Why not 100% TIPS for Bond portfolio?

[mystang52]

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?

 

[Rich_by_the_Bay]

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.

 

[Gone4Good]

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"

 

[Gone4Good]

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.

 

[MichaelB]

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.

 

[DoraM]

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.

 

[Gone4Good]

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.

 

[Gone4Good]

<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.

 

[Gone4Good]

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.

 

[DblDoc]

<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...

DD

 

[DoraM]

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.

 

[MichaelB]

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.

 

[Gone4Good]

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.

 

[MichaelB]

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.

 

[Gone4Good]

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.

 

[Zero]

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.

 

[FIREd]

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.

 

[MichaelB]

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.

 

[Gone4Good]

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.

 

[Gone4Good]

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 . . .

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.

 

[Nords]

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?

"In theory" the markets are efficient, too.

In general, any portfolio on this board that lacks diversification has been a bad idea. However if you pile up the TIPS high enough then it really won't matter what interest rate they're paying. It worked for Groucho Marx. Suze Orman, Warren Buffett, and Oprah Winfrey seem pretty happy with their bond investments.

How long would you be needing this strategy? TIPS have gone through periods where you couldn't buy the 30-year version at auction, only through the secondary market. Makes it kinda tough to build a ladder to last the length of your retirement.

How long would you like to be working for this strategy? If you're already retired, no problem. If you're still working but not going to be beating inflation during ER then you might be working a few years longer to make your pile a lot higher.

What inflation rate are you planning to experience? If your personal rate of inflation is lower than the CPI then you shouldn't have any problems. However if the BLS keeps tinkering with the hedonic adjustments, and TIPS are tweaked to match, then your inflation may involve the pricing difference between Friskies and Fancy Feast.

Remember how you used to be able to buy I bonds on a credit card? And then how you could only buy a certain amount of I bonds? And then they made the limit even more severe? Hopefully that won't happen to TIPS.

Finally, I'd be annoyed as heck if I had to buy 30-year TIPS in a taxable account and pay phantom tax every year before I got my money back. But this might not be a problem if you bought them all in a tax-deferred account.

 

[Independent]

I figure nominal bonds will outperform TIPS if CPI growth is low, and TIPS will outperform nominal bonds if CPI growth is high.

I also note that I will want to spend more money if CPI growth is high and less money if CPI growth is low.

My financial goal isn't maximizing nominal dollars but stabilizing purchasing power. So TIPS look like they do a better job of helping me reach my goal.

(I may be more sensitive to inflation than some people here because I have a non-COLA'd pension.

 

[Gone4Good]

I figure nominal bonds will outperform TIPS if CPI growth is low, and TIPS will outperform nominal bonds if CPI growth is high.

Yup.

And one way to evaluate that is to think about 10-year inflation break-even rates. Right now the break-even between 10-yr TIPS and nominal Treasuries is an average annual CPI increase of 2.5%.

Some questions to consider:
1) Is inflation over the next decade more likely to be above, or below, 2.5%
2) Is the risk of runaway inflation more or less likely than runaway deflation
3) Is my financial plan more at risk in one scenario versus the other.

My answer to those questions guide me in the direction of TIPS, but reasonable people can certainly come to different conclusions.

Edit to add:
MichaelB brought up a good point about how the TIPS market tanked in 2008 when deflation fears were rampant. It is worth pointing out that not all TIPS securities behaved the same. Those with large accrued inflation adjustments got smoked. Those without did well, although not as well as nominal treasuries. It's my strategy to hold individual TIPS bonds (not funds) in tax advantaged accounts and periodically roll out of bonds with large inflation adjustments in to newly auctioned bonds with zero inflation adjustments (every five years, or so). I'll pay a small price on the bid-offer spread on the sale, but the new issue bonds have no such costs and often benefit from a 'new issue discount.' I imagine the cost of my TIPS portfolio will be lower over time than what even Vanguard charges to manage their fund. So my portfolio will be resilient to deflation, while still outperforming normal bonds during periods of inflation.

 

[veremchuka]

100% TIPS is not diversifying your fixed income, how about 50% TIPS and 50% ST or ITT?

Also TIPS provide against unexpected inflation not inflation in general if I understand them correctly. So if there is no unexpected inflation perhaps TIPS are not going to do much for you? Can someone clarify that?

Larry Swedroe has a chart for TIPS allocation and he does recommend 100% but I think the yield has to be 3% or 3.5%. Good luck seeing that yield! I think the government tinkers with CPI to control COLA increases.

 

[Gone4Good]

Also TIPS provide against unexpected inflation not inflation in general if I understand them correctly. So if there is no unexpected inflation perhaps TIPS are not going to do much for you? Can someone clarify that?

TIPS provide protection against every kind of inflation that is captured by CPI, unexpected or otherwise. It's a mechanical feature of the security. The principal balance is adjusted periodically based on changes to CPI.

I'm one who doesn't believe CPI is manipulated. If it were, you'd see credible economists adjusting their models to back out whatever they believed the government was doing wrong. You'd see the same discussion of adjustments every time the CPI was released. And if the index was bad enough, you'd see Wall Street firms publishing their own competing indexes. There are people in the private sector who have a lot of money at stake in getting this stuff right. Until you see them walking away from government statistics, I think you have to take the people casting stones who have nothing at stake with a grain of salt.

The other thing you'd see are inflation break-even spreads significantly higher than CPI readings. You don't see that. Which means that either the internet chatter boxes are wrong about CPI manipulation, or the market is stupid.