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

[brewer12345]

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Originally Posted by Anansi Bonds are kind of boring, but I have to put money somewhere and most things just look too expensive right now. I only mentioned it because I do like OSM better than TIPS. But I like beer better than either.

Smoked porter is next on my list...

[Patrick]

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Originally Posted by brewer12345 Smoked porter is next on my list...

Goss?

[haha]

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Originally Posted by brewer12345 Smoked porter is next on my list...

This stuff will make you fat. Better stick to lagers!

Ha

[JohnEyles]

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Originally Posted by brewer12345 I like ISM and OSM and I find them attractive, especially as they approach 22. You get 100 or so BP of extra spread over TIPS for exposure to an A-rated credit and the bonds often trade down when it seems like they shouldn't (translation: illiquidity sometimes gives you a bargain). At maturity, you do indeed get $25 back. These things are more akin to an I bond than TIPS, though. They also have an advantage over TIPS in that you get your inflation adjustment every month as cash on the barrel head, so if we subsequently enter a period of deflation (highly unlikely, IMO) you won't get the deflation taken out of your principal. The best free source for info on ISM, OSM and other retail income securities that I know of is www.quantumonline.com I think they will make you register, but since I am registered as "Heywood Jahblowme", I think it is pretty informal. As these things head for 22, I am increasingly interested in adding to my position. A nice, low risk play, IMO.

It looks like interest rate is the percent increase in the CPI over the previous 12 months,
plus 2.05%. I talked to Schwab and they say they're looking at 3-month old data to
make this calculation. So even though the current dividend is 6+%, that's based on
August numbers (the increase from Aug '05 to Aug 06), so since we already have later
numbers, we can predict what the dividend will be in subsequent months - for example,
she computed the Jan '07 dividend rate as only 3.36%. I guess this explains why the
price dropped from nearly $25 (in March) to close to $22 now.

Apparently the interest rate is paid on the $25 par value. But this principal is never
adjusted as with TIPS. Thus, if inflation drops very low, the dividend rate drops to
2.05%. Seems like disinctly different behavior from TIPS, where if there's lots of
inflation, and then none, you still get the advantage of the inflated principal from
the high-inflation period.

I wonder why one would choose OSM instead of ISM. Looks like the interest rate is
lower, but I see no advantage.

[brewer12345]

That's a reasonable summary. Although these things are a bit different tahn TIPS, they are pretty similar. So it is a bit of a mystery to me to see TIPS move up while ISM and OSM move down. After all, lower CPI means TIPS total yield (nominal) will be lower, too.

The only obvious difference between ISM and OSM is that OSM matures a year earlier and there is $200MM face of OSM vs. $75MM of ISM. At one point there was almost $2 a "share" difference in the price. I wanted to buy ISM and short OSM but I couldn't get a borrow on OSM.

Bought some more ISM today.

[JohnEyles]

Quote:

Originally Posted by brewer12345 That's a reasonable summary. Although these things are a bit different tahn TIPS, they are pretty similar.

Seems pretty distinct difference: TIPS is based on CPI, ISM is based on *derivative* of CPI.
TIPS adjusted principal basically follows the CPI, and the interest paid is based on that
adjusted principal. But for ISM, during periods where CPI is increasing, the interest rate is
great; if CPI goes flat, interest drops near 2% (of the $25/share par value), no matter how
much higher CPI is than when you bought the ISM.

I guess it's just a different kind of inflation hedge, and hence probably a good addition to
a diversifed fixed-income allocation. And like any bond held to maturity, you get your
principal back, although there probably IS a real loss in principal (since it's likely the
$25 par 10 years from now would be less real dollars than the $22 you pay today).

Thoughts on holding it in tax-deferred vs taxable accounts ? I guess there's no
phantom interest, but apparently the dividends are taxed as oridnary income.
Can't quite tell if they're state-tax exempt.

[brewer12345]

I think the differences are minor, compared to, say, a nominal fixed bond.

Since CPI is extremely unlikely to be flat to down for an extended period, I think this is relatively unimportant. You should be aware that TIPS can acually decrease in accrued par value if inflation is negative. That is not the case for ISM/OSM.

I happen to hold it in a taxable account, since that is where I have the money to buy it. Obviously a tax deferred account would also be a good idea. The interest it pays is fully taxable as interest income.

[FIRE'd@51]

Quote:

Originally Posted by JohnEyles .............................. for example, she computed the Jan '07 dividend rate as only 3.36%. I guess this explains why the price dropped from nearly $25 (in March) to close to $22 now.

Actually, the price drop from near 26 to 22 occurred from mid-January to late June, while 10-year real interest rates were rising about 70 basis points.

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Originally Posted by JohnEyles Can't quite tell if they're state-tax exempt.

Since OSM and ISM are not direct obligations of the US Treasury, the interest would not be state tax-exempt.

I'm not sure they are a great value versus TIPS, even with a 100 bp higher YTM since they are rated single A. I believe the current spread between 10-year single A corporates and Treasuries is something like 85 bp.