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Ted · 11-21-2003, 05:38 AM

Here are a few more considerations about TIPs:

It is true that both the interest and annual increase in principal of TIPs are taxable. As with other bonds, that makes it desirable to hold them in a retirement account, BUT this is only important while a person is still working and has a large amount of earned income that -- in effect -- causes their investment income to be taxed in their highest bracket. Once a person is retired, their income is almost entirely from investments (and social security). Not only is the tax rate much lower, but there isn't usually much advantage to deferring taxes to the future, when they will have to be paid anyway, presumably at the same rate (or possibly even higher!).

In fact, an early retiree presumably is not drawing social security benefits, and so may be in a lower tax bracket now than when the s.s. benefits start.

If long term interest rates in general rise -- which is very likely -- the driving force will probably be an increase in inflation. This will cause the market value of most bonds to drop. By law, it will cause the principal value of TIPs to increase. It is possible that longer term TIPs could still temporarily lose some market value (causing their yield to rise) but it is extremely unlikely that they would lose as much as other bonds of similar maturity. I certainly wouldn't worry about much loss on 10 year TIPs.

Jdvalle pointed out the that it is theoretically possible for the taxes on TIPs (in a particular year) to exceed the interest payment. Well, yes, but for that to happen there would need to be a hugh increase in inflation that would produce huge losses in conventional bonds (and probably stocks too). TIPs are very liquid, and it would always be convenient and not too costly to liquidate some to supplement the income from the interest.

Ats5g said that a disadvantage of TIPs and high yield bonds is that they haven't been in existence long enough to have established a track record. That's somewhat true, but a person should remember that past performance, while relevant, is not the only consideration in investing for the future. To its credit, FIRECalc contains a provision for "modelling" the hypothetical past performance of TIPs. This model contains the simplifying assumption that the annual return of TIPs would have been the inflation rate plus the interest rate that is specified by the user. It does not account for fluctuations in the market value of the TIPs -- but it is reasonable to believe that this would have been fairly minor. Playing around with FIRECalc, I find that TIPs with a base yield of 2.5% are indicated to support a higher rate of withdrawal (in conjunction with stocks) than the other fixed income options.

With regard to high yield bonds, I have done some research of my own on their performance relative to stocks and bonds over the past 12 years or so and will give some further comments on that after I refine it more. A general comment, though, is that a lot of people are as ignorant about high yield bonds as they are about TIPs. All they know is that they are "risky" and so they write them off. Well, it's true that they are risky, but as an asset class are not nearly as risky as stocks. So it is completely irrational for people who readily invest large amounts of their money in stocks to reject high yield bonds out-of-hand as being "too risky." As with other financial assets, they have their place in a diversified portfolio.

11-21-2003, 05:38 AM	#14
Ted Recycles dryer sheets Join Date: Nov 2002 Posts: 398	Here are a few more considerations about TIPs: It is true that both the interest and annual increase in principal of TIPs are taxable. As with other bonds, that makes it desirable to hold them in a retirement account, BUT this is only important while a person is still working and has a large amount of earned income that -- in effect -- causes their investment income to be taxed in their highest bracket. Once a person is retired, their income is almost entirely from investments (and social security). Not only is the tax rate much lower, but there isn't usually much advantage to deferring taxes to the future, when they will have to be paid anyway, presumably at the same rate (or possibly even higher!). In fact, an early retiree presumably is not drawing social security benefits, and so may be in a lower tax bracket now than when the s.s. benefits start. If long term interest rates in general rise -- which is very likely -- the driving force will probably be an increase in inflation. This will cause the market value of most bonds to drop. By law, it will cause the principal value of TIPs to increase. It is possible that longer term TIPs could still temporarily lose some market value (causing their yield to rise) but it is extremely unlikely that they would lose as much as other bonds of similar maturity. I certainly wouldn't worry about much loss on 10 year TIPs. Jdvalle pointed out the that it is theoretically possible for the taxes on TIPs (in a particular year) to exceed the interest payment. Well, yes, but for that to happen there would need to be a hugh increase in inflation that would produce huge losses in conventional bonds (and probably stocks too). TIPs are very liquid, and it would always be convenient and not too costly to liquidate some to supplement the income from the interest. Ats5g said that a disadvantage of TIPs and high yield bonds is that they haven't been in existence long enough to have established a track record. That's somewhat true, but a person should remember that past performance, while relevant, is not the only consideration in investing for the future. To its credit, FIRECalc contains a provision for "modelling" the hypothetical past performance of TIPs. This model contains the simplifying assumption that the annual return of TIPs would have been the inflation rate plus the interest rate that is specified by the user. It does not account for fluctuations in the market value of the TIPs -- but it is reasonable to believe that this would have been fairly minor. Playing around with FIRECalc, I find that TIPs with a base yield of 2.5% are indicated to support a higher rate of withdrawal (in conjunction with stocks) than the other fixed income options. With regard to high yield bonds, I have done some research of my own on their performance relative to stocks and bonds over the past 12 years or so and will give some further comments on that after I refine it more. A general comment, though, is that a lot of people are as ignorant about high yield bonds as they are about TIPs. All they know is that they are "risky" and so they write them off. Well, it's true that they are risky, but as an asset class are not nearly as risky as stocks. So it is completely irrational for people who readily invest large amounts of their money in stocks to reject high yield bonds out-of-hand as being "too risky." As with other financial assets, they have their place in a diversified portfolio.