Seems ISM is taking a bit of a beating this week...

[haha]

Who said I'd never use calculus after you leave college LOL.

Thanks for clearing this up Rusty. However, my brain is starting to hurt.
Does the smart bond folks think this is a better alternative to a 2.375% 10 year TIP or worse? My 3.875% TIPs bonds muture in Jan of 2009, I am interested in an alternative.


Clearly, I am why down in the pecking order of bond understanding.

Best thing is to understand it or pass.

Ha

 

[cute fuzzy bunny]

The laymans (non heavy math) version...

You're getting the bonds at a nice discount, you'll most likely get that four bucks or so extra per share when they mature, unless of course SLM goes belly up. Probably not gonna happen.

Since you're buying them at a discount, you're also getting a discount on the CPI and the 2.05% coopun, so they're 'fatter' by that same margin.

Tips doesnt pay out the inflation adjustment, just the coupon. But you pay taxes on the inflation adjustment every year.

ISM pays out the inflation adjustment, so the future payouts arent inflation adjusted on the basis of principal unless you reinvest the inflation portion into more ISM.

ISM might return to closer to its face value well before it matures, so there may be an opportunity for a nice little capital gain for those not holding to maturity.

 

[wabmester]

The inflation-adjusted principal of TIPS seems to confuse a lot of people. I'm not sure why. It's just reinvested interest.

You might ask yourself why the treasury decided to adjust the principal rather than pay out the CPI component of interest. The answer is "deflation."

If you were the treasury, how would you handle the case of deflation?

If deflation was -3% and the real coupon was 2%, what would you do? Ask for money back? The treasury doesn't need to ask for money back, they simply take it out of the adjusted principal.

In this way, ISM is better than TIPS. ISM will pay 0% in the case above, whereas TIPS will actually have a negative return. Not a huge deal, really, but there is no good argument that TIPS are "better" than ISM wrt to adjusted principal vs CPI payout.

 

[clifp]

Well I sat down and created a spreadsheet to compare ISM vs TIPs. ISM is better, assuming you can live with the risk that Congress decide to get out of the business of guarrantee Student Loans which would impact Sallie Mae. Assuming a reinvestment of dividends for both ISM and a mythical 11 Year TIPs bond @2.375%. (Which obviously isn't practically because of the monthly dividends from ISM)
It looks like ISM provides a future value that is almost 200 basis points higher than the same TIPs at the current price of $21.32

The major assumption I made was that ISM approached par at either a linear rate or an exponential rate of 1.3% per year. Varying interest rates didn't seem to matter much.


Now you all got promise you aren't going to get early the morning before us Hawaii boys have time to buy some of these puppies.

 

[wabmester]

Now you all got promise you aren't going to get early the morning before us Hawaii boys have time to buy some of these puppies.

We'll be the ones selling to you. Why do you think we've been pumping ISM?

 

[cute fuzzy bunny]

Funny, but that thought occurred to me briefly yesterday while we were on our brief tour of 17 prospective new homes

"Gee, I wonder if this is just one of those schemes where a couple of guys pump a thinly traded issue on a web site populated by high net worth individuals to create some arbitrage volatility...?"

 

[brewer12345]

Lest we all get overexcited by ISM, there are two very similar securities: OSM, which is the same issuer, 5BP lower coupon, 1 year sooner maturity and trading at about the same YTM; and PFK, which is issued by Prudential Financial (rated one notch lower than SLM), matures in 2018, and trades at 50BP lower YTM.

 

[RE2Boys]

Brewer,

Since you've had ISM for awhile, can you tell me if the "dividend" paid on ISM is treated as a qualified dividend for tax purposes or an ordinary dividend, or even as interest. Suspect it is non-qualified but thought I'd ask. If it was qualified, that would amount to a potentially significant tax break.

Thanks,

RE2Boys

 

[FIRE'd@51]

.............. can you tell me if the "dividend" paid on ISM is treated as a qualified dividend for tax purposes or an ordinary dividend, or even as interest. Suspect it is non-qualified but thought I'd ask. If it was qualified, that would amount to a potentially significant tax break.

