TIPS for cash component?

Discussion of the Cash portion of the Permanent Portfolio

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SmallPotatoes
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TIPS for cash component?

Post by SmallPotatoes » Thu Aug 05, 2010 11:05 pm

Title says it. Why (or why not) use TIPS  as the cash component?
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foglifter
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Re: TIPS for cash component?

Post by foglifter » Fri Aug 06, 2010 12:25 am

SmallPotatoes wrote: Title says it. Why (or why not) use TIPS  as the cash component?
TIPS are supposed to protect against inflation. In PP this is taken care of by gold. Cash should to some extent save your portfolio when everything else goes down, so TIPS won't be a good choice in this case. Remember 2008? TIPS posted about -10% losses. I wouldn't feel safe replacing cash portion of my PP with a bond instrument that carries both interest rate risk and "inflation calculation" risk.

I would use short-term treasuries or high-yield CDs/savings as cash, but not TIPS. Also, don't forget that TIPS are fairly new and have not lived through a period of high inflation, so we just don't know how well they will work.

Craigr's blog talks in detail about TIPS in the Gold Allocation FAQ.
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Re: TIPS for cash component?

Post by SmallPotatoes » Fri Aug 06, 2010 1:00 am

Thanks for the reminder. I do see that TIPS are a less-than-ideal method of holding cash. I'll probably just keep my MM at ING for now… maybe look at more I Bonds.
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Re: TIPS for cash component?

Post by foglifter » Fri Aug 06, 2010 1:18 am

SmallPotatoes wrote: Thanks for the reminder. I do see that TIPS are a less-than-ideal method of holding cash. I'll probably just keep my MM at ING for now… maybe look at more I Bonds.
I know some people prefer MM funds to bank accounts, but given miserable yields I prefer to keep cash in high-yield accounts in bank or a credit union (my Alliant CU pays 1.5%). I also max out my HSA which pays 5% tax-free (yes, you read it right - 5%). After age 65 HSA  may be used for any purposes - like traditional IRA.
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Re: TIPS for cash component?

Post by MediumTex » Fri Aug 06, 2010 7:45 am

With TIPS you have principal risk and thus they are unsuitable for the cash piece, IMHO.

As I have written many times before, though, ibonds are a terrific TIPS-like instrument and are perfect for the cash piece.
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Re: TIPS for cash component?

Post by Otto » Fri Aug 06, 2010 2:37 pm

MediumTex wrote: With TIPS you have principal risk and thus they are unsuitable for the cash piece, IMHO.

As I have written many times before, though, ibonds are a terrific TIPS-like instrument and are perfect for the cash piece.

So is the key difference between them that TIPS have principal risk while I-bonds do not?
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Re: TIPS for cash component?

Post by MediumTex » Fri Aug 06, 2010 4:16 pm

Otto wrote:
MediumTex wrote: With TIPS you have principal risk and thus they are unsuitable for the cash piece, IMHO.

As I have written many times before, though, ibonds are a terrific TIPS-like instrument and are perfect for the cash piece.

So is the key difference between them that TIPS have principal risk while I-bonds do not?
Ibonds also give you great tax benefits (no tax until redemption), while TIPS give you terrible tax treatment (potential tax on gains you haven't actually received).
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Re: TIPS for cash component?

Post by craigr » Fri Aug 06, 2010 5:31 pm

MediumTex wrote:
Otto wrote:
MediumTex wrote: With TIPS you have principal risk and thus they are unsuitable for the cash piece, IMHO.

As I have written many times before, though, ibonds are a terrific TIPS-like instrument and are perfect for the cash piece.

So is the key difference between them that TIPS have principal risk while I-bonds do not?
Ibonds also give you great tax benefits (no tax until redemption), while TIPS give you terrible tax treatment (potential tax on gains you haven't actually received).
TIPS are a horrible deal for a taxable investor. The more inflation you have, the more money you have to pay in taxes on the inflation adjustments.
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Re: TIPS for cash component?

Post by pplooker » Mon Aug 09, 2010 4:27 pm

Previous posters have nailed it, but I'd like to add a thought.

The reality is that the Cash portion of the portfolio often needs to be something you can get at right away since you tend to deposit into and withdraw from the cash holdings.  It depends on how you do your mental accounting to some degree I suppose. 

