TIPS vs. Mutual Fund with TIPS?

[Telly]

I'm not sure if this is the correct Forum to post this in...

I am trying to determine the Pros and Cons of buying TIPS (Treasury Inflation Protected Securities) directly, versus mutual funds whose goal is inflation protection, that are heavily into TIPS. This would be for another asset allocation type, I'm not gonna go overboard with it.

So far I've got:

TIPS directly is lowest cost, versus typically a .25% expense ratio on a mutual fund.

The mutual fund is liquid, compared to holding actual TIPS.

Any and all comments appreciated!

 

[Ted]

As long as the expenses of the particular TIPs mutual fund are low (less than 0.3% per year) with no load, your probable return will be about the same as purchasing TIPs through a broker. The main difference is that by purchasing them directly, you can purchase them with over 20 years to maturity, and thus "lock in" the higher interest rate associated with the longer maturities.

If long-term interest rates in general rise, it will probably be in response to increased inflation. The market value of the long-term TIPs may then fall somewhat, but probably not nearly as much as conventional bonds of equal maturity. In any case, you are guaranteed a particular real rate of return if you hold the TIPs to maturity. The real return that you get from a TIPs mutual fund will be positive over the long term, but not as predictable.

When in doubt, invest in some of each .

 

[Alec]

There is the tax consideratin b/w the ind. bonds and the bond fund if you hold the bonds in a taxable account. The TIPS funds (at least Vanguard's) distribute both the yield and inflation adjustments to the TIPS. The individual TIPS only distribute the yield, and the inflation adjustment is added to the principle of the bond. The IRS taxes both the yield and the inflation adjustment to the TIPS. By holding ind. TIPS, you still have to pay income taxes on the inflation adjustment, even though you can't get that money until you sell the bond or it reaches maturity.

Alec

 

[Ted]

What Alec says about the taxability of the interest and price appreciation on TIPs is true. However, it is not likely to be that much of a problem for people owning individual TIPs if they have a substantial amount (say, $20,000 or more) invested in them.

TIPs are issued in $1,000 denominations and have good liquidity; thus, if a person owns them directly they can sell them individually when they need cash.

As good an investment as TIPs are, I have a strong impression that brokerage firms are not eager to recommend them. Could this be the case because the sales commissions on government securities are not very high?

 

[Telly]

Another TIPS question! This time, on TIPS themselves.

I saw that in the latest treasury auction of 10 Year inflation protected notes (TIPS), that the latest Rate was down to 1.875 and the Yield was 1.999.

Does this mean that the assumed inflation adjustment is 1.999 minus 1.875 = .124 on an annual basis
Or is there a formula that is used to calculate the Yield from the Rate and the assumed inflation adjustment, that I can work backwards from?

And is this on an annualized basis for TIPS? I saw that I-Bonds were done on a 6 month basis.

 

[wzd]

From the treasury page(http://wwws.publicdebt.treas.gov/AI/OFNtebnd):

type: 10-YEAR NOTE
maturity: 07-15-2013
coupon: 1.875
yield: 1.999
price: 98.881
CUSIP: 912828BD1

This means that you pay $98.881 for each $100 of face value of the note. The yield of 1.999 is the yield to maturity. That is the yield given an investment of $98.881, a return of annual coupons, and a return of $100 after 10 years.

I believe there is a yield to maturity formula, which I don't have. However the yield to maturity is basically the sum of two components: The average coupon yield on investment, plus the yield from the increase in 'price'.

So an approximation is: the first year coupon yield on investment is 1.875/98.881 (times 100) or 1.896. For the last year the coupon yield is 1.875/100. Since for later years, the value of the bond goes up, a close approximation is the average of 98.881 (first year) and 100 (last year) or 1.875/((100+98.881)/2) or 1.886. Then the yield from the increase in price is simply (from excel) RATE(100, 98.881, 10) or 0.113. That is, the interest rate needed to get $100 from an initial investment of $98.881 after 10 years. When these two components are added together, you get 1.886+0.113 or 1.999.

This ignores the inflation adjustments, and I believe that is correct.

