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TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 10:05 am
by fnord123
Ftf: I searched for a similar thread, and found http://gyroscopicinvesting.com/forum/in ... opic=205.0, but I think this proposal is slightly different, so decided to create a separate thread.

The proposal: Hold a small (maybe < 25%) portion of the cash part of the PP in TIPS, with the intent of holding them to maturity.

The reasoning:
  • 75% of ones cash would be in liquid instruments (I-Bonds, FDIC insured savings accounts, short term treasuries, etc.) in case one needs to draw down the cash for rebalancing. Given that one of the key PP attributes is low volatility, the chance of blowing through that 75% in rebalances and having to grab the tips seems quite low.
  • Holding TIPS to maturity means no risk of principal loss
  • TIPS are taxed like interest, but this is no different from short term treasuries, savings accounts, etc.
  • TIPS are available currently with >0% real yield, and will yield more if inflation goes up. 30 year tips have > 2% real return, which is pretty nice!
  • This would only be for someone who plans to hold or contribute to their PP for a long time (the duration of whatever TIPS they buy). For someone in a draw-down mode this isn't a good idea as the 25% TIPS part of the cash would grow as the other cash parts were liquidated, invalidating the first bullet.
Thoughts?

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 10:25 am
by MediumTex
With TIPS, you are buying interest rate risk, principal risk and bad tax treatment.

I understand that if held to maturity the first two risks go away (sort of), but the purpose of the cash component of the PP is to ALWAYS have liquidity and safety in that quadrant of the portfolio.

I just don't like TIPS.

For most investors, though, I-bonds do a great job and I would stick with that if you are wanting to venture outside of ST treasurys.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 10:28 am
by AdamA
It's an interesting proposal...

Curious to hear what some of the more experienced guys on the site think.  

The one think I would I comment on tangentially is that I would not count on the FDIC insured savings account if there's a huge deflation.  I'd want the money in treasuries, and maybe a little underneath my mattress, but I'm probably a little paranoid.  

Adam

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 10:29 am
by AdamA
Medium Tex--

Can you expand a bit as to why you like I-bonds?

Thanks,
Adam

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 11:28 am
by MediumTex
Adam1226 wrote: Medium Tex--

Can you expand a bit as to why you like I-bonds?

Thanks,
Adam
1. Total deferral of taxes on interest until redemption (up to 30 years)

2. Zero interest rate risk

3. Zero prinicipal risk

4. Full faith and credit of U.S. government

5. Complete liquidity (redeem at the bank on the corner any time you want)

What's not to like?

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 11:33 am
by moda0306
MT,

Why not them over LT bonds then?  Is there some kind I-bond fund one can purchase?  The tax deferral sounds like a sweet deal, but is it priced into the effective interest rate?

And how do they have no interest rate risk?

Curious how these work...

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 11:49 am
by AdamA
[/quote]

1. Total deferral of taxes on interest until redemption (up to 30 years)

2. Zero interest rate risk

3. Zero prinicipal risk

4. Full faith and credit of U.S. government

5. Complete liquidity (redeem at the bank on the corner any time you want)

What's not to like?
[/quote]

Forgive the naive question, but why is the interest paid one this greater than a Treasury Bill?  Is it b/c you have to hold for at least a year?

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 11:57 am
by moda0306
Nevermind... read up on them.  Seem like a sweet deal.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:14 pm
by AdamA
Moda--

I have read on them, and I think I understand how they work.  The thing is, I can't really figure out how the fixed rate is determined. 

With T-bills, notes, bonds, at least you can compare the rates of various maturities and get an intuitive idea of why they are what they are.  With the Ibond, I'm not sure what to expect. 

Does that make sense?

Adam

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:15 pm
by moda0306
I think the fixed rate stays the same for the life of the bond, and the only thing they can adjust is the inflation rate... though I could be wrong.

Sure isn't very "fixed" if it doesn't stay the same.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:19 pm
by AdamA
Right, but what am I comparing the Ibond to?  ie, "I can get 2% + interest from the Ibond versus X% for the ? bill/bond/note?"

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:19 pm
by MediumTex
moda0306 wrote: I think the fixed rate stays the same for the life of the bond, and the only thing they can adjust is the inflation rate... though I could be wrong.

Sure isn't very "fixed" if it doesn't stay the same.
It's a weird methology, but you can't lose your principal and that is what is important for PP cash purposes.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:21 pm
by moda0306
http://www.treasurydirect.gov/indiv/res ... dterms.htm

The fixed portion "stays the same for the life of the bond"... but the inflation piece can go negative to offset the fixed return.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:22 pm
by AdamA
You can't lose your principal with a T-bill either, so what are the questions you should ask yourself when trying to choose between the two?

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:22 pm
by MediumTex
Adam1226 wrote: Right, but what am I comparing the Ibond to?  ie, "I can get 2% + interest from the Ibond versus X% for the ? bill/bond/note?"
Nothing is really comparable to I-bonds.  There isn't anything else in the bond market that can give you an inflation-adjusted interest rate for up to 30 years with no principal risk.

The tax deferral is just gravy.

For PP purposes, it is to me a perfect option for cash.

Note the $5,000 a year limit, though. 

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:25 pm
by MediumTex
Adam1226 wrote: You can't lose your principal with a T-bill either, so what are the questions you should ask yourself when trying to choose between the two?
For a couple of years now, I-bonds have provided a MUCH higher return than t-bills.

Even if the yield spread between t-bills and I-bonds closed, you would still have the better tax treatment of interest using I-bonds.

I expect that I-bonds will be discontinued at some point.  It's too good a deal.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:26 pm
by AdamA
Very interesting...do they hold up during deflationary periods?  I saw in Nov of 09 (I think) there was negative inflation.

 

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:28 pm
by moda0306