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

[flipstress]

Quote:

Originally Posted by JohnEyles What's wrong with corporate bonds held as part of a highly-regarded low-expense broad-based ETF like AGG ? Seems a little undiversified to have ALL your fixed-income in Treasuries.

I don't know how to evaluate individual corporate bonds. I also read David Swensen's book "Unconventional Success..." and he lays out the disadvantages or drawbacks to corporate bonds, which I take to include bond funds. Of course, I don't remember them Hmmm, let me try--something about the bonds being tailored to benefit the issuing party more and I'm not sure about this--high correlation with stocks anyway? My understanding was that corporate bonds are not for unsophisticated investors like me.

I do intend to have a ladder of TIPS and short-term to mid-term Treasury bonds.

[JohnEyles]

Quote:

Originally Posted by flipstress My understanding was that corporate bonds are not for unsophisticated investors like me.

Yes, which is exactly the point of using a mutual fund or ETF.

[brewer12345]

A high grade ond index like AGG or the VG total bond market index fund holds high grade (A to AAA ated) medium term bonds, including corporates, mortgage backeds, and treasuries. Very plain-vanilla stuff you are unlikely to see experience a loss except for interest rate fluctuations. Even then, you'd need a real big rise in rates to see a loss.

[bamsphd]

I like a 5 year TIPS ladder, each rung worth 4% of my portfolio
at the time of purchase. That is my "great depression" insurance.
I add 4% in a Vanguard short term fund for the unexpected major
expense, and 0.5% to 4% in a Money Market for liquidity.

The rest of my portfolio goes into Equities, though I sometimes think
about adding a slice of long term zero coupon bonds for excitement.
I have not done that yet, in part because of the current yield curve.

[ESRBob]

Jane,
One thing-- you need to be careful holding TIPS (or TIPS funds) in your taxable account: the inflation-adjustment portion of the bond price is calculated as taxable income to you each year, which can be a drag. You don't actually get the money until you redeem your TIPS, but you have to pay ordinary income tax on it each year, just the same.

If you have the ability, it is easier to hold these things in a tax-advantaged account. It at least saves you needing to do that math and come up with those taxes on unrealized paper gains each year.

[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]

Quote:

Originally Posted by ESRBob 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.

Quote:

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]

Quote:

Originally Posted by ESRBob 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]

Quote:

Originally Posted by wab 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]

Quote:

Originally Posted by HaHa 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]

Quote:

Originally Posted by wab 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]

Quote:

Originally Posted by FIRE'd@51 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]

Quote:

Originally Posted by JohnEyles 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]

Quote:

Originally Posted by wab 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.

Quote:

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.