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I am thinking of selling my Vanguard Total Bond Market fund, in my IRA, for a TIPS bond. My thinking is that this will keep my bond percentage the same but protect me if and when rates (inflation) ever rise. What do you guys think? I also have a large dollar amount in the Pa Municipal Long Term Fund, in my taxable account. That I don't want to touch, but I just am getting a bit concerned that rates have little downward movement left and I don't want to get whacked completely by a falling bond market. 50% of my portfolio is in indexed (Total Stock Market and EAFE) stocks and 10% in the Vanguard REIT fund. I don't want to change my allocations, just give myself some protection on the bond side.
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daryll40 asks:
I am thinking of selling my Vanguard Total Bond Market fund, in my IRA, for a TIPS bond. My thinking is that this will keep my bond percentage the same but protect me if and when rates (inflation) ever rise. What do you guys think?

It depends on what's your purpose for your fixed income portion of your portfolio. If you want to tread water, go with TIPS. If you want to try and make some money with your FI, stick with the bond fund.

Why don't you do this: sell one-third or one-half of your bond fund and put the procedes into TIPS?

I still think it's difficult to beat the laddered MMF / CD combination for the FI part of your FIRE portfolio.
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Galeno Responds To My Idea of Swapping a Total Bond Market Fund for TIPS It depends on what's your purpose for your fixed income portion of your portfolio. If you want to tread water, go with TIPS. If you want to try and make some money with your FI, stick with the bond fund.

My purpose is to try to make some money, but also NOT TO LOSE money. I guess I just don't see how the bond index fund can do much better than the TIPS since interest rates can only go to ZERO and we ain't too far from there right now. If I bot a 30 year TIPS now, I'd get the 2.5% coupon guaranteed, and if I held to maturity I'd have no risk of deflation causing loss of principal. Am I missing something here?

D40
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D40 wrote:
My purpose is to try to make some money, but also NOT TO LOSE money. I guess I just don't see how the bond index fund can do much better than the TIPS since interest rates can only go to ZERO and we ain't too far from there right now. If I bot a 30 year TIPS now, I'd get the 2.5% coupon guaranteed, and if I held to maturity I'd have no risk of deflation causing loss of principal. Am I missing something here?If I bot a 30 year TIPS now, I'd get the 2.5% coupon guaranteed, and if I held to maturity I'd have no risk of deflation causing loss of principal. Am I missing something here?

Is the deflation a typo?

Technically, interest rates can only go to zero. But deflation can go below zero (see Japan). During periods of deflation, if you put your cash under your bed in a box, it will be worth more at the end of the year by the amount of the deflation rate because you can buy more bread with the same dollar.

I think you're assuming too much that we are about to go into an inflationary cycle. We may and then again we may not; we may see a long and protracted deflationary period. Who knows? IMHO, you are doing "market timing" with your FI portfolio.

The purpose of my 25% (six years of living expenses) in FI is to serve as a buffer to smooth out my annual monthly income which is driven by selling 4% of the value of my stock portfolio and buying a new 2y CD with the procedes. I don't go further out than a 2y CD.

At the begining of the year, my 25% in FI looks like this:
8% in MMF
8% in 2y CDs maturing in 1 year
8% in 2y CDs maturing in 2 years

I still believe that using the above structure (2 years of living expenses in the MMF) keeps me protected from unexpected expenses AND more than keeps up with inflation (and if there's deflation I'm making serious money). But most of all, it serves as a great retirement income buffer by smoothing out my annual monthly draws.
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No, the term DEFLATIONARY was not a typo. My point was that TIPS are required to pay at least face value at maturity, as I understand it, so if you hold till maturity there is no risk of getting less principal back due to DEFLATION.

I tend to agree with you that inflation is probably NOT right around the corner, and rates could stay this low for a long time. But it just seems that at least a portion of long term fixed income fund would be best positioned in this environment in TIPS.
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D40 wrote:
No, the term DEFLATIONARY was not a typo. My point was that TIPS are required to pay at least face value at maturity, as I understand it, so if you hold till maturity there is no risk of getting less principal back due to DEFLATION.