ISM is a note (bond) which trades on the NYSE. The "dividend" is an interest payment and is taxed as ordinary income.

 

[brewer12345]

ISM is a note (bond) which trades on the NYSE. The "dividend" is an interest payment and is taxed as ordinary income.

I'd go a step further and suggest that it is an ideal investment for an IRA.

 

[JohnEyles]

Well I sat down and created a spreadsheet to compare ISM vs TIPs. ISM is better ...

I concur, attach my similar spreadsheet, apologize for my spurious arguments
that ISM *may* not be as good as TIPS under certain conditions, and bow to
Brewer.

Mine also assumes a putative 11-yr TIPS that matures in Jan 2018 with the ISM
bonds, and makes the somewhat TIPS-favoring assumption that price is 99.
(The 10-yr TIPS that was auctioned last month was priced at 99.34).
I assume both would be in an IRA so tax can be ignored. Since ISM has no
DRIP-ability (at least not with Chuck), I simply assume that the interest from
both TIPS and ISM are deposited into a money-market fund which earns an
interest-rate equal to the annualized inflation (over the 11 years) plus 1%.
At the beginning of 2018, I take the m'mkt account, combine it with the
maturing bonds, and see what the total is. Then compute the average annual
return for each, and the real return. In every combination of inflation I try
(flat 0%, flat 3%, flat 10%, big bubble early as shown here, big bubble late)
the ISM has a real yield about 1% higher than the real yield of TIPS.

I wish there were a way to attach the XLS file, because I'd love someone to
check my work - because I find this really exciting - a guaranteed (subject to
the viability of Sallie Mae) real yield of 3.5 % ! (That supports an SWR of 4.4%
for 40 years).

Now excuse me while I go check the pressure on the truck tires !

P.S. Speaking of good Brewer ideas, I added some DSX to "juice up my
yield" and it's doing well. Anybody profit-taking yet ?

 

[FIRE'd@51]

Let's do a little ninth-grade algebra. To keep the math simple, assume interest is paid once per year, and the price of ISM is always 25.

R = annual coupon rate (e.g. the 2.05%)

I = annual inflation rate

N = years until maturity

Buy 1 share of ISM

Interest in year 1 = 25(R + I) = 25R + 25I

Reinvest the inflation component, 25I, in more ISM

Maturity value of ISM owned = 25 + 25I = 25(1 + I) => now own (1 + I ) shares

Interest in year 2 = 25(1 + I)(R + I) = 25(1 + I)R + 25(1 + I)I

Reinvest the inflation component, 25(1 + I)I

Maturity value of ISM owned = 25(1 + I) + 25(1+ I)I = 25(1 + I)(1 + I) = 25(1 + I)^2 => now own (1 + I )^2 shares

Also note that the real component of the interest, 25(1 + I)R, has grown at the inflation rate in year 2 (just like TIPS)

At maturity (after N years), the amount of ISM owned = 25(1 + I)^N. You will own (1 + I)^N shares of ISM with a par value of 25. Your principal (25 x number of shares) has grown at the compounded inflation rate (just like TIPS)

Clearly, this result can be generalized to the case where the inflation rate varies each year - just put subscripts on the inflation rate(s) - the results will be the same.

In the real world, the price of ISM will move around. This can lead to some slippage (or gain) relative to TIPS of the same initial real coupon rate. So long as the inflation component is reinvested at a price of 25 or less, the shares you own will grow at least as fast as the rate of inflation. However, to realize exactly the expected real yield-to-maturity (YTM), the reinvestments (as with any bond) must be at prices which have the same real YTM. So, there is some uncertainty as to what the actual achieved real rate of return of ISM relative to TIPS will be if held to maturity, due to this reinvestment effect. This reinvestment effect, as your spreadsheet indicates is relatively small, especially since you are purchasing the ISM at a substantial discount to par.

 

[brewer12345]

P.S. Speaking of good Brewer ideas, I added some DSX to "juice up my
yield" and it's doing well. Anybody profit-taking yet ?

