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Interesting column from CBS MarketWatch.

http://www.marketwatch.com/story/tips-the-latest-big-steal-2...

Some investment losses are unavoidable, but not this one. This one is a lock. Just take some money from your pocket and throw it away. In football terms, this isn’t playing defense. This is taking a safety. Give up points.

Tom Atteberry, manager of the FPA New Income /quotes/comstock/10r!fpnix FPNIX 0.00% bond fund, thinks it’s absurd. “I struggle with why someone would accept a negative real return on their money,” he told me. “If you look at history, owning a 5-year Treasury, my real return should be somewhere in the 2% to 2.5% range.”

The real story on TIPS may be even worse. “That real yield is based on a manipulated statistic, the CPI,” according to Josh Strauss, co-manager of the Appleseed Fund /quotes/comstock/10r!applx APPLX -1.39% . For most people, day-to-day costs are rising faster than the official Consumer Price Index.

</snip>


intercst
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At the current low interest rates, for any fixed rate investment, TIPS may be the "least bad choice" for someone needing fixed rate exposure.

The biggest unknown is what future inflation will be and right now the spread between a five year treasury at 1.86% and a five year TIPS at -0.46% is 2.32%

http://www.bloomberg.com/markets/rates-bonds/government-bond...


Given that the March CPI number was 2.7% and that the last few months have been running about half a percent a month, then pricing TIPS for 2.32% inflation seems pretty low. I would suspect that is low because the Fed has been buying so many bonds with the quantative easing

http://www.bls.gov/news.release/cpi.nr0.htm


It is hard to get excited about TIPS at this price but it makes sense.


Greg
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"Least bad" -- I agree.

Tell me where else you want to park funds. Money Markets? Worse.

If you read Mauldin and Hussman regarding valuation -- not there.

Dividends Stocks -- better, but what if you might need the capital?
REITS -- What might happen to leveraged investments and perhaps again the risk of deleveraging?
Gold -- nope
Even international TIPS have worries.

So IMO TIPS can be a hedge on your investments, if you're willing to lose less, and treat them as a place to "keep your powder dry."

Other options???

Hockeypop
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I pretty much lost interest in TIPS after I heard a commentator who I respect call them "double-taxes government bonds".

IMHO TIPS are a complex instrument, what with one component being straight interest and another being a change in the principal amount. One thing I have learned over the years is that when you are presented with a financial instruent/transaction is complex----you are about to get screwed. Especially when the papers are drawn up by the counterparty. More especially when the counterparty is the one who gets to determine the details of what happens inside the transaction in the future.

"1) the annual increase in principal value will be taxable income but the increase won’t be paid to you until the TIPS matures. If inflation is high enough then your annual taxes might approach or even exceed the interest payments.
2) TIPS inflation changes are based on CPI changes which might not be accurate."

I have also figured out that when the popular press starts going ga-ga about some particular investment issue----that they are dead wrong and those who subsequently jump in stand to lose big-time.

Have also learned that when some investment is presented to you as "protection" against inflation, market losses, etc. that while you are being "protected" from one thing, the sponsor is busily picking your pocket. Ex: Indexed Annuities.
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TIPS should rarely be owned outside of a retirment account because of the way they are taxed.

In a deductable retirment account like an IRA, if the person is in a lower tax bracket when they retire, then the inflation adjustment is taxed less and is actually a bounus since they were able to take a tax deduction at a higher rate. For example if someone is on a 25% tax bracket when they are working and makes a $1000 deductalbe contribution, the tax break is worth $250 (1000 * 25% ) When they are retired many years from now if the inflation factor is 10X then the principal part of the TIPS would be worth ten times as much or $10,000. If they are in the 15% tax bracket the taxes on this would be $1500, which leaves them with a thousand (inflated) dollars more to spend because of the lower tax rate.

I don't have a link handy, but by its very nature the CPI is a measure of inflation for some "average" counsumer. A persons personal inflation rate based on what they astually spend their money on would be different for most people. Some studies have indicated that the CPI actually overstates inflation for many peoples personal inflation rate, expecially for retired people that own their own house, are covered by medicare, and spend less on gas because they don't commute.


Greg
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Watty56 writes,

Some studies have indicated that the CPI actually overstates inflation for many peoples personal inflation rate, expecially for retired people that own their own house, are covered by medicare, and spend less on gas because they don't commute.

