make you poorer Brett Arends' ROI - MarketWatch

About like going to a casino that decides the odds on a horse race after it's over.
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Old 05-06-2011, 04:07 PM   #17
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I agree with G4G, I would rather go 100% TIPS than 100% nominal bonds. The concern regarding taxes and principal losses in case of early redemption apply equally to both TIPS and nominal treasuries, so this is a non-issue for me. In a taxable account, you do have to be mindful of the peculiar cash flow situation that TIPS can present.
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Old 05-06-2011, 04:18 PM   #18
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Aren't you comparing after tax returns on TIPS with before tax returns on treasuries? Not exactly a fair comparison, in my view. ST treasuries may track inflation before tax, but suffer the same problems as TIPS after tax. The only difference is that I can own longer duration TIPS without fear of having actual inflation wipe out the portion of my yield that was supposed to be 'real.' Tax treatment for the two securities is exactly the same. One is not tax advantaged relative to the other.
I'm not comparing returns. We can't know what future returns will be for either. I'm looking and past correlations between inflation, short term treasuries (bills) and TIPS. The correlation between ST treasuries and inflation is stronger. That means ST treasuries are safer and more reliable.

I agree returns matter. Fixed income has to earn it's keep. But it also needs to provide an element of safety in the portfolio. This adds stability, lowers volatility, and allows for rebalancing. The return that matters is total portfolio return, not that of any individual component.

Look at Vanguard TIPS in '08. The point is that fixed income needs to "be there" when you need it.
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Old 05-06-2011, 04:26 PM   #19
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I'm not comparing returns. We can't know what future returns will be for either. I'm looking and past correlations between inflation, short term treasuries (bills) and TIPS. The correlation between ST treasuries and inflation is stronger. That means ST treasuries are safer and more reliable.
If you weren't talking about returns, why mention taxes?

In any event, you'll have to direct me to the research that shows nominal treasuries have higher correlation with inflation than similar maturity TIPS. I would be stunned if a 1 year nominal treasury correlated more highly with inflation than a 1 yr TIPS. I'm guessing that the research is comparing the TIPS market (with an approximate duration of 8 years) with short duration treasuries.

And if that is the case, then we're really not saying that nominal treasuries offer better inflation protection than TIPS (I don't see how they could). What we're really talking about is how much volatility you want in your fixed income portfolio as determined by duration. In either case, whether I go short or long, I think I'm going to be better off with TIPS when it comes to inflation protection. But lets compare apples to apples, whether we're talking about duration or tax implications.
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Old 05-06-2011, 05:27 PM   #20
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I couldn't find any reliable research comparing TIPS and Treasury correlations with inflation (and I'm done looking, but if anyone else knows about such research, I would be interested in seeing what it has to say). What I did find was this from the Journal of Financial Planning. The conclusions were pretty much what one would expect . . .

Quote:
Over the long run Treasury bill yields have generally moved with inflation. Most of the time, Treasury bill yields have been higher than inflation, providing investors with a positive average real return. For the 1954–2007 period used in this study, the average real return was a positive 1.20 percent. However, on an estimated after-tax basis, the average real returns became negative and thus did not preserve an investor’s capital.

. . . Over the full 1954–2007 period, bonds and stocks clearly provided better inflation protection, corroborating conventional wisdom.
So yes, T-Bills generally keep up with inflation on a before tax basis. But as a complete alternative to longer-duration fixed income assets? Probably not. And with the longest duration T-Bill currently yielding 16bp (0.16%), I'll leave it to the OP to decide whether they make sense at this time for his portfolio either as an inflation hedge, or for anything else.
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