But TIPS would be rather horrible for that due to their relative (and I do mean relative) volatility and the tax treatment, since most likely you'd them in a taxable account so that you didn't have to jump through hoops to withdraw them in a hurry.

Hooray for I bonds.  You could take the song "Day Dream Believer" and change the lyric to "I Bond Believer" and I'd fit right in.
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Re: TIPS for cash component?

Post by foglifter » Mon Aug 09, 2010 4:47 pm

I've never dealt with I Bonds and since many of you recommend them I got intrigued. Looks like current yield is 1.74%, which is not that bad.

Can someone outline the best way to buy them - TreasuryDirect, my brokerage account etc.? Is it easy to sell them if I need cash?
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Re: TIPS for cash component?

Post by MediumTex » Mon Aug 09, 2010 5:33 pm

foglifter wrote: I've never dealt with I Bonds and since many of you recommend them I got intrigued. Looks like current yield is 1.74%, which is not that bad.

Can someone outline the best way to buy them - TreasuryDirect, my brokerage account etc.? Is it easy to sell them if I need cash?
I would start off by going to your local bank branch and buying a few paper bonds in smaller denominations (perhaps a few $100s).

You can download the Savings Bond Wizard program to see the updated value of your ibonds each month.

The elegance of ibonds for PP purposes is that you are NOT depending on them for inflation protection.  You are simply purchasing a treasury-like instrument that is almost certain to outperform t-bills, with amazing tax benefits to boot (complete tax deferral until redemption).

In my view, using ibonds for PP cash purposes is easily the best kept secret out there.

I would buy ibonds with the intention of never selling them (or not for a long time anyway).  Thus, it would make sense to allocate no more than 20-40% of your PP to them over time, while using other cash-like assets for rebalancing purposes (such as SHY, SHV, VFISX, etc.).

For those who use a mix of bullion and ETFs for the gold portion of the PP, think of your ibonds as the bullion portion of your PP cash holdings.

Series EE savings bonds are also not a bad bet for the cash portion of the PP.  Although the EE bond rate isn't much right now, there is the alternate rate for series EE bonds that is used to guarantee that they double in value after 20 years.  I think this alternate rate is something like 2.43% (though you have to hold the bonds for 20 years).  Putting a little piece of your PP cash into EE bonds (perhaps 5%) provides some nice risk free protection in the event of a long deflationary episode (where a 2.43% risk free return would be very hard to find).

Cobbling together a robust cash PP allocation in today's market can be an interesting exercise in creativity.  Buying some ibonds, EE bonds, maybe a few CDs at different banks, a little 401(k) account stable value fund money and some VFISX can put you in a position to earn way more than t-bills are paying with very appealing tax treatment for the overall cash allocation.  Note that this is a departure from a pure HB PP approach, but I believe that the modification has a good risk/benefit profile.

The only downside to ibonds would be if CPI were to go negative for an extended period, in which case ibonds would pay zero interest, though your principal would never be at risk.  Considering all of the bad things that would accompany an extended period of negative CPI, however, I have faith that the Fed will figure out some way of keeping CPI changes on the positive side (even if it means monkeying with the index itself).

For the belt-and-suspenders crowd, splitting the annual savings bond maximum purchase between ibonds and series EE bonds might be a prudent approach.

Whatever you do with savings bonds, though, buy the paper bonds.  I just love holding them in my hand and in a pinch you can redeem them at almost any bank on a moment's notice.  It's one more small way to deploy your money outside of the traditional money channels (i.e., brokerage accounts, mutual funds, the banking system, etc.).

I have been accumulating series EE bonds since 1993 and ibonds for the past few years.  As I watch the savings bond portion of my PP increase every month with no taxes to pay and no possibility of a monthly decline, it gives me a warm feeling.  The savings bond portion is about 30% of my cash PP holdings, so I don't have any reason to think about selling them any time soon.

One final point regarding ibonds is that while they are very liquid and easily redeemable, they do require more than a mouse click to liquidate, which I think is a plus because it is a small safeguard against making a hasty decision.

I view the PRPFX/EDV 90/10 strategy and the ibonds in the PP cash portion to be the two best ideas I have come up with in the whole PP discussion.
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Re: TIPS for cash component?

Post by foglifter » Mon Aug 09, 2010 7:04 pm

Thanks for a good input, MediumTex. Do you know if the interest payments from I bonds are taxable at the state level?
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