TIPS vs I Bonds

[ron]

So far I found you cannot buy I Bonds from a broker. Only from a bank and treasury direct. Also, you can buy from a bank for a trust account with the tax ID#. Not sure about treasury direct yet , still checking.

 

[cute fuzzy bunny]

Couple of points.

The term "real return" has been bandied about. As we've explored before, inflation adjusted securities offer a "cpi adjusted return", which may or may not be a "real return" depending on your personal rate of inflation.

In my case, CPI appears to be woefully inadequate as a predictor of my personal inflation, or inflation as it exists in my area of the world.

Ask anyone who's been on CPI adjusted pensions or social security for 10+ years about how well the adjustments have kept them up with inflation. According to my dad his SS money buys about 20-40% less than it did ten years ago.

Between questionable "hedonic adjustments" and measures that eliminate many rather typical categories, making a bet that ibonds or tips will create a true "real" return that makes you immune to inflation would probably be a very, very bad idea.

Other thoughts around these rates of return might be intermediate to long term municipal bonds, EE bonds, or even a plain old treasury ladder. Yields on intermediate to long term munis, either in a fund or bought and held to maturity, can be competitive with current aggregate ibond/tips returns. Tax free. Without the tax implications of tips.

Not saying one is bad and one is good, just that if you believe inflation rates will remain moderate to tame, you might consider other options. Or do more than one.

 

[Cut-Throat]

Ask anyone who's been on CPI adjusted pensions or social security for 10+ years about how well the adjustments have kept them up with inflation. According to my dad his SS money buys about 20-40% less than it did ten years ago.

And SS is supposedly wage adjusted not CPI adjusted. You're supposed to be ahead of inflation!

 

[Peter]

And SS is supposedly wage adjusted not CPI adjusted. You're supposed to be ahead of inflation!

I thought ongoing payments were adjusted according to the CPI? It's the initial benefit that's wage adjusted, I think.

Peter

 

[Cut-Throat]

Yeah, you're probably correct. - this is a confusing topic for me. But, I'm sure one, which we'll all come to understand in the year ahead.

 

[haha]

And SS is supposedly wage adjusted not CPI adjusted. You're supposed to be ahead of inflation!

I think this is true only until age 62. From then on, it is CPI -U adjusted.

Mikey

 

[Bob_Smith]

SS is adjusted to wages while you're working, but when you start collecting checks your income is adjusted per the CPI.

Regarding the term "real return"... yes, the CPI is the yardstick the feds use to apply adjustments to the principal of TIPS and I-Bonds. There is some evidence that the CPI is understated, but you'll seldom see disclaimers accompanying the term - the CPI is what it is. However, I'd be cautious about focusing too much on the possibility that the CPI might lag the "true" cost of living in a global sense. While that may be true, and it could certainly add up, there are other more ominous risks that must be considered. For example, it's entirely possible for nominal bonds to produce negative real rates of return - for a very long time. CPI fudging is one element to consider, among many, but I'd say it's a moderate concern. Other concerns supersede it, IMHO. It's not so much a matter of examining TIPS/I-Bonds in light of what they claim to do (keep pace with inflation) and finding them lacking relative to that expectation. It's more a matter of examining them relative to other investments one can buy, and determining their purpose in the portfolio. Covering all the bases is about the best one can do.

Speaking of the CPI, here is something useful that AARP or some consumer organization could do - calculate an honest CPI and unveil it with great fanfare, and a big publicity campaign every year. Headline: "Feds Cheat On CPI". Might help to keep the b***ards honest.

 

[cute fuzzy bunny]

That would be a very interesting annual article. I just have a very visceral and negative reaction to bullpuckey. We've all seen my reactions to certain posters

Bill Gross published a couple of blog articles regarding CPI. His overall estimate from my recollection is that he felt it lagged by a percent to a percent and a half. I dont think he factored in the 'basket substitutions' (CPI analysts say that when steak gets too expensive, it is replaced in the basket of goods by hamburger, for example) or 'hedonic adjustments' (a computer got more expensive, but its faster, so therefore the cpi analysts say its extra value makes it cheaper). I dont believe theres any place for these sorts of subjective alterations in what should be a very stable calculation: take the total cost of living for the average american family and measure the changes in costs from one year to the next.

Just to be clear I'm not disputing the value and benefits of an inflation adjusted instrument. In fact, should inflation run up like it has in the past, they would be very good things to have in ones portfolio.

I'm suggesting the occasionally floated investment idea of buying a purported 'real rate of return' and presuming this will insulate you from the effects of inflation for the term of that investment vehicle may not necessarily be a good idea.

