TIPS funds and deflation

[wabmester]

We recently had a thread that discussed how TIPS funds distribute the inflation adjustment via dividends:

link

So, what happens when the CPI goes down (i.e., deflation)? Do they ask for the money back?

Sort of. Basically, they skip a dividend distribution and may treat prior distributions as return of capital.

Here's Vanguard on the topic:

link

 

[brewer12345]

Hard to imagne it will ever come up in practice, though.

 

[wabmester]

Hard to imagne it will ever come up in practice, though.

Err, they are describing actions taken this quarter.

 

[brewer12345]

Err, they are describing actions taken this quarter.

Oh, I see. You were talking about the quirky temporary stuff hat went on. I thought we were reviving some tinfoil hat discussions on the US entering a prolonged deflationary environment.

 

[milmoose]

I thought we were reviving some tinfoil hat discussions on the US entering a prolonged deflationary environment.

I amazes me how many people worry about "inflation-proofing" their portfolios, but never concern themselves about "deflation proofing".

Keep in mind that nominal prices declined from 1875-1920 in the US and from 1991-Present in Japan. It's not out of the question in the future.

- M

 

[brewer12345]

I amazes me how many people worry about "inflation-proofing" their portfolios, but never concern themselves about "deflation proofing".

Keep in mind that nominal prices declined from 1875-1920 in the US and from 1991-Present in Japan. It's not out of the question in the future.

- M

True, deflation has happened in the past, but bouts of deflation have been far rarer and generally less destructive to diversified portfolios than bouts of inflation. The SWR-buster scenario in US history wasn't the great depression. It was 1966 to 1982 (a time of rampant inflation).

 

[Nords]

Keep in mind that nominal prices declined from 1875-1920 in the US and from 1991-Present in Japan. It's not out of the question in the future.

With a Federal Reserve that sees deflation as a very bad thing, I suspect that we'll be very unlikely to see prolonged deflation ever again.

 

[brewer12345]

With a Federal Reserve that sees deflation as a very bad thing, I suspect that we'll be very unlikely to see prolonged deflation ever again.

Not with "Helicopter Ben" at the helm, at any rate.

 

[haha]

Not with "Helicopter Ben" at the helm, at any rate.

I will book anybody's bet who wants deflation. I put the likelihood of US deflation lasting more than a year at most somewhere below the likelihood of Gwyneth Paltrow kidnapping me to be her sex slave.

OTOH, I fully expect Ben and the boys to start braying about deflation as soon as the econmy slows and they want to lower rates without kicking the USD into the toilet.

When this happens, wait a few months and load up on gold 'cause always and ever in modern USA deflation talk is a head fake.

Ha

 

[Gone4Good]

I amazes me how many people worry about "inflation-proofing" their portfolios, but never concern themselves about "deflation proofing".

It's already built in to your normal portfolio.

Regular bonds are rock-stars during periods of deflation.

 

[mickeyd]

VIPS distributions are more volatile than other bond funds because of the variability of the income stream that is tied to inflation, which is affected by short-term changes in commodity prices and seasonal variations in inflation figures.

About 50% of my FI AA is in TIPS. When I set up my AA years ago, I realized that TIPS were a diversifier and made me somewhat inflation proof. I also understood that if we ever entered a deflationary period, other investments that I had would be winners and TIPS would not be part of that party. I fully expected this situation, in fact I sleep better knowing that I chose TIPS for a specific reason and they continue to respond to what they were advertised to do.

Those who got into TIPS without fully understanding why they selected this kind of bond allocation, will be understandably upset at this development. This is just a lession in why it is so important to know why your investments are allocated the way that they are. Those who have REITs as part of the mix, may also be eventually hurt unless they understand the investment.

 

[Rich_by_the_Bay]

About 50% of my FI AA is in TIPS. When I set up my AA years ago, I realized that TIPS were a diversifier and made me somewhat inflation proof.

Mickeyd,

Can you explain your rationale for holding that high a percent of FI as TIPS? A year or two's worth of expenses in TIPS is easy for me to understand. But in a typical 60:40 AA, your approach would put 20% of total assets in TIPS. Seems like a lot for an asset class that will underperform in most years.

Just curious as to your reasoning on this. Thanks.

 

[brewer12345]

Mickeyd,

Can you explain your rationale for holding that high a percent of FI as TIPS? A year or two's worth of expenses in TIPS is easy for me to understand. But in a typical 60:40 AA, your approach would put 20% of total assets in TIPS. Seems like a lot for an asset class that will underperform in most years.

Just curious as to your reasoning on this. Thanks.

Um, how do you know that TIPS will underperform most years? They have only been around a few years.

 

[ats5g]

Mickeyd,

Can you explain your rationale for holding that high a percent of FI as TIPS? A year or two's worth of expenses in TIPS is easy for me to understand. But in a typical 60:40 AA, your approach would put 20% of total assets in TIPS. Seems like a lot for an asset class that will underperform in most years.

Just curious as to your reasoning on this. Thanks.

Rich,

Check out this [fairly easy to read/understand] paper from Ibbotson Associates on TIPS:

TIPS as an asset class

- Alec

 

[Rich_by_the_Bay]

Um, how do you know that TIPS will underperform most years? They have only been around a few years.

Pages 6 and 7 of ats5g's link above explain that assumption, though of course time will tell.

 

[brewer12345]

Pages 6 and 7 of ats5g's link above explain that assumption, though of course time will tell.