The Bureau of Labor Statistics has been specifically tracking inflation for those 62 years of age and older since 1987. Because of the catastrophic rise in medical costs, inflation for seniors is much higher than the "normal" CPI-U.

http://www.bls.gov/opub/mlr/2008/04/art2exc.htm

intercst
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Here's a more recent article discussing the affect of medical inflation on retirees.

http://www.smartmoney.com/personal-finance/retirement/social...

A recent study by researchers at Stanford University looked at the amount of Social Security benefits seniors retain after paying out-of-pocket medical costs. For the average man born in 1918 who began collecting Social Security benefits in 1983 (at age 65), payments net of medical expenses rose from an initial $542 a month to $867 a month by the end of 2007. If his net payments had kept up with inflation for non-medical goods, he would have had $1,081 in net payments that year. Even though the gross income was rising, health-care inflation effectively cut his benefits. Were payments indexed to the CPI-E, the researchers found, the same man would have collected payments net of medical bills of $957 in 2007, easing but not quite eliminating the cost-of-living squeeze.

</snip>


intercst
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Rayvt writes,

I pretty much lost interest in TIPS after I heard a commentator who I respect call them "double-taxes government bonds".

Sounds like the commentator is bad at math. He certainly isn't someone I'd be taking financial advice from.

There is no "double taxation" on TIPS. There is a problem on the timing of taxation (as you've explained in your post) if you hold TIPS outside of an IRA/401k. That's why most people only hold TIPS in tax-protected accounts.

intercst
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"double-taxed government bonds"...
Sounds like the commentator is bad at math. He certainly isn't someone I'd be taking financial advice from.

There is no "double taxation" on TIPS. There is a problem on the timing of taxation (as you've explained in your post) if you hold TIPS outside of an IRA/401k.


I think he called them double taxed because you pay taxes in the interest and also taxes on the principal value increase. But the principal value increase is just the adjustment form inflation, yes? So in addition to 2 tax components, one of the components is not really a "profit" at all, it's just an adjustment for inflation.

But then I wonder, what happens if there is high inflation one year and identical negative inflation the next year? Does it work like gains/losses in stocks? When you get a gain in one year you pay income tax on the entire gain, but if you have an equal sized loss the nest year you can only deduce $3000 of the loss. But if you already have a large carry-over loss you don't get to deduct anything extra, it just gets added to the carry-forward.

A very real concern w/r/t TIPS, but I've never run across any article that talks about this.

... That's why most people only hold TIPS in tax-protected accounts.
For me, TIPS fall in the category of "If it's not worth doing, it's not worth doing well." It seems much easier and simpler to protect my fixed-income asset class by buying plain old ("old" as in: has worked the same way for hundreds of years) 3/5/7 year term bonds & bills. And I don't have to worry about paying taxes on phantom income.

Another handy rule-of-thumb I have: If Money Magazine and/or SmartMoney say to do something, you are probably better off by doing the exact opposite.
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Well, you still haven't addressed where to "park" money in tax-deferred accounts.

* Money market's pay very little;

* ST Treasuries or Fed paper about .5 to .75%

* TIPS about 2.3% (4.5% in a Vanguard fund YTD) plus some guaranteed increase. That's better than a lot of intermediate term bonds, and not a bad place to take money off the table in today's IMO overvalued market.

Hockeypop
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Well, you still haven't addressed where to "park" money in tax-deferred accounts.

When it comes to parking money I've always thought that Wil Rogers had it right. "I am not so much concerned with the return on capital as I am with the return of capital."

If you are parking money for only a short while (waiting for an good investment opportunity to come along), then you are not going to collect much interest anyway, so there's no reason to reach for yield. In fact, since TIPS pay interest at six month intervals, it is quite possible that you'll collect NO interest for a short-term park.

If the money is "parked" as part of your asset allocation, then intermediate-term bonds (perhaps something like BND or VBTLX) seems like the sweet spot to me. Simple, straightforward, and doesn't have a complex component (like TIPS do) that is new and hasn't stood the test of time.
As I said before, when you buy something that is touted to "protect you against inflation/market crash, etc." it usually means that you are going to get screwed. I've seen too many "100% safe" things auger into the ground.
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hockeypop asks,

Well, you still haven't addressed where to "park" money in tax-deferred accounts.

