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Author: trptrade Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35345  
Subject: Re: 5 year fund vipsx and vfstx? Date: 12/22/2009 12:41 PM
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I disagree with this, or at least put the emphasis on NO GRARANTEE, especially for the projected term (3 to 5 years).

I thought my second paragraph did a decent job of honing that point.

Rates of inflation and interest rates on treasuries do not walk arm in arm.

Of course not, but he's not investing for maximum return, he's saving in a way to try to protect himself against inflation for a specific project. By investing in traditional bonds (Strips, zeros, whatever), he bears the risk of being incorrect based on today's perceived inflation vs. what really happens. Swapping to TIPS trades that risk to the government in exchange for any error in the CPI-U vs. inflation in his specific segment (home upgrade). Investing in TIPS seems like a reasonable trade for that situation.

There are then additional risks of being in a TIPS bond fund, which means you are relying on the required real rate of return to not change significantly.

But my best reccommendation now is to stick with direct ownership of a bond, zero or coupon.

Part of the point here is to get cheezyches to the point of understanding the risk tradeoffs - because that's what is going on. There is NO risk free investment.

I don't think bonds, zeros, or CDs are a bad decision.

If the bonds are TIPS, it deserves reiteration of the "distortion" point in case someone chooses to go down that path and uses TIPS. TIPS purchased on the secondary market (vs. auction from the treasury) and held to maturity may lose principal value if deflation occurs. This is a risk you take on when you buy TIPS on the secondary market which does not exist if they are purchased at auction. It is up to you as to whether you feel this is a practical risk or a theoretical one. (That discussion is getting into Master's thesis territory, IMHO)

The point would be that doing the research to understand what the principal correction (aka index ratio) is on the bond is important. A TIPS issued in 2001 is riskier than a TIPS issued in 2008.

Specifically, this TIPS:
http://www.treasurydirect.gov/instit/annceresult/tipscpi/201...
is riskier than this one:
http://www.treasurydirect.gov/instit/annceresult/tipscpi/201...

You can see the "index ratio" in the last column (the bond is guaranteed to pay at 100).

So let's summarize:

FDIC insured CD:
- 100% principal guaranteed (give or take FDIC limits and the time it may take to get your check if the bank goes under and isn't subsumed into another institution)
- You bear inflation risk in the form opportunity cost... in that the current payment may not keep up with inflation (you are at risk in a high-inflation scenario)

Treasury Zero/Strip/Bond (non-TIP) *that matures on or before the date when you will do the project*:
- 100% principal guaranteed
- You may incur fees depending on the broker that you use to purchase the products (you can avoid these with certain brokers or by buying directly from TreasuryDirect)
- You bear inflation risk in the form opportunity cost... in that the current payment may not keep up with inflation (you are at risk in a high-inflation scenario)

Treasury Zero/Strip/Bond (non-TIP) that matures *after* the date when you will do the project:
- You bear inflation risk in the form opportunity cost... in that the current payment may not keep up with inflation (you are at risk in a high-inflation scenario)
- You bear interest rate risk in the form that the current price may be above or below par value at the date you need to sell to complete your project. It will be below par in higher interest rate environments, and above in lower interest rate environments (you are at risk in a high-inflation scenario and receive a benefit in a lower-inflation scenario)
- You bear interest rate risk in the form of changes to required rate of real return. The current price may be above or below par value at the date you need to sell to complete your project. It will be below par in higher interest rate environments, and above in lower interest rate environments (you are at risk in a high-inflation scenario and receive a benefit in a lower-inflation scenario)

TIPS that matures on or before the date when you will do the project:
- 100% principal guaranteed if purchased at auction or index ratio <= 100
- You bear inflation risk in the form of CPI-U accuracy... in that the current payment based on the CPI-U may not keep up with (or may be higher than) inflation in the home upgrade segment of the economy (if home repair rises faster than CPI-U you are at risk, if home repair rises slower, you receive a benefit)
- You bear inflation risk in the form of CPI-U deflation risk. TIPS purchased on the secondary market (vs. auction from the treasury) and held to maturity may lose principal value if deflation occurs, as their index ratio is above 100, and the bond is only guaranteed to pay 100 at maturity

TIPS that matures *after* the date when you will do the project:
- You bear inflation risk in the form of CPI-U accuracy... in that the current payment based on the CPI-U may not keep up with (or may be higher than) inflation in the home upgrade segment of the economy (if home repair rises faster than CPI-U you are at risk, if home repair rises slower, you receive a benefit)
- You bear inflation risk in the form of CPI-U deflation risk. TIPS purchased on the secondary market (vs. auction from the treasury) and held to maturity may lose principal value if deflation occurs, as their index ratio is above 100, and the bond is only guaranteed to pay 100 at maturity
- You bear interest rate risk in the form of changes to required rate of real return. The current price may be above or below par value at the date you need to sell to complete your project. It will be below par in higher interest rate environments, and above in lower interest rate environments (you are at risk in a high-inflation scenario and receive a benefit in a lower-inflation scenario)

Above and beyond those there are additional costs (fees) and risks that are present when investing in a fund rather than individual bonds/CDs/etc. I discussed that in a previous post:
http://boards.fool.com/Message.asp?mid=28140978


Overall:
- Purchasing anything with a maturity after your project involves risks that you may perceive as investing rather than saving. This is magnified in a normal bond, but is still present in TIPS. Personally, I highly advise against purchasing any individual bonds/CDs/etc that mature after you plan to do your project. It's too risky due to potential NAV changes.
- You need to think about whether you are more comfortable protecting against a high inflation scenario (buy TIPS because they protect against real inflation because the market's current perceived inflation is very low) or a deflation scenario (buy CDs/zeros/strips because TIPS have risk of losing principal due to index ratios over 100). In a constant environment, it's theoretically immaterial either way (in practice there will be pricing differences in the market that you could optimize if you really felt the Master's thesis level analysis was important)

Tom
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