Maybe someone has the real formulas that are used. The above are an approximation based on my understanding of the bond market.

Wayne

 

[Telly]

Thanks Wayne    I really ran off the track there!  I'm back on with your help!

The publicdebt.treas site could use a little more info on TIPS than what they give.  In contrast, the savings bond site has exellent info on the I-Bonds, including how they work up a composite interest rate, using the bond's interest rate and the inflation adjustment.   I realize the two instruments are different, but the TIPS area needs its user education area expanded.

 

[Ted]

As an enthusiastic advocate of TIPs (together with other, more risky assets) I'd suggest this other Treasury site:
http://www.publicdebt.treas.gov/sec/seciis.htm

To add to Telly's comment about the interest rate on 10-year TIPs.....

The longest maturity that the Treasury is presently offering on new issue TIPs is 10 years, and these are paying about 1.9% plus actual inflation. However, previously issued TIPs with maturities up to about 30 years are readily available on the secondary market, and these are paying about 2.5% plus actual inflation. Unlike buying a used car, these "used" bonds guarantee better long-term performance than the "newer" ones!

Some people in other posts are bemoaning the fact that interest rates on short-term bonds/CDs etc. are so low. They apparently don't appreciate the fact that the only time that interest rates on short-term investments are "high," it is in response to high inflation that keeps the real rate of return near zero (or even negative after income taxes). A real rate of return much higher than that -- without associated risk -- is the financial equivalent of a "free lunch," and there ain't no such thing. TIPs with longer maturities are about the closest thing to a "free lunch" that anyone is likely to find.

Unlike forums in which I argue with people about public policy, I'm happy to have people not agree with me about TIPs, and not invest in them. The relatively modest demand for TIPs is what keeps the interest rate fairly high. I suspect that the demand will increase substantially when inflation increases, and I'm betting my invested money that it will.

(I'm not worried that the few dozen people who read this post will run out and drive down the interest rate on TIPs by buying them.)

 

[wzd]

Ted says"

Some people in other posts are bemoaning the fact that interest rates on short-term bonds/CDs etc. are so low.

I have to agree with those doing the bemoaning.

Looking at the TIPS on the recent auction history web page (http://wwws.publicdebt.treas.gov/AI/OFNtebnd), the yield on bonds issued in 2002 is over 3%. That is the base rate before adding the inflation adjustment. The same is true for I bond's (see http://www.publicdebt.treas.gov/sav/sbirate2.htm).

By the way, when looking at the TIPS info (the entries with an asterisk) and comparing them to standard bonds of similar maturity, it looks like the TIPS are 1 to 1.5% lower than standard bonds - i.e. that is the discount the market applies for the inflation protection.

The rates on this page for older bonds are the rates that were paid to those purchasing the bonds at that auction - not the price you can get them at today. I have not been able to find TIPS on the secondary market available for purchase. If anyone has a good source of info on the bond market, let me know - It seems shrouded in secrecy to me. I can find a few bonds on various brokerage inventory lists, but I don't see any TIPS. I would expect the yield on older ones to be close to the yield on the newer ones, if one were to purchase them on the secondary market, so the older ones are good if you bought them when they were new...

One thought for an investment strategy - Buy I bonds when you feel rates are low. I bonds can be cashed in after 12 months with a 3 month interest penalty, or after 5 years with no penalty. If the TIPS rates go back up it may actually make sense to cash in I bonds, pay the penalty and buy TIPS (or newer I bonds). I bonds appear to have the advantage that one can cash them in for full value, where as TIPS can only be sold on the secondary market (prior to maturity). When rates go up, the price paid on the secondary market goes down. I bonds let you lock in the rate for 30 years, but also let you get out before that. The cost for the flexibilty is that the rate is only 1.1 currently vs. 2 for TIPS.

Wayne

 

[Ted]

A simple fact about bonds in general:

They are not listed on exchanges like stocks are (largely because there are so many more issues; i.e., a company typically has one common stock but may have many separate issues of bonds, as does the U.S. Treasury). However, there is a very active "OTC" market in bonds, and U.S. Treasuries are particularly liquid. All a person needs to do is to deal with a broker, and I would recommend a discount broker who won't try to talk you into buying something that pays them a higher commission than "plain old U.S. Treasuries."

