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Author: xcskier One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35272  
Subject: Re: TIPS funds vs straight bond funds Date: 1/22/2005 1:25 PM
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lokicious: I'm back, have thought about your post. In general, I understand/agree. Couple of minor clarifications:

>If I buy a $1000 10-year TIPS with a 1.5% coupon (and the expectation >of an average of 2.5% annual inflation, to make it equivaent to a 4% T->bill), I get $15 each year, with the inflation adjustment being added >to the original $1000. If I hold the TIPS until maturity, I get back >$1000 plus the inflation adjustment.

Never having purchased a TIPS bond myself, I wasn't aware--but suspected--that the coupon rate differs from that of the comparable-maturity straight bond. That would help to explain the lack of correlation between the inflation rate and the returns of the two kinds of funds. However, my understanding from TIPS "courses" at different websites is that the principal value is adjusted for inflation at each coupon payment, ie, the coupon payments will vary. This is at the heart of my hypothesis: the difference in performance should show up each year, not just at maturity. (In addition to the coupons, the final face-value itself will also be higher if inflation has been positive, but cannot be lower, at maturity.)

>If I sell the TIPS before maturity, that's where stuff gets dicey. >Ignoring the accumulated inflation adjustments, you would sell the >TIPS at a premium or discount based on the prevailing coupon (fixed >rate) and the years left till maturity.

Do you know if fund managers commonly sell before maturity, attempting to use their judgement throughout the year to improve fund performance? Or only if forced to do so when investors withdraw from the fund?

Finally, it begins to occur to me that most of my concern here about risk would be met if I simply purchase the TIPS bond and not a TIPS fund. That concern was the lack of consistent difference between TIPS funds and straight-bond funds dependant on the rate of inflation. To be sure, I'd still have to correctly predict the near-future direction of inflation--this is because of the recurring effect on coupon payments throughout the life of the bond, ie, those payments could actually decrease during deflationary times from what I expect when I buy the bond. But I'd feel more comfortable making that prediction, than trying to decide which kind of bond fund to purchase.
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