And adding that diversification is as good an idea with bonds as it is with stocks. Looking at vanguards target retirement income fund is a good peek at this diversification...a smidgeon of stocks, a bucket of variety bonds, and 25% TIPS.

In my neck of the woods where a house worth $175k 2 years ago now sells for $335k, gas is up 35% since 2002, electricity and water rates have doubled in 4 years, and some basic food items are up 15-40% in 3 years...a 3.3% adjustment isnt going to help "keep it real"...

What would be REALLY cool, besides being a little more accurate in calculating the CPI (because I dont consider switching from steak to hamburger a reasonable adjustment and my new computer doesnt help me surf the web any better than my old one did), is regionalizing the CPI and paying that regional adjustment to inflation adjusted bond holders.

 

[MooreBonds]

Bill Gross published a couple of blog articles regarding CPI. ... I dont think he factored in the 'basket substitutions' (CPI analysts say that when steak gets too expensive, it is replaced in the basket of goods by hamburger, for example) or 'hedonic adjustments' (a computer got more expensive, but its faster, so therefore the cpi analysts say its extra value makes it cheaper). I dont believe theres any place for these sorts of subjective alterations in what should be a very stable calculation: take the total cost of living for the average american family and measure the changes in costs from one year to the next.

Just to be clear I'm not disputing the value and benefits of an inflation adjusted instrument. In fact, should inflation run up like it has in the past, they would be very good things to have in ones portfolio.

TH...I used to be in complete agreement with your argument. However, how would you evaluate the impact of technological advances?

Whether it's computers or cars, how does one calculate the benefit of advances, whether or not there is a price impact? If you take the entire sales of computers and consumer electronics, there's a hell of a big change in quality, despite a huge drop in prices over the past 10 years. And that's not even comparing safety/other advances in cars, homes, energy-efficient/better appliances (yes, sometimes they do break down more often ), etc.

Also, while some areas of the country do have large increases in various items (utilites, taxes, etc.), many areas do not. I'm not sure how the CPI-U (CPI for "urban" consumers, which I think is the official CPI used for T-bonds/I-bonds) weights various areas (i.e. since NY has 10 million people, are those local price changes weighted 5x as much as St. Louis, which has 2 million people?)

One last comment - if one were to look at the 'average' family's cost change from one year to the next, consider that many people do upgrade their TVs, computers, etc., because of the technological upgrades, not because of prices (the same computer they have is always getting cheaper - rather than buying a new computer with the same specs, many purchase a better computer for the same - or slightly lower - price). Therefore, they are upgrading based on technological advances and not based on price. This is very similar to an inverse of productivity advances that effect GDP growth. However, given that the productivity advances of computers is something like a 67% annual increase (doubling every 18 months), that would have a huge impact on CPI, even if consumer/business electronics made up just 2%-5% of GDP.

So, part of the problem is the average family's lust for more gadgets, rather than a moderate allocation of income to both savings and expenditures for that new plasma tv. If they were more conservative, then the CPI would be more accurate for them (given that the CPI doesn't fully take into account technological advances).

 

[cute fuzzy bunny]

Thats a tough one, and my first take is that if you cant concretely make an argument for any kind of 'adjustment', you simply dont do it. Or take your concrete stuff and put that in one bucket and make your case for optional adjustments in a well defined 'separate section'.

Talking from the perspective of computers, which I feel ok about addressing

I ran out of excuses for why someone really drew benefit from a faster computer around the 1GHz range. While I can visibly see the difference in overall application start and load times between a 1GHz machine and a 2GHz machine, as a professional in the marketplace I struggled with coming up with a rational argument for a real benefit for users that wouldnt get me laughed at on an analyst tour. Which by the way happened all the time.

If you're converting video formats (mpeg2 to mpeg4), mastering videos from multiple formats or playing the latest twitch FPS games, then something in the 2+GHz range is called for. Excepting those frankly non-mainstream uses a 1GHz machine probably does the trick for most people.

NOW...if you wanted to game this in the CPI to say that a GHz machine is "good enough" and therefore train the number for a computer on the slowest cheapest thing available as "good enough and comparable to the last machine we measured only less expensive"...then you might find me receptive.

But to say that computers are faster today and therefore "better", and that "betterness" translates into some measure of "cheaper", reducing impacts to cpi? Try running that by one of the guys at Forrester, IDC or Dataquest. Or even one of the magazine guys thats desperately trying to believe you so he can go write an article that creates a "buzz".

That as an example makes me ponder CPI with doubt.