I have my cash (about 10 year's worth of living expenses) in the Vanguard Short-term Bond Fund (VFSTX) with a 3-year average maturity. The TIPS fund (VIPSX) has a 9 year average maturity -- that's way too risky in an environment where interest rates are likely to rise once the Fed ends QE2.

intercst
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...The Bureau of Labor Statistics has been specifically tracking inflation for those 62 years of age and older since 1987. Because of the catastrophic rise in medical costs, inflation for seniors is much higher than the "normal" CPI-U.

http://www.bls.gov/opub/mlr/2008/04/art2exc.htm...


Thanks for catching that, I must have mis-remembered it. I looked into it some more and I think what I was remembering was how the CPI index uses a factor called, "Owners' equivalent rent of primary residence" to adjust for inflation based on what a person's house would rent for even though they might own it free and clear. For a person who owns a house, what a similar house would rent for doesn't really make a lot of difference since their "rent" is zero except for home maintenance.


... Here's a more recent article discussing the affect of medical inflation on retirees.

http://www.smartmoney.com/personal-finance/retirement/social......

A recent study by researchers at Stanford University looked at the amount of Social Security benefits seniors retain after paying out-of-pocket medical costs. For the average man born in 1918 who began collecting Social Security benefits in 1983 (at age 65), payments net of medical expenses rose from an initial $542 a month to $867 a month by the end of 2007. If his net payments had kept up with inflation for non-medical goods, he would have had $1,081 in net payments that year. Even though the gross income was rising, health-care inflation effectively cut his benefits. Were payments indexed to the CPI-E, the researchers found, the same man would have collected payments net of medical bills of $957 in 2007, easing but not quite eliminating the cost-of-living squeeze.


If I understand this correctly then it is basically saying that the social security payments have not risen enough to cover all the increases in medical costs. The example seems to assume that there is no other income other then social security. Wouldn't a more reasonable example be that social security is say one half (or less) of a person's retirement income? If that is true then for social security to keep up with inflation proportionally, then the social security increases would only need to cover one half of the medical cost increases.

Greg
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Watty56 asks,

If I understand this correctly then it is basically saying that the social security payments have not risen enough to cover all the increases in medical costs. The example seems to assume that there is no other income other then social security. Wouldn't a more reasonable example be that social security is say one half (or less) of a person's retirement income? If that is true then for social security to keep up with inflation proportionally, then the social security increases would only need to cover one half of the medical cost increases.

</snip>


Depends on who you are. For a lot of people their Social Security benefit makes up the bulk of their retirement income. I remember seeing a breakdown of sources of retirement funding (i.e. SS, pension, savings, etc.) I'll see if I can find it.

intercst
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You make a good point about the average maturity. However, comparing five year maturities, this from Swedroe:

http://moneywatch.bnet.com/investing/blog/wise-investing/why...

the question Arends should have asked is: “What is the yield on alternative investments — nominal fixed income investments of similar credit quality?”

At the close on Friday, five-year TIPS had a yield of -0.46 percent. The current consensus five-year inflation forecast of professional economists is 2.1 percent. Thus the expected nominal return is 1.64 percent. With five-year nominal Treasury bonds yielding 1.86 percent, the expected real return on these bonds is -0.24. So while these bonds aren’t guaranteed to provide a negative real return, the expectation is that they will. And what’s worse, if inflation is just 0.22 percent higher than expected, they’ll provide a lower real return than the five-year TIPS. Thus, investors in TIPS are only paying an insurance premium of 0.22 percent to protect against the risk of unexpected inflation. That seems a relatively cheap price to pay in light of all the concerns investors have about this risk (concerns that have fueled the rise in the price of gold).

Here’s another example. Five-year high-quality municipal bonds currently have a yield of about 1.45 percent, well below the expected inflation rate. So it isn’t TIPS alone that have expected real returns less than the inflation rate. Arends is suggesting that all investors in short- to intermediate-term bonds are nuts. The alternative answer seems far more likely.


Hockeypop
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Sorry, I meant to add an alternative to 8 year duration TIPS in STIP (the iShares short-term 0-5 year TIP fun):

http://us.ishares.com/product_info/fund/overview/STIP.htm?fu...

Scroll down to duration and yield. Again, best in a tax-deferred account.

Hockeypop
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Depends on who you are. For a lot of people their Social Security benefit makes up the bulk of their retirement income.

FWIW, a number of our (also retired) neighbors are in the position of: "If Fred/Mary (their spouse) dies, I'll have a very difficult time when their SS check stops. We need both of our SS checks to get by." My wife reports that when the women's group gets into this discussion, a number (a significant number, but not the majority) of the women nod in agreement and chime in, but most of the women stay silent.
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