TIPS for Dummies

[Rich_by_the_Bay]

I searched and read. I still don't have a good feel for the place of TIPS in a FIRE portfolio.

My goal is to have some place to withdraw cash in the face of surging inflation when MMF, stocks, and short-term bonds are not keeping up. If I have a TIPS mutual fund, I presume it would given me such an option.

But to generate the kind of cash which would make a serious difference in this setting you would need a fair amount in TIPS, for which performance is not stellar in a noninflationary setting. Talking tax sheltered accts, BTW.

My questions, in essence:

a) how much in TIPS makes sense relative to annual expenses and

b) is it worth it compared to just to sitting it out til stocks catch up (which they tend to do most of the time with inflation)?

 

[Cut-Throat]

Rich,

The way I look at it is that I'm committed to having a 55/45 Stock Bond Mix. Less stocks as I get Older.

Of the 45% Bonds - I have committed 40% to a TIPS fund. (Quite a Chunk) Bonds are there to smooth out volatility and yes they won't get you as much returns in the long run as stocks. But that's the price you pay for lower volatility.

I have heard recs of half of your Bond Mix should be TIPS. 30%, 40% etc.

Pick a number and stick to it.

 

[Dawg52]

I have also had a tough time determining the appropriate allocation % for TIPS. Brewer gave this opinion on another thread.

You make a trade off when you swap nominal bonds for TIPS. You lock in a real yield and gain inflation protection, but you lose out if the economy cools. I think the smartest thing to do is split the difference. Put some of your bond allocation in a bond index fund, and some in TIPS. You can hold TIPS directly, or buy a fund. There are various TIPS mutual funds, or there is TIP, and ETF.

 

[youbet]

I searched and read. I still don't have a good feel for the place of TIPS in a FIRE portfolio.

My questions, in essence:

a) how much in TIPS makes sense relative to annual expenses and

Rich......this is one of the many things that makes this game so darn interesting!! A portfolio cannot be optimized for divergent scerarios, it's all a compromise. Sadly, none of us seems to have found a sure way to get to a low risk - high gain situation! And any one allocation scheme only seems to be right for one particular set of market conditions. Darn!

Dividing the portfolio into separate categories, whatever you name them, doesn't really change anything either.

My first comment would be that I wouldn't quantify my TIPS holdings relative to annual expenses but rather as a percentage of total portfolio value.

Second comment is that VTSTX has a duration of 6.6 and average maturity of 10 and that should be accounted for. Various gurus suggest various amounts and the numbers I've seen vary from 10% to 30% of your fixed allocation.

 

[JohnEyles]

I think the smartest thing to do is split the difference. Put some of your bond allocation in a bond index fund, and some in TIPS.

In another thread I asked for a couch-potato-esqe bond portfolio and Brewer told
me to put half in AGG and half in individual TIPS. He recommended the 5-yr
"re-opening" occurring later this month. I think the general notion is to use
funds for corporate bonds, because it's too complicated for the casual investor
to pick good ones themselves and funds spread risk (especially in the case of
high-yield aka junk bonds); but to use individual issues for treasuries, because
then you're guaranteed to get your principal back if you hold to maturity. In
particular, I think bonds are kinda for the 5'ish-year timeframe so that makes
th 5yr TIPS a good fit. And almost everyone says that TIPS should be held in
a tax-advanaged account (e.g. IRA) else you'll be reamed by the phantom
interest.

I admit I find TIPS bewildering too. The interest rates seem so low - 2.37% for
the 5yr one available in a week. I think the notion is that if that rate PLUS
inflation is greater than yields on non-inflation bonds, then you come out
ahead. So you're basically hedging your bets for 3+% inflation.

Looking at TIPS in terms of a SWR mindset they seem very unappealing. It's
axiomatic that you can take a 4% initial WR from your portfolio and increase
it for inflation each year. One way this can work is if your portfolio principal
keeps up with inflation and you simply harvest dividends of 4% of portfolio value
each year; this is EXACTLY what a TIPS does, EXCEPT it pays a LOT less than 4%.
But the TIPS is guaranteed to keep up with inflation, whereas of course a stock
portfolio can potentially do a whole lot worse than keeping up with inflation. And
that's exactly what you expect from your bond allocation - to underperform your
stocks in general, but to be a whole lot more reliable.

 

[wabmester]

Looking at TIPS in terms of a SWR mindset they seem very unappealing. It's
axiomatic that you can take a 4% initial WR from your portfolio and increase
it for inflation each year. One way this can work is if your portfolio principal
keeps up with inflation and you simply harvest dividends of 4% of portfolio value
each year; this is EXACTLY what a TIPS does, EXCEPT it pays a LOT less than 4%.

