TIPS: Buy Bond or Bond FUND? Pros & Cons please!

[JohnEyles]

Speaking of TIPS, I just read the following at Bloomberg (went to the "Economic
Calendar" and clicked on one of the TIPS auction links:

You pay $1,000 for a TIPS note and receive interest payments every six
months based on the inflation-adjusted principal at the time of payment.
If the coupon is 3% and the rate of inflation, for instance, stays at 3%,
you get $30 every six months for a total of $60 per year.

This isn't right, is it ? You get a $15 interest payment biannually. And the
principal increases by about $30 each year. (Of course, their and my
statements are good only for the first year and grow from there). Your
tax liability is $60 per year, but you only see half of that (in this example).

Am I wrong ? Seems like a pretty grievous error !

 

[astromeria]

Not quite. Every six months your interest compounds--you also get 3% plus 3% on the interest you earned to date. It works the same way if you leave your interest on deposit--for example, in an ordinary bank account or CD--instead of having the bank send you a check for your interest.

 

[ESRBob]

John,
I think your point is that you don't receive the distribution of the inflation-adjustment portion. Then, as Astro says, would that portion itself (which in effect is added onto the face value of the bond) be effectively compounding, since you'd receive interest on that larger value next coupon?

I confess I don't own TIPS outright so am not sure exactly how that works.

But importantly Wab pointed out (kindly, in a PM ) that my previous post about having to pay taxes on un-received inflation adjustments is only half-true. If you own your TIPS in a mutual fund or ETF (instead of owning them outright), it seems the funds pay out regular dividends comprised of interest as well as gains in the par value (inflation adjustments) of any bonds which matured or were sold. So the payments they make are treated as non-qualified dividends and taxable to you as ordinary income. But other inflation-adjustments in bonds not yet sold would presumably just be reflected in a growing NAV for the fund, and might only be taxable to you as capital gains if/when you sell the fund.

If this is all true, then Wab points out that there may be no logic in holding a TIPS fund in a tax-advantaged account, since you're giving up deductions on state taxes, and there's no PITA issue to be trying to avoid.

Anybody have the details on this? Wab is contacting Vanguard today so hopefully we can get the real skinny on this one.

 

[JohnEyles]

I think your point is that you don't receive the distribution of the inflation-adjustment portion.

Yes, I am not talking about the compounding effect which Astro quite correctly points out.

I'm saying they are off by a factor of TWO.

I confess I don't own TIPS outright so am not sure exactly how that works.

I confess that I DO own TIPS outright, but I'm not sure exactly how they work.
Actually, I thought I was sure, but the thing I posted made me wonder.

Maybe I'm missing something (probably am) but when I look at the various
"total returns" numbers for TIP or VAIPX (the two best low-expense TIPS
holdings ?) I see numbers that do not impress me - not compared to what
the individual issues currently give.

 

[wabmester]

Anybody have the details on this? Wab is contacting Vanguard today so hopefully we can get the real skinny on this one.

Yeah, this is one of my pet peves. I just got off the phone with Vanguard. I only talked to a customer service droid, so take this with a grain of salt:

Vanguard makes 4 quarterly distributions. The March/Sept distributions include "real" interest. The June/Dec distributions include the inflation adjustment.

I asked him how they do this. I.e., do they sell bonds to get the inflation adjustment; do they simply "manage" the dividends to match the taxable income reported by the treasury? His answer, after talking to somebody in house, was that they use STRIPS. So, they actually receive seperate distribution of the inflation adjustment from the treasury as income, and then simply distribute that income to fund holders via dividends.

This last bit is news to me. I didn't realize the treasury offered stipped inflation adjustment streams from TIPS. I plan to look into this a bit more.

 

[haha]

Yeah, this is one of my pet peves. I just got off the phone with Vanguard. I only talked to a customer service droid, so take this with a grain of salt:

Vanguard makes 4 quarterly distributions. The March/Sept distributions include "real" interest. The June/Dec distributions include the inflation adjustment.

I asked him how they do this. I.e., do they sell bonds to get the inflation adjustment; do they simply "manage" the dividends to match the taxable income reported by the treasury? His answer, after talking to somebody in house, was that they use STRIPS. So, they actually receive seperate distribution of the inflation adjustment from the treasury as income, and then simply distribute that income to fund holders via dividends.