Other "adjustments" such as the one that replaces steak with hamburger in "the basket" when steak becomes too expensive? That frankly isnt showing me a measure of inflation, but a reaction by a consumer to inflation when its out of control.

Anyhow, I'll say it again...tips and ibonds arent bad investments. With runaway inflation they'll be good to have. The primary objection I wanted to get across was the "its a 'real' return", implying that buying these instruments almost completely insulates one from the effects of inflation for 20+ years.

It does nothing of the kind.

When sawdust replaces hamburger, and computers are so good they offset a tripling of gas prices, home prices and other costs in the year 2020...maybe it'll become a little more apparent

 

[ak4195]

An interesting side note on TIPS,there was an auction 10 days or so ago.The offering yield has now dropped below 2% something like 1.75% on a 10 yr(dont quote me).Theres a 20yr auction coming up,but i suspect the yield trend may be lower.Kinda thinking that the fed is pricing in a back off of inflation expectations.Of course this only apply's to those who dont live in the real world--ak

 

[rapoole]

Here are the current yields of 10 year TIPS and nominal Treasury Bonds according to Bloomberg:

TIPS: 1.65
Nominal: 4.14

These yields are determined by markets, not "the fed." I find them puzzling.

First, the difference between them is 2.49%. This means that the market "expects" inflation over the next 10 years to average 2.49%. Since inflation was over 3% last year, that seems unrealistically low. So TIPS look like a good deal compared to nominal treasuries.

Second, the real rate of return at 1.65% seems very low. The market is predicting that real returns over the next 10 years will be only 1.65%, a prediction that seems pretty gloomy to me. However, if you believe in efficient markets (as buyers of stock market indexes, most of us have implicitly adopted that theory), then a 1.65% real rate of return seems like a reasonable prediction of where the markets are headed over the next 10 years.

I don't think any of this is gospel, but I think it makes sense to listen to what the markets are telling us.

 

[ak4195]

rapoole,i think your confusing the current yield with the offered yield @ auction.If you look to the left youll see the coupon is 1.62%,even worse than my memory was on the anectdote.Previous issues(10yr)were 2.0% offered.If you notice all the issues listed here are dropping in price.Of course one data point does not a trend make.As a side note,Ive been toying with an idea for some time now,and recently put it into action.With the Us Treasury no longer issuing 30 yr bonds,I wonder if they have disconnected the long end from the rest of the yield curve(not completely of course).So now the long end is more effected by supply/demand,and less effected by inflation expectations(to a point!).To gain exposure to the long end of the curve without buying individual ytm compressed bonds i chose ACG a closed end fund.Another way would be to buy zero coupons which would result in price move only and no yield,so the advantage here is the nice current 8% yield on the fund.There is leverage risks involved and of course inflationary expectations which i think will turn out to be overblown shortly.Except of course for those of us that dont live in the hedonicly adjusted world--ak

 

[rapoole]

AK-

I looked, as you suggested, and Bloomberg says the current yield is 1.65 and the coupon 1.625. I don't think I confused the two, but I stand ready to be enlightened. I didn't follow all of your comments on the long end, but I have noted that the longest maturity TIPS (28 years out as I recall) actually have a lower yield than somewhat shorter (i.e. 25 year) TIPS. I guess that's because of demand at the far end of the yield curve. Suggests to me that Treasury would be smart to reinstate 30 year Treasuries. Of course if SS is privatized and Treasury needs $2 trillion more borrowing, we'll see the 30 back again, and maybe a 40 year bond to boot.

Cheers,
rapoole

 

[ak4195]

HI rapoole,my point is the coupons @ auction are offered less and less,for example last year(oct i think) the coupon was 2.0,this last auction now 1.625,both 10 yr auctions .If you look at a table of TIPS auction offerings and there corresponding coupons,the declining coupons jumps out(least for me).So while the world is crying "Inflation!",and even though WE realize inflation,the Fed does not.And that is really the bottom line.In my mind,by discontinuing the 30 yr auctions,the cost of debt is brought down for the fed.Many longer dated maturities are simply called or rolled over and refinanced at the short(er) end of the curve.If the long end is indeed disconnected from the rest of the curve(rember only to a point) than simple supply/demand will control the market.And since the supply is now finite,and demand is certainly there(look at the secondary market from your broker)then price will.......At some point i will perhaps buy zero coupons 2015 and beyond,since '14 is the end of our ladder.Ive also started lightening up on HY closed end funds last week,and will continue to skim off a bit more and discontinue to reinvest the divvy's.Hope this helps clarify my point.Good luck-ak