Take a closer look at the "axiomatic" 4%. A 4% withdrawal rate is considered "safe" if your assets don't go below zero during your lifetime, right? That means the model assumes it's OK to deplete your principal.

So, how long would a 2.5% TIPS last you at a 4% inflation-adjusted withdrawal rate? About 40 years. With zero volatility.

Now, the "axiomatic" 4% SWR assumes a mix of 75% stock and 25% nominal bonds and a 30-year withdrawal period. It "guarantees" survival in the face of worst-case historical market performance. In the best case, that mix would have supported a withdrawal rate of something like 10%. So, while TIPS would give you a guaranteed 4% SWR, you'd be giving up any possible upside.

You have to decide for yourself how much of a guaranteed zero-volatility 4% SWR you want vs the potentially larger upside (and downside) of stocks.

It's basically the same argument for and against annuities, but without the hidden transaction costs of annuities.

 

[JohnEyles]

how long would a 2.5% TIPS last you at a 4% inflation-adjusted withdrawal rate? About 40 years. With zero volatility.

It's basically the same argument for and against annuities, but without the hidden transaction costs of annuities.

I'm a little confused. Yes, I see your point that if I have an investment that has a
ROR which is 2.5% higher than inflation, then it will last me 40yrs at an inflation-
adjusted WR of 4% of initial value. So theoretically a guaranteed ROR of
inflation+2.5% is "good enough" if I'm happy with my "axiomatic" 4% SWR.

That makes it seem tempting to put my ENTIRE nestegg into TIPS. But of course
I can't withdraw ANY of the principal of a TIPS until it matures, so this won't actually
support a 4% WR. Too bad there's nothing like a TIPS annuity Perhaps a TIPS
ETF or mutual fund where you sell enough each year so that the proceeds plus the
yield provides your inflation-adjusted 4% ? Does that make any sense at all ??

 

[brewer12345]

But of course
I can't withdraw ANY of the principal of a TIPS until it matures,

Really? What universe do you inhabit? In the one I live in, there is an active and liquid secondary market for TIPS.

 

[wabmester]

In addition to brewer's tactful comment, you can ladder TIPS just like any bond or CD.

 

[Rich_by_the_Bay]

In addition to brewer's tactful comment, you can ladder TIPS just like any bond or CD.

Or buy the Vanguard inflaction protected bond fund (among others).

 

[wabmester]

Or buy the Vanguard inflaction protected bond fund (among others).

A ladder is really the only way to go if you want to hold to maturity and get a guaranteed zero-volatility SWR.

Selling on the secondary market or using an ETF or bond fund will subject you to potential capital gains and losses, so you give up the "zero-volatility" bit. But for practical purposes, a TIPS fund as part of your bond allocation should be fine.

 

[brewer12345]

A ladder is really the only way to go if you want to hold to maturity and get a guaranteed zero-volatility SWR.

Selling on the secondary market or using an ETF or bond fund will subject you to potential capital gains and losses, so you give up the "zero-volatility" bit. But for practical purposes, a TIPS fund as part of your bond allocation should be fine.

Just as a point of clarification: the "zero volatility" that WAB is talking about refers to the portfolio withdrawals (guranteed by the gubmint and inflation-adjusted). A portfolio of TIPS will have plenty of volatility if we are talking about the value of the portfolio because TIPS actually have more volatility than nominal treasuries.

 

[JohnEyles]

Or buy the Vanguard inflaction protected bond fund (among others).

Well, while we're all being smart-asses , I believe I mentioned that in the
next sentence or two !

But good points - not sure what universe my head was in when I said that.

 

[haha]

IMO, when TIPS can be bought at today's yields, they dominate straight bonds with maturities >= 10 years, except when you are consciously speculating on interest rate movement.

I keep liquid funds in 6 month to 3 year notes, all the rest in inflation adjusted bonds.

HA

 

[yakers]

I keep liquid funds in 6 month to 3 year notes, all the rest in inflation adjusted bonds.

HA

HA,

Are those TIPS, ibonds or something else that is inflation protected? I liked ibonds until the base rate went so low.

 

[My Dream]

Is there actually a book called " Investing or Investments for Dummies"? Sorry to highjack this thread.

 

[REWahoo]

Is there actually a book called " Investing or Investments for Dummies"? Sorry to highjack this thread.

Investing for Dummies

 

[haha]

HA,

Are those TIPS, I bonds or something else that is inflation protected? I liked ibonds until the base rate went so low.

Mostly TIPS, some I-bonds bought at the earlier rates, and some corporate inflation adjusted bonds that were mentioned earlier by Brewer.