I tend to agree with you that inflation is probably NOT right around the corner, and rates could stay this low for a long time. But it just seems that at least a portion of long term fixed income fund would be best positioned in this environment in TIPS.


I was hoping that it was a typo. That it's not means you don't understand the concept. In fact, you are looking at it backwards.

If you are to receive $100 in the future in a DEFLATIONARY economy, that future $100 will buy MORE goods and services in the future (future prices of goods and services will have gone DOWN). The value of your $100 will have gone UP.

If you are to receive $100 in the future in a INFLATIONARY economy, that future $100 will buy LESS goods and services (future prices of goods and services will have gone UP). The value of your $100 will have gone DOWN.

If you are to receive $100 in the FUTURE and interest rates go UP, the PRESENT value of that future $100 will go DOWN.

If you are to receive $100 in the FUTURE and interest rates go DOWN, the PRESENT value of that future $100 will go UP.

The longer the term of maturity of that $100, the more sensitive its PRESENT value is to changes in interest rates.

Do you get it?
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I thought I got it before...but I am not sure. Yes, I understand that a dollar today is worth MORE today if inflation exists in the future. And a dollar today is worth LESS today if we have deflation going forward.

My concern is that if inflation goes up, even just from under 2% to 3% or 4%, "conventional" bonds will go down in value as interest rates rise because investors will demand more to compensate them for that inflation. But TIPS, on the other hand, should stay relatively stable (no? yes?) since the inflation adjustment makes this a non-issue.
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I personally think bond funds (not bonds) are a little risky right now. As interest rates rise, the price of the bond will drop which means you might have to hold the bond until maturity to avoid selling at a loss. Frex if you buy a five-year bond now when interest rates are low and think about selling it three years from now in a time when interest rates are presumably higher, it may be unattractive and you have to hold the bond to maturity to avoid taking a loss.

But a share in a bond fund never matures, as interest rates rise the return of the bond fund will rise, but the share price (NAV) of the fund will drop. But because it's a fund, you can't hold a share to maturity because there is no maturity and can't sell without taking a loss.

Since we're at a time of historically low interst rates, I think it's reasonable that interest rates will be higher in the future than now, meaning bond funds (not bonds) are unattractive. That's just a SWAG though.

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Sykesix Writes personally think bond funds (not bonds) are a little risky right now. As interest rates rise, the price of the bond will drop which means you might have to hold the bond until maturity to avoid selling at a loss. Frex if you buy a five-year bond now when interest rates are low and think about selling it three years from now in a time when interest rates are presumably higher, it may be unattractive and you have to hold the bond to maturity to avoid taking a loss.

But a share in a bond fund never matures, as interest rates rise the return of the bond fund will rise, but the share price (NAV) of the fund will drop. But because it's a fund, you can't hold a share to maturity because there is no maturity and can't sell without taking a loss.

Since we're at a time of historically low interst rates, I think it's reasonable that interest rates will be higher in the future than now, meaning bond funds (not bonds) are unattractive. That's just a SWAG though.


Sykesix,

Your point is a "bonds vs bond funds" argument. My question was TIPS vs fixed interest rate bonds.

I agree with your statement...for people who will need to sell a 5 year bond in 3 years. For people like me with PERMANENT (meaning I'll never ever sell the principal unless of dire emergency) bond allocation, there is no difference other than the fees incurred in the bond fund. And if you use a low cost index bond fund, you can even argue that those fees are comparable to the spread you have to pay when buying individual bonds. Bottom line is that if interest rates rise, both a portfolio of individual bonds will drop in value as will a bond fund. As long as you are a long term investor with no fixed date where you need the principal, it's the same thing...with less hassle and perhaps better bond selection in the fund.