Note that the study used simulated data (i.e. made up). Pretty much rips the bottom out of the study, IMO.

 

[Rich_by_the_Bay]

Check out this [fairly easy to read/understand] paper from Ibbotson Associates on TIPS:

TIPS as an asset class

Thanks, Alec. So well-written even I can more or less understand it. Never paid much attention to correlation in my bond portfolio, just maturity dates. Maybe TIPS are a good thing to add for that reason alone.

 

[mickeyd]

Can you explain your rationale for holding that high a percent of FI as TIPS?

You know Rich, I really do not think that my % of TIPS is that high. I know folks that have 100% of their FI in TIPS and I think that this is going overboard. As for why I like my TIPS AA, diversification, inflation hedge, risk reduction and increase return potential that I believe that TIPS will deliver me in the long term.

Time will tell, of course if it all pans out, but all of our LT plans are a bit of a crap-shoot that we will only know at the end if we selected the best course. Of course, at that time, we will be age 95 and won't really give a s**t as long as we don't have to eat cat food on a regular basis.

 

[Rich_by_the_Bay]

You know Rich, I really do not think that my % of TIPS is that high. I know folks that have 100% of their FI in TIPS and I think that this is going overboard. As for why I like my TIPS AA, diversification, inflation hedge, risk reduction and increase return potential that I believe that TIPS will deliver me in the long term.

Thanks, Mickeyd. My understanding of TIPs was naive, it appears. I thought of them as inflation protection at the cost of decreased returns compared to similar FI of similar maturity.

While that's not entirely off-base, the benefits of additional diversification and returns that have an upside potential, too, make them more attractive.

 

[brewer12345]

Thanks, Mickeyd. My understanding of TIPs was naive, it appears. I thought of them as inflation protection at the cost of decreased returns compared to similar FI of similar maturity.

While that's not entirely off-base, the benefits of additional diversification and returns that have an upside potential, too, make them more attractive.

But only if the low correlation the authors of the study made up holds in the future.

 

[ats5g]

Thanks, Mickeyd. My understanding of TIPs was naive, it appears. I thought of them as inflation protection at the cost of decreased returns compared to similar FI of similar maturity.

While that's not entirely off-base, the benefits of additional diversification and returns that have an upside potential, too, make them more attractive.

Rich,

I think whether TIPS return more or less than similar maturity bonds depends on the actual rate of inflation versus expected inflation [see pg 5 of the ibbotson paper]. Hence, owning both TIPS and nominal bonds hedges your bets either way. Someone posted some returns for TIPS and nominal bonds in the UK from 1981-2000 over the VD board. It looks like in the 80-90's in the UK, TIPS did not return very much. Perhaps this was due to inflation expectations [from the 70's] being higher than real inflation. Also interesting is that post 2000, things flip-flopped, with TIPS beating nominal bonds.

Since TIPS have been around since about 1997 in the US, and TIAA-CREF has had a TIPS fund since 4/1997 we can do the correlation matrix for a bunch of their accounts [from 4/1997 to 8/2006]:

CREF Inflation linked bond
CREF Bond Market
CREF Equity Index
CREF Money Market
30 day Tbills [courtesy of Ken french]
CPI

CREFbond CREFequi CREFinfb CREFmony Tbills CPI
CREFbond 1
CREFequi -0.136042 1
CREFinfb 0.765623 -0.190142 1
CREFmony 0.169195 0.025680 -0.007228 1
Tbills 0.144833 0.013781 -0.020410 0.981431 1
CPI -0.093373 -0.116935 0.048917 0.001293 0.024667 1

Which is what the Ibbotson paper found [from 1970 - 1998]. TIPS had lower correlation to equites than nominal bonds, albeit slightly.

Anyway, if anyone wants to run efficient frontiers, I've got the monthly returns [nominal and real]. Looks to me like most of the efficient portfolios included both TIPS and nominal bonds.

fyi - here are three more academic papers on diversification with TIPS.

- Alec

 

[Rich_by_the_Bay]

I think whether TIPS return more or less than similar maturity bonds depends on the actual rate of inflation versus expected inflation [see pg 5 of the ibbotson paper]. Hence, owning both TIPS and nominal bonds hedges your bets either way.

Thinking about a little bit of TIPS in my "near cash" bucket (tax deferred), then dipping in when they do well, and essentially rebalancing every year or two. If nothing else, it would buy me time during an inflationary spell for things to settle down.

 

[FinanceDude]

I'd like to see an updated study using real numbers over the period 1997-2005. I think it would show they have underperfomed over that time frame.

However, they will probably look better as time smooths out the Fed's actions from 2000-2003...........

 

[AlmostDone]

I've been slowly reallocating our funds now that we have almost everything at Vanguard. I was planning a 10% allocation to TIPS in a 50/50 portfolio. When we had our financial plan done by Vanguard, then did not suggest any TIPS. I questioned the planner, but I wasn't satisfied with his answer - actually, he didn't really give me an answer, just that they don't think they are a good investment at this time. Is 10% too high an allocation?

 

[FinanceDude]

I've been slowly reallocating our funds now that we have almost everything at Vanguard. I was planning a 10% allocation to TIPS in a 50/50 portfolio. When we had our financial plan done by Vanguard, then did not suggest any TIPS. I questioned the planner, but I wasn't satisfied with his answer - actually, he didn't really give me an answer, just that they don't think they are a good investment at this time. Is 10% too high an allocation?

I doubt it............10% of your money tracking the inflation index isn't a bad thing..........