This last bit is news to me. I didn't realize the treasury offered stipped inflation adjustment streams from TIPS. I plan to look into this a bit more.

I hope you can find out about this. Likely the treasury does not offer it; but anything with a coupon can be stripped, so I would imagine that it is done by a brokerage.

I think we had a similar discussion about TIPS funds about 6 months ago- how do they manage their cash flows to be able to make those pay-outs? This woud be an excellent solution, so I would expect that your customer service guy is correct.

Ha

 

[brewer12345]

I think we had a similar discussion about TIPS funds about 6 months ago- how do they manage their cash flows to be able to make those pay-outs? This woud be an excellent solution, so I would expect that your customer service guy is correct.

Ha

I think it is more likely to be funded by a combination of bond sales and recycling new cash that comes in the door. Look at the turnover in most bond funds (including TIPS) and you will see that there is a lot of cash moving around. It would be pretty easy to divert some of it to pay out the interest.

 

[wabmester]

Some info on TIPS STRIPS here:

link

Making TIIS interest components fungible required special procedures geared to inflation-indexed securities' unique reference Consumer Price Index (CPI) value. The value applied is based on the date of its original issuance, which is used to calculate inflation adjustments to the principal amount of the security. To make the interest components fungible to facilitate STRIPS trading, the Treasury Department's rules call for all interest components of inflation-indexed securities (referred to as TINTS) to be converted to a common reference CPI of 100. This is done mechanically by calculating an adjusted value of each TINT, by multiplying the par amount of the inflation-indexed security to be stripped by the security's semiannual interest rate, and then multiplying this amount by the ratio of 100 divided by the reference CPI for that security's original issue date.

Inflation-indexed TINTS are then maintained in accounts or transferred at their adjusted value to the penny. Stripped principal components of inflation-indexed securities are maintained and transferred at their par amounts, and therefore, are not fungible.

So, my reading of this is that the stripped coupons include the inflation adjustment.

 

[FIRE'd@51]

So, my reading of this is that the stripped coupons include the inflation adjustment.

Yes, and perhaps more important, the stripped coupons contain no "phantom interest". The holder of the stripped principal piece would be reponsible for paying the tax on the "phanton interest", if it were held in a taxable account.

Thanks, wab, for getting that info and sharing it with us.

 

[JohnEyles]

Yes, and perhaps more important, the stripped coupons contain no "phantom interest".

Didn't quite follow the long technical discussion above ... but, does this mean
it IS possible to buy a coupon-only TIPS ?

There was an interesting posting (a week or two back, in another TIPS thread)
about how a stripped TIPS could provide an absolutely-guaranteed
inflation-adjusted 4+% SWR.

 

[wabmester]

Didn't quite follow the long technical discussion above ... but, does this mean it IS possible to buy a coupon-only TIPS ?

Yes, TIPS are stripped, but not by the treasury. So, if you want to buy the income stream, you need to find a broker who offers the STRIPS.

To me, the more interesting finding in this thread for most people is that TIPS funds, like TIP and VIPSX, pay out both the inflation adjustment and real interest as dividends, so all the conventional wisdom about "phantom" interest in TIPS funds is wrong. And STRIPS provides one possible mechanism that explains the phenomenon.

 

[JohnEyles]

I'm not sure if we ever reached a consensus about whether individual TIPS,
or funds/ETFs, make more sense. One thing for sure, inidividual TIPS are
pretty confusing when you buy them on the secondary market. Here's one
I'm thinking of buying (at Schwab). Perhaps my thinking out loud here will
be instructive to the novices, and perhaps the people who really understand
these things will be gracious enough to chime in ...

CUSIP 9128275W8, a 10-year one maturing in 1/15/2010
4.25% coupon
price = 104.843
inflation factor = 1.20895 (the cumulative CPI inflation from when it was
issued in 2000, until today)

According to Schwab, their commission is $55 (not sure if that's for any
amount or for the nominal $30K I'm contemplating), and is a spread built
into the 104.843; I'm certainly at peace with 20 or so bp's of commission.

It seems like a good deal to me (assuming I buy into the idea of holding a
substantial chunk of my fixed-income in TIPS). I'm paying a 4.8% premium
over the nominal price (the 104.843 number) but that seems well worth it to
get the higher coupon.