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I agree with your statement...for people who will need to sell a 5 year bond in 3 years. For people like me with PERMANENT (meaning I'll never ever sell the principal unless of dire emergency) bond allocation, there is no difference other than the fees incurred in the bond fund.

That might not be true though, you can actually lose some of the principle in a bond fund, because the share price can drop if interest rates rise.

Maybe not you in particular, but someone I'm sure needs to sell some of their bonds/bond funds occasionally to rebalance or take withdrawls. Just something to take into consideration.



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Sykesix WritesThat might not be true though, you can actually lose some of the principle in a bond fund, because the share price can drop if interest rates rise.

Maybe not you in particular, but someone I'm sure needs to sell some of their bonds/bond funds occasionally to rebalance or take withdrawls. Just something to take into consideration.


For someone who is doing a permanent fixed income portfolio, it's the same thing. The bond fund reinvests called and matured bonds for you while the individual investor has to do it for himself. As long as the individual investor actually does this, the comparison is the same.

EXAMPLE:

A. I invest $100,000 in the Vanguard Total Bond Market fund today. The duration might be 7 years. Interest rates rise over 5 years and at the end of 5 years my fund might be worth $90,000. I received coupon payments equal to example B so I am ignoring them for this example.


B. You invest $100,000 in a portfolio of bonds with a duration of 7 years. As some of those bonds mature, you reinvest so that the duration stays the same...7 years. Your coupon interest payments received is the same as example A so I am ignoring them for this example. At the end of 7 years, your individual bonds are only worth $90,000.

I think you are confusing the concept of a fixed maturity date (5 years) with the concept of a permanent fixed income portfolio.

Daryll40









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Here's another example comparing apples and oranges...which is what I think you are doing:

I invest $100,000 in a bond fund and interest rates rise because inflation rises. At the end of 5 years, my fund is worth only $90,000.

You, on the other hand, invest $100,000 in a 5 year bond. At the end of 5 years, you get your $100,000 back while I only got back $90,000. The difference is that my fund kept reinvesting matured/called bonds along the way at higher interest rates. So my higher interest received plus my $90,000 at the end should (assuming all other aspects are equal) be the same as your lower interest plus your $100,000. But you THINK you are ahead of the game because you got your $100,000 back as a lump sum while I got some of mine back in the form of higher interest.
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I am thinking of selling my Vanguard Total Bond Market fund, in my IRA, for a TIPS bond. My thinking is that this will keep my bond percentage the same but protect me if and when rates (inflation) ever rise. What do you guys think?

I think that, absent any limitations I am not aware of, this is probably a good move - although something directly interest-rate indexed might be a better choice than something inflation-indexed.

There is, as you note, very little downside room on interest rates, but there is a LOT of upside room. It is extremely likely that, as the global economy turns more solidly up, interest rates will increase, which is bad news for people holding fixed-rate bonds - or bond funds.

In my opinion you are slightly underweighted in stocks (assuming that the two bond funds you name account for the remaining 40% of your portfolio), but MY opinion isn't what determines whether YOU can sleep comfortably.
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I personally think bond funds (not bonds) are a little risky right now.

There's another factor. If you have $1000 to invest in US government notes, or $10K put in investment-grade munis or commercial bonds, you should seriously consider bypassing the bond funds and purchasing individual bonds directly.

* If the value of a bond declines, you can choose to suffer the capital loss, or to hold to maturity. But if the value of the collection of bonds in your bond fund declines, the fund manager makes that choice.

* If the value of a bond increases, you can choose to take the capital gain if it makes tax sense to you. But if the value of the collection of bonds in your bond fund increases, the fund manager can choose to take the capital gain if it makes him and his fund look good.

* A $30 commission on a $1K bond held for 20 years is $30. A 0.3% expense ratio on a $1K bond-fund investment held for 20 years, assuming you withdraw all the intervening interest payments, is $60. That $60 has to come from somewhere; either it decreases your $1000 principle to $940, or it decreases the interest you receive.
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