Regarding TIPs in particular:

The thing that matters in deciding whether to purchase TIPs or some other instrument (such as I-Bonds) is the Yield to Maturity (YTM). By law, any broker must tell you what this is on any issue that you are considering. The stated YTM on TIPs DOES NOT INCLUDE ANY INFLATION ADJUSTMENT. That is added at the end of every year, depending on the actual inflation that occurs. So, even though the stated YTM on long-term TIPs is only about 2.5%, the actual return will be that PLUS whatever inflation occurs. So, if inflation for 2003 turns out to be 2%, the par value of the TIPs will be "bumped up" by 2% at the end of 2003, and the total return for 2003 will be 4.5% (plus or minus any changes in market price).

In contrast, the current yield on I-Bonds is typically quoted in a way that INCLUDES the inflation adjustment (which is applied every 6 months). So if the current rate being paid by I-Bonds is 3.5%, it really is not likely to yield as much as TIPs yielding 2.5%. The advantage of I-Bonds is that the tax on their price appreciation is deferred, whereas the interest and inflation adjustment on TIPs is currently taxable unless held in a qualified account.

I think that more people would buy TIPs if they understood them better. But they don"t receive much promotion from brokerage firms because there isn't much commission on them (to the benefit of investors).

 

[Telly]

Thanks for all the info!

I too have been looking at I-Bonds, and beyond the 1 year mark the penalty for redeeming isn't too bad, if new bait in the future should be juicy enough

But the higher base interest rate of the older TIPS is certainly appealing. I may have to look into that. But it would seem that a year or two old TIPS with a significantly higher base rate is going to command a higher price on the resale market, right? So does this all end up in a present-value analysis to try to figure out what a reasonable price would be for a year or two old TIPS? My natural skepticism says I might be taken to the cleaners on that!

 

[Telly]

Somewhere we have a thread that has a list of known TIPS mutual funds. Wherever it is, we can add:

T Rowe Price Inflation Protected, ticker is PRIPX. E/R is .5, fund was just started up in October of 2002, so it's real new.

 

[Ted]

Thanks for all the info!

 But it would seem that a year or two old TIPS with a significantly higher base rate is going to command a higher price on the resale market, right?  So does this all end up in a present-value analysis to try to figure out what a reasonable price would be for a year or two old TIPS?  My natural skepticism says I might be taken to the cleaners on that!

The difference between the market price of the bond and its par value is what makes the YTM different than the "coupon" yield.  Determining the YTM does involve a present value analysis (It's the same as internal rate of return) but this will be done for you by the financial firm brokering the transaction.  They will also tell you the coupon yield.  I said before that this information must be disclosed by law -- more precisely, it's by NASD regulation.

The thing that is different about TIPs than other bonds is that the par value (which is initially $1,000 as it is for other bonds) is increased every year to account for inflation.

For example, the following information for a TIP maturing 4/32 was quoted in today's Wall Street Journal:

Rate (Coupon rate): 3.375    Bid/Asked 115-24/25  Yield (to maturity): 2.593   Accrued Principal: 1035

This means that a person could purchase the bond for the "ask" price of 10 times $115 25/32 ($1157.81), plus a commission or mark-up by their broker.

As of this year, the bond's par value has increased from its initial $1,000 to $1,035 (the accrued principal).  This year's interest payment will thus be the coupon rate, 3.375%, times the accrued principal, or $34.93.  Next year, the accrued principal will increase in proportion to this year's inflation, and next year's interest payment will increase proportionately.  

However, if it assumed that there is no further increase in accrued principal (since future inflation is not yet known) then the interest payments would remain at $34.93 per year, and the yield to the bond's maturity in April 2032 would be 2.593% per year.

About the only way that a person could be moderately "taken to the cleaners" would be to deal with a broker that charged the maximum legal mark-up.  Even that would be relatively insignificant if the person held the bonds for an extended period of years.

Or you can invest in a TIPs mutual fund .