I let a quarter of mine go at 20, but only because I doubled my stake when it dipped under 16 recently. I am hanging onto the rest, although I am starting to have a serious concentration in that industry. What I decide depends on shipping rates. Usually they go down during the week of the Chinese New Year (last week). This year they went straight up. If rates keep popping this week as the Chinese (and the rest of Asia) are back at their desks, I plan on hanging on for a wild ride.

 

[youbet]

Since ISM has no
DRIP-ability (at least not with Chuck), I simply assume that the interest from
both TIPS and ISM are deposited into a money-market fund which earns an
interest-rate equal to the annualized inflation (over the 11 years) plus 1%.

Rusty.... Nice analysis, thanks for the effort.

One question. Since the inflation component of the tips interest would be added to principal and compound at 2.375% + inflation, why add it to a money market and assume 1% + inflation? Minor detail, but..........

I've done some analysis myself and have tried to understand the work the rest of you have done. I think the reinvestment of the ISM inflation component is a key variable which is hard to model. And the higher inflation is, the more significant this becomes.

For myself, for situations where I want to park some money in a secure investment and know with certainty it will maintain/grow its value vs. inflation and be available having grown in real terms sometime in the future, I am chosing TIPS. For situations where I plan to spend or reinvest the interest payments in other opportunities, I chose ISM/OSM.

I have a significant position in ISM and am generally happy with it so far. But I realize that the inflation protection feature is heavily dependent on how reinvestment of the monthly payout goes. For the amount I own, one option would be to accumulate the payouts for three months which would approximately support the purchase of 100 additional shares.

 

[cute fuzzy bunny]

I think of it a bit more from the mechanics of my needs rather than the mechanics of the investment. I wouldnt own TIPS because I'm not fond of the idea of paying the taxes on the inflation adjustment and not getting it. My interest for this chunk of my portfolio is an inflation boosted income stream that only costs me tax-wise for whats being distributed to me. The lack of compounding without reinvestment sucks a little.

Anyone remember the Countrywide (I think) inflation indexed bonds that Charlie was touting a couple of years ago? I dont remember if they adjusted principal or paid out the inflation adjustment or what the rates were like.

 

[cute fuzzy bunny]

Ah I found it...could have sworn it was countrywide, but couldnt see anything on that:

Charlie, from a year ago: "My biggest holding is a CD from Std Fed Bank that pays CPI + 2%.
I also hold J. Hancock (CPI + 2%), Principal Life (CPI + 1.8%) bought
at 90, Household Financial Corp (CPI + 2.38% and Boeing (3 mo T-bill
plus 2.05%)."

 

[JohnEyles]

Rusty.... Nice analysis, thanks for the effort.

I had my own selfish motives, because all the hand-waving and algebraic analyses
are nice, but I thought the spreadsheet was a good sanity-check ... but thanks.

One question. Since the inflation component of the tips interest would be added to principal and compound at 2.375% + inflation, why add it to a money market and assume 1% + inflation? Minor detail, but..........

I'm not adding the inflation component to the MM fund; that can't be done in real life
anyhow. If you look at my numbers, I'm simply doing what the Treasury does, growing
the principal with inflation and paying out coupon * principal. I'm only putting the coupon
payment into the MM.

But for ISM, yes, I *am* putting the inflation component into the MM fund. Yes, I suppose
one could reinvest it, but not automatically and commission-free (theres's no DRIP, at
least at Schwab), so the hassle and commission wouldn't be worth it (to me) except maybe
one or a few times per year as you suggest. But it's not like anyone is going to take the
ISM interest and spend it on lottery tickets. I assume I'll invest it in something worthwhile,
where it'll compound - and that worthwhile thing may or may not be more ISM, depending
on its price and whatever else becomes available. So in looking at the total return of
ISM, I'm simply assuming something semi-reasonable is done with the interest, and the
conclusion (of ISM vs TIPS) is valid even if that reasonable use of that money isn't
putting back into more ISM. Make sense ?

Inflation + 1% seemed like a reasonable hack at MM rates. If you just fix them at
today's 5%, and if inflation is significantly higher than that, then TIPS and ISM will
perform equally (or TIPS may even be slightly ahead), I guess because it would really
be hurting you to just dump the ISM interest into the negative real-return MM fund.

 

[FIRE'd@51]

I wouldnt own TIPS because I'm not fond of the idea of paying the taxes on the inflation adjustment and not getting it. My interest for this chunk of my portfolio is an inflation boosted income stream that only costs me tax-wise for whats being distributed to me. The lack of compounding without reinvestment sucks a little.

Yes, and in a high-inflation environment the TIPS coupon might not provide enough cash flow to pay the taxes due (depending on your bracket). At least that can't happen with the ISM structure.

Of course, this is why most people hold TIPS in non-taxable accounts.

 

[JohnEyles]

See another attached spreadsheet. It shows taking a lump-sum and investing it
in ISM at today's price. Then take an inflation-adjusted payout, with an initial
withdrawal rate of about 3.75%. The payout comes from the ISM interest, and
the remainder is invested in a m'mkt fund with APY 1% better than inflation.
The m'mkt fund is added to the matured value of the ISM bonds and hopefully
this is equal to (or greater than) the inflation-adjusted value of the initial
investment (the number 'surplus'). Of course, when inflation is below 1.2%
or so, you end up borrowing money from the fund, but it all holds together
over various assumptions of inflation. As pointed out earlier, you're probably
better off DRIP'ing the excess interest if commissions aren't a problem and prices
are good; it's just easier to analyze with the m'mkt fund.

Seems like an eternal inflation-adjusted SWR of 3.75% on a "safe" investment
is pretty good. (Assuming, of course, that's there something out there just as
good in 11 years).

 

[youbet]

See another attached spreadsheet.

Thanks! Both are very interesting and helped me understand the pros and cons of ISM and TIPS.

 

[brewer12345]

Further confirmation that ISM/OSM are a smoking good deal. The below is a new issue offering I saw today at Schwab being sold by SLM (same issuer as our fave bonds). The below are 4 year bonds that are being sold at par (plus a fistful of dollars under the table to Schwab) at CPI+2.7%. At current prices, ISM and OSM yield about 4% over CPI.

Additional Text Field: Inflation Protected MTN: Initial Coupon 5.24% = 2.54% (year over year cpi-u percentage change, beg 12/06) + 270bps (fixed spread), re-sets monthly



SECURITY DETAILS
Cusip: 78490GAN7
Maturity Date: 06/15/2010
Coupon Rate %: 5.24
Coupon Type: Variable (based on CPI-U), rate resets MONTHLY.
Coupon Frequency: Monthly
Dated Date: 03/08/2007
First Coupon Date: 04/15/2007
Next Coupon Date: ---
First Settle Date: 03/08/2007
Exchange: Over the Counter

 

[dm]

I have some ISM already but added OSM today. This generally means you can wait and pick some up cheaper now that I'm running short on cash to invest.

 

[youbet]

At current prices, ISM and OSM yield about 4% over CPI.

Brewer.....how are you coming up with this number? I'm not questioning that it's correct. I just can't duplicate it and am trying to learn. Or, can anyone else help?

 

[FIRE'd@51]

Brewer.....how are you coming up with this number? I'm not questioning that it's correct. I just can't duplicate it and am trying to learn. Or, can anyone else help?

At a price of 21.30, here's what I calculate for YTM's:

Inflation ISM OSM
0% 3.70% 3.77%
1% 4.80% 4.86%
2% 5.89% 5.96%
3% 7.00% 7.06%
4% 8.10% 8.16%

 

[JohnEyles]

At a price of 21.30, here's what I calculate for YTM's:

Inflation ISM OSM
0% 3.70% 3.77%
1% 4.80% 4.86%
2% 5.89% 5.96%
3% 7.00% 7.06%
4% 8.10% 8.16%

Interesting, went and added OSM to my little spreadsheet (that I posted yesterday
to show ISM beating TIPS). I found that OSM (when trading at the same price
as ISM) has about 30bp better yield than ISM. The OSM of course has maturity
value identical, and the m'mkt fund (where I dump the interest) is slightly smaller
due to the slightly smaller coupon and one year less time; but it's more than made
up for by the year-earlier maturity (so it's the 10th root, not 11th, of the ending
value divided by the beginning lumpsum).