So if cumulative inflation over the next 3yrs-2mos is 4.8% (about 1.5%
annually), I'll exactly get back exactly the principal I paid. Meanwhile I'm
getting interest payments equal to the "current yield" of 4.054 (the 4.25%
coupon divided by the 104.483 premium). So It's not quite as good as a
regular T'Note. But if inflation is higher at all, seems like I'm ahead.
And in fact the 4.054% current yield of this one is roughly equal to the
2.375% coupon of new TIPS plus the 1.5% annual inflation required to
return the exact principal. I guess it all adds up.

I guess the YTM (yield to maturity) encapsulates all this, which according to
the popup calculator, or Schwab, is about 2.5-2.6 (they don't quite agree).
Apparently, for a TIPS, the YTM is quoted assuming ZERO inflation from now
til the maturity date.

 

[wabmester]

The "current yield" is pretty meaningless. It would be a useful measure if the bond value stayed at 104, but it is guaranteed to be worth 100 (par) at maturity, so the YTM is the measure you want to pay attention to.

2.5% YTM (real) for a 3-year maturity doesn't sound terribly exciting to me. Since you can get around 5% from short-term bonds, inflation would have to average over 2.5% pa for the next 3 years to break even. Why go to the trouble of buying a bond on the secondary market for such a short term?

 

[bamsphd]

Because inflation MIGHT average more than say 10% over the next 3 years.
It certainly has been worse than that before, and could be that bad again.

 

[JohnEyles]

The "current yield" is pretty meaningless. It would be a useful measure if the bond value stayed at 104, but it is guaranteed to be worth 100 (par) at maturity, so the YTM is the measure you want to pay attention to.

Well, the current yield is actual precentage I'll earn of the money I actually put in, right ?

Seems to me that what happens to the 104 number, after I purchase, should be
pretty meaningless if I intend to hold the bond to maturity. The fact that I paid
104+ originally of course *IS* important; that 4+% price premium (which is about
1.5% annualized) must be subtracted from the yield from the interest payments.

2.5% YTM (real) for a 3-year maturity doesn't sound terribly exciting to me. Since you can get around 5% from short-term bonds, inflation would have to average over 2.5% pa for the next 3 years to break even. Why go to the trouble of buying a bond on the secondary market for such a short term?

Good point. I guess I want more money in TIPS, generally speaking. But perhaps it
makes more sense to buy ones with longer maturity than the 4/2011 I just bought
(at the Treasury re-opening).

I realize that TIPS is an inflation-hedge (so one is betting inflation averages 2.5% or
more during the course of the bond); of course I'd put at most 50% of fixed-income
allocation into TIPS. Given all that, the main point of this exercise was to work
out that this particular one at Schwab is an "ok" deal, after teasing out all the various
yields, inflation factors, price premiums, etc. Perhaps all that's really necessary is to
see that YTM is something I'm comfortable with, since it all seems to boil down to that.

 

[wabmester]

Well, the current yield is actual precentage I'll earn of the money I actually put in, right ?

You can sort of think of it as the "instantaneous" yield. It's simply the result you get by taking the first coupon payment and dividing by the price you paid for the bond. But the bond value, in this case, is guaranteed to get smaller as you get closer to maturity, so the yield gets continuously reduced. The YTM captures your overall yield through maturity.

Believe me, if it were possible to get a 4% real yield today from bonds, I would be backing up the truck and loading up.

 

[Mr._johngalt]

Because inflation MIGHT average more than say 10% over the next 3 years.
It certainly has been worse than that before, and could be that bad again.

Or it might be 20%. Or you may contract amoebic dysentery or terminal
blee-bly-bloatus. Thoughtful caution is good but you just can't protect against/foresee everything. Hope for the best and have a plan for the
worst.

JG

 

[JohnEyles]

You can sort of think of it as the "instantaneous" yield. It's simply the result you get by taking the first coupon payment and dividing by the price you paid for the bond.

Yes.

But the bond value, in this case, is guaranteed to get smaller as you get closer to maturity, so the yield gets continuously reduced. The YTM captures your overall yield through maturity.

