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Author: iamdb Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35272  
Subject: TIPs, Short-Term Bonds or CD Date: 2/21/2003 10:25 AM
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Background:
I have $200,000 to allocate to fixed income investments in a taxable account, about 25% of the portfolio. Each year, an inflation-adjusted $20,000 would be moved into a money management fund to supplement income. I'm considering Vanguard's Inflation-Protect Securities (VIPSX) or Short-Term Bond Index (VBISX) Funds. An alternative would be to put part or all of it into a 5-year bond ladder.

Decision factors:
Sensitivity of NAV to interst rate increases; tax consequences.

Question 1:
If interst rates correlate strongly with inflation, will the inflation adjustment feature of TIPs protect against deflated NAV? That is, if return is adjusted for inflation (increasing interest rates), will the NAV remain relatively constant.

Question 2:
VBISX has a higher current yield than VIPSX, but there is no 5-year data for VIPSX. Is there reason to expect a higher yield from VBISX or a 5-year CD ladder?

Question 3:
I assume any interest or dividend earned each year is fully taxable with VIPSX, VBISX, or a CD ladder. Is that assumption correct? That is, there is no tax consideration in the decision.

Thanks for your advice.
db
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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6428 of 35272
Subject: Re: TIPs, Short-Term Bonds or CD Date: 2/21/2003 11:52 AM
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Maybe I'm the one confused about TIPS Funds, but I don't think so. They aren't any different than other bond funds, specifically treasury funds. If the interest on the bonds goes up, you get a higher interest return, but the fund NAV goes down.

You're right, everything you are talking about in a taxable account has taxable interest: interest on treasuries is not taxable in most (all?) states, so if you have a high state income tax, that might factor in. My calculations suggest currently, at least, the extra taxes on CDs is more than compensated for by higher yields. I suspect this will prove true most of the time because of basic principles of supply and demand and competition: lots of banks and credit unions competing for your savings. Government has a monopoly.

Anyway, you are definitely planning on withdrawing principle, so a capital loss due to a lower NAV matters, which would not be the case if you had so much invested you could live indefinitely off the interest. If interest rates go up when you need the money, you will be looking at a capital loss, and if you aren't continuing to reinvest the dividends, that's not going to help dollar cost average your way out over time (an important fallacy some article pointed out—retirees living off interest income don't get to reinvest dividends to compensate for deflated NAVs).

A TIPS Fund, like any other bond fund, buys and sells bonds. When you sell your shares, the fund has to sell bonds to give you cash (more or less how it works, though an efficiently managed fund won't actually buy and sell on your behavior). So, the TIPS will sell for whatever they are worth at the time. The fact that some of their value is in the inflation component is irrelevant—that will not protect you from market valuations. TIPS will be valued by the market at what they are thought to be worth compared to regular treasuries, combining their fixed component and predicted value of the inflation component. If when you need the money, treasuries are trading at higher yields than now, you can rest assured that TIPS will also be trading at higher yields than TIPS are now.

Now, the Vanguard TIPS fund is classified as a short term fund, so it probably should be compared with the short term treasury fund. I find it hard to believe you will do better than a CD ladder, even if the interest rate risk on a short term fund is lower.

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Author: splotto Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6429 of 35272
Subject: Re: TIPs, Short-Term Bonds or CD Date: 2/21/2003 12:34 PM
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DB:

If it's a taxable account, why not consider a short term muni fund? I know Vanguard offers some for various States.

Splotto

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Author: foobar73 Big red star, 1000 posts Feste Award Nominee! Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6430 of 35272
Subject: Re: TIPs, Short-Term Bonds or CD Date: 2/21/2003 2:34 PM
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Maybe I'm the one confused about TIPS Funds, but I don't think so. They aren't any different than other bond funds, specifically treasury funds. If the interest on the bonds goes up, you get a higher interest return, but the fund NAV goes down.

The point of TIPS is that their interest rates do not behave the same way as most ordinary bonds. If inflation happens to rise to 20% next month, you will see ordinary bond interest rates rise to, say, 23%, but TIPS will still maintain the same yield, say 3%. This is because the adjustment due to inflation is built in to TIPS, so that a 3% TIPS bond is still competitive with a 23% ordinary bond, in an environment with 20% inflation. This means that inflation should never directly affect the yields of TIPS, and hence never directly affect the NAV of a fund which holds TIPS.

On the other hand, inflation may have secondary effects on TIPS. If a large rise in inflation is seen, this may drive more people to buy TIPS, raising their prices. These secondary effects are somewhat unpredictable, though, and certainly of less significance than the manner in which TIPS can avoid the effects of inflation. That is to say, given a large increase in inflation, the loss of NAV in a TIPS fund will be much less than the loss of NAV in an ordinary bond fund.

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Author: PolymerMom Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6433 of 35272
Subject: Re: TIPs, Short-Term Bonds or CD Date: 2/21/2003 10:01 PM
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I was in VIPSX for a while (probaly got out too soon). My main concern is that the current price is too high. I got out when the going price per share was 11.88 ( and apreciated good gains in my 401k). Last time I looked (this afternoon before todays results were posted) it was at 12.80. Don't think this is a good time to enter the fund.

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