Ha

 

[JohnEyles]

A ladder is really the only way to go if you want to hold to maturity and get a guaranteed zero-volatility SWR.

So to do this you'd probably want to purchase your TIPS on the secondary market,
since the auctioned ones have such a limited set of terms (5, 10, 20 years), right ?

I understand the basics of TIPS (as purchased at auction), but unfortunately my brain
finds the secondary market ones even more confusing. I can't seem to find a website
that really explains it, so if anyone feels like a tutorial for dummies, thanks ...

Suppose, for the rung of my ladder that matures in about 2 yrs, I choose one Schwab lists
that has a 3-7/8% coupon, originally issued in 1/1999 and maturing in 1/2009 (a 10yr
term). Other statistics are:

Price: 102.73527
Yield To Maturity %: 2.607
Current Yield %: 3.772
Gross Price: $127.63316
Inflation Factor: 1.24235

Schwab wants $12,890 for a nominal $10,000 of these puppies. How do I decide if this
is something I want to buy (given I think I wanna put a bunch of money in TIPS) ?

First off, I guess the difference between Schwab's price and 10 X "gross price" would be
what I'm paying in commission ? And apparently "gross price" is "price" X "inflation factor"
which is presumably the cumulative CPI adjustment since the original issue in 1/99 ?

At maturity will this pay me $10000 X "inflation factor" X inflation between now and 2009 ?
And my interest payments will be 3.772% of $12763, increasing with inflation between
now and 2009 ?

 

[JohnEyles]

How do I decide if this
is something I want to buy (given I think I wanna put a bunch of money in TIPS) ?

Or, is perhaps a better way to think of it is that "it all comes out in the wash" ?
In other words, if full-term/bought-at-auction TIPS make sense and seem like a
good idea to me, then the partial-term secondary market ones are a good idea
too (even though I don't quite grok all the mathematics yet) ? Modulo the fact
that Schwab appears to be making about $100 on the deal.

 

[wabmester]

So to do this you'd probably want to purchase your TIPS on the secondary market, since the auctioned ones have such a limited set of terms (5, 10, 20 years), right ?

Right, you can use a combination of new issues and secondary offerings to build your ladder. I tend to use nominal CD's for the "lower" rungs of the ladder since I'm less concerned about short-term inflation than long-term inflation.

my brain finds the secondary market ones even more confusing

I didn't sense any confusion in your details -- you seem to have the secondary market figured out. Focus on the real YTM to make your purchase decisions. As an extra bonus, you can get higher coupons on the secondary market which means you'll get more inflation-adjusted income (and less "phantom" inflation-adjusted principal). And you also get to write-off a capital loss at maturity since you're paying over par.

 

[JohnEyles]

Focus on the real YTM to make your purchase decisions.

That's the main statistic I didn't understand. It was 2.607% for my example.
What does it mean and how is it computed ?

As an extra bonus, you can get higher coupons on the secondary market which means you'll get more inflation-adjusted income (and less "phantom" inflation-adjusted principal). And you also get to write-off a capital loss at maturity since you're paying over par.

So this would be viable in a taxable account, unlike the new issue, which is probably
a bad idea in the taxable account. But can you help us to understand how it is that
by buying one with a high coupon value that the phantom interest (for a given year)
is less than the principal times that year's inflation ?

 

[wabmester]

That's the main statistic I didn't understand. It was 2.607% for my example.
What does it mean and how is it computed ?

You're paying 102.7 for a bond with a 3.77% coupon, which brings the real YTM to the market yield of 2.6% (for which you would pay closer to 100 on a new issue). 2.6% real sounds pretty good to me for a 2-year bond since inflation has been in the 4%+ range recently. You'll break even vs a nominal CD if inflation stays above 2.5% or so.

Yield to Maturity

So this would be viable in a taxable account, unlike the new issue, which is probably a bad idea in the taxable account. But can you help us to understand how it is that by buying one with a high coupon value that the phantom interest (for a given year) is less than the principal times that year's inflation ?

Personally, I think the taxable vs tax-deferred deal is an overplayed bugaboo. I'm able to keep my marginal tax rate pretty low in retirement even with a fairly large income (thanks to low earned income, high deductions, and the ability to tax-manage most of my income). Another way to think of the "phantom" TIPS income is as reinvested interest, just like a CD (except the TIPS interest is state-tax free).

But basically you're paying more upfront for a higher coupon on the secondary market, so you'll get more income from the coupon payments and less on the back-end principal payment at maturity compared to a new issue.

 

[bobbee25]

If tips are paying 2.5% over inflation, how can you safely withdraw 4%.

 

[haha]

If tips are paying 2.5% over inflation, how can you safely withdraw 4%.

You can't, if you are immortal.