TIPS in your bond allocation?

[dfw_pilot]

In a recent post, WCI said something that really caught my attention:

“[TIPS] are bonds whose value is indexed to inflation. This is one of my favorite funds and one I’ve owned for years.”

That sentence deserves its own blog post and I would love to read an elaboration on that point.

 

As a newbie, I've read every blog post by WCI, POF, & TFB. I can't get enough of this stuff and owe these gents a debt of gratitude. My mistake was to buy some TIPS [VIPSX] in my Roth prior to hammering out an IPS. I now have to work backwards and figure out where they fit, if at all.

Opinions on TIPS are all over the place, especially at Bogleheads. I was initially drawn to them for diversification and because guys like Jim and Harry seem to like them, but I'm leaning more toward the simplicity of VBTLX. Further simplicity isn't always a good thing, but I do love the idea of the Three-Fund portfolio.

Bernstein seems to suggest owning a lot of them closer to retirement, Harry's Cascading Asset Allocation® suggests 50/50 with nominals, and our very own WCI has 10%.

While they only protect investors against unexpected inflation on the percentage they own in their portfolio, maybe there is more than meets the eye? Why do you invest in them or why do you avoid them?

 

Thanks.

[jz]

Great topic  I anguished over myself.  Especially relevant during these years of scant inflation.

I understand two strategies for inflation:  1) TIPS or Series I bonds, and 2) high ratio of stocks/bonds. During the decades of high inflation, stocks barely eked out inflation-adjusted gains; bonds never kept up with inflation. **

I am on the verge of retirement.  I keep them in my taxable account as a quasi-cash-equivalent,  available during a bear market. They will also provide psychological balm during inflation years. I understand the tax inefficiencies of paying cap gains on phantom dividends, at high marginal tax rates.  However, I will soon be in a lower marginal tax bracket in retirement .

**I'm referencing Ben Carlson at A Wealth of Common Sense blog.

 

[dfw_pilot]

Crixus, I tend to agree that there may be errors between the CPI numbers used to determine TIPS increases vs real-world inflation numbers that would affect my own spending. That's a bit over my head, though.

jz, I also tend to agree, that long term inflation premium built into stocks may be better than the increased complexity of splitting a bit of my bond portfolio into TIPS.

Does anyone else here have TIPS fund in the FI part of their portfolio? Is there anyone else who would claim TIPS are one of their favorite funds? Does anyone buy individual TIPS instead of using a fund?

I think I'm leaning toward just using a total bond fund.

[docnews]

I was wondering as well if others used I bonds and/or TIPS. I like the idea of saved money and it's value never going away, especially for an emergency fund. Has anyone paired these nearly no risk bonds with high risk stock as their total investment plan? I feel like you can never be sure that bond funds won't hold junk that will just follow the market and/or increase risk. Does that make any sense?

[Michael George]

If you strongly want to own U.S. Government Bonds, then I believe you are better off owning Intermediate Treasuries instead of TIPS.

A few main points

1) CPI is a very skewed index, thus the gain in TIPS is not attractive.

In the last 26 years (Since 1991) the highest annual rate for the CPI was 4.1% in 2007.  The lowest rate was 0.1% in 2008.  Over the last 10 years, the average CPI has been 1.82%.

Except for a gallon of gasoline, I can’t think of one item that I purchase that has only gone up 1.82% per year for the last 10 years.

Food, Clothes, Utilities, Cars, Insurance, Property Tax, Education, etc.

Not to mention the elephant in the room – Health Insurance.  Health Insurance is a line item in the calculation of the CPI that gives it an index weight of less than 1%.  (It sure would be nice if your health insurance was less than 1% of your income)

2) U.S. Treasuries are better to own during a bearish stock market.

The ‘Flight to Quality’ still resides with U.S. Treasuries.  In 2008, the Vanguard Intermediate Term Treasury Fund was up 13.49%.  The Vanguard TIP fund was down 2.78%

3) If you need income – Treasuries are better.

TIPs pay a low interest rate.  The design of TIPs is that the value of the TIP goes up every year based on the rate of the CPI.  At the last TIP auction, the interest rate on the 10 year TIP was 0.375%.

If you need or desire income, then you should be looking to incorporate corporate bonds into your portfolio of U.S. Treasuries (or TIPs).

However, if your objective to to combat inflation, then you need to own equities. 

[VagabondMD]

I have always viewed TIPS as an optional asset class. I have a position in my retirement plan that was built in by an advisor. While I have not sold it, I have not added to it either, and it becomes a smaller fraction of my overall bond position over time.

[dfw_pilot]

Thanks for the comments. I tend to agree.

It seems like Bernstein and others are bigger fans of TIPS ladders instead of funds, and suggest them for nearing or in retirement, when the game is won. I'm going to move my small sum of VIPSX into my bond fund.

[Hank]

TIPS, laddered CDs, or some other cash-like product has a role just before retirement, albeit a small role.

James Cloonan with the American Association of Individual Investors (AAII) makes a pretty good case for a near-retiree to keep 2-5 years worth of living expenses in "safe" investments, then investing the rest 100% in equities.  You should cover the difference between your guaranteed sources of income versus your needs, then pick an amount of two to five years based on your risk tolerance.

As an example, suppose your mortgage is paid off and you have needs of $50K per year to pay for food, utilities, property taxes, insurance, etc.  Suppose you also have a modest pension of 20K per year.  Thus you would set aside $30K per year times 2-5 years for a "safe" investment stash of $60-150K and invest the rest in equities for a 40+ year retirement as well as investing for generational wealth for your heirs.  Each year you replace the safe investments that you used in the prior year.

My wife and I are shooting for four years of needs in safe investments.  Accurately differentiating between needs and wants and minimizing fixed expenses makes this a bit easier.  Paying off the mortgage and not owing anything for your kids' college makes it easier to have lower needs to cover in early retirement.