I don't think this is correct, if you mean the interest payment "gets continuously
reduced". The interest payment is already reduced from the 4.25% coupon to the
4.05% "current yield" by the price premium paid 104.8. But as the principal is
adjusted upward by inflation, the interest payment still gets larger.

The only sense in which the "bond value gets smaller" is if the bond is sold before
maturity (and even this doesn't happen unless interest rates rise and make the
4.25% coupon not seem so desirable anymore). And yes, of course the final principal
paid out is reduced by the 1.048 factor. Which is why, as you point out, the YTM is
considerably less than the current yield - to a first apporximation, I believe it's the
current yield MINUS the price premium annualized over the time one owns the
bond.

Hate to keep hammering on this, but want to make sure my understanding is correct ...

 

[wabmester]

Hate to keep hammering on this, but want to make sure my understanding is correct ...

Yes, what you're saying is correct, but the market only cares about YTM. Think of it this way: somebody is selling you 3 years of coupon payments and one principal payment. You pay 104.8 upfront, and over 3 years they give you 4.25 + 4.25 + 4.25 + 100. So, your total (real) return over 3 years is 112.75 / 104.8 = 7.6%. Annualized, that comes out to something like 2.5%.

 

[youbet]

Some time back a NYSE traded security, ISM, was mentioned here on the board. From what I could tell, it's based on a Sallie Mae (SLM Corp) floating rate note (cuspid 78442P601), expires 1/16/18, which is linked to CPI with a 2.05% spread. Issued at a $25 PAR, it's now trading at about $22.25 which, to me, makes it look fairly attractive.

I wonder if anyone else is looking at this type of investment in lieu of TIPS or I Bonds?

 

[Dawg52]

I bought some earlier this year at $22.50. I was just trying to decide whether to buy a little more. Brewer, what you think?

 

[wabmester]

Some time back a NYSE traded security, ISM, was mentioned here on the board. From what I could tell, it's based on a Sallie Mae (SLM Corp) floating rate note (cuspid 78442P601), expires 1/16/18, which is linked to CPI with a 2.05% spread. Issued at a $25 PAR, it's now trading at about $22.25 which, to me, makes it look fairly attractive.

I wonder if anyone else is looking at this type of investment in lieu of TIPS or I Bonds?

Brewer likes ISM and OSM for some reason. Seems like the yield is lower than TIPS, and the risk is a little bit higher than TIPS, so I don't see the attraction.

 

[youbet]

Brewer likes ISM and OSM for some reason. Seems like the yield is lower than TIPS, and the risk is a little bit higher than TIPS, so I don't see the attraction.

Yep, Brewer did mention them. I've been trying to understand them a little better ever since then. I purchased a token 100 and plunked them in one of the grandkids ESA account just to watch...... They've been spitting out something between 6.5% - 7.0% (annualized and based on the $22.40 I paid for them) the 15th of every month.

Why do you say the yield is lower? Did you consider the discount to PAR?

Agree on the risk. They aren't Gov issue. But, I think Sallie Mae would be a pretty low risk??

 

[wabmester]

Why do you say the yield is lower? Did you consider the discount to PAR?

Hmm, I was going by the stated yield I read off some quote. But calculating the YTM myself, it looks pretty attractive.

Assuming coupon is 2.05%, maturity is 11 years, and price is 88.8 (4 x 22.2), then the YTM is 3.28% real, which is a bargain!

Edit: I guess it comes down to whether you actually get 25 back at maturity. Anybody know how these things work at maturity?

 

[youbet]

Hmm, I was going by the stated yield I read off some quote. But calculating the YTM myself, it looks pretty attractive.

Assuming coupon is 2.05%, maturity is 11 years, and price is 88.8 (4 x 22.2), then the YTM is 3.28% real, which is a bargain!

Edit: I guess it comes down to whether you actually get 25 back at maturity. Anybody know how these things work at maturity?

I just scanned the prospectus and they don't specifically explain what happens at maturity. They did say in the tax section, that the difference between what you paid and what you receive at maturity would be considered ordinary income, not capital gain, for tax purposes. That implies, but doesn't specifically say, that you get PAR $25.

Go here http://www.salliemae.com/

Click on "investor" at the bottom of the page. Then click on loan trusts. Pick the 2018 maturity year. Then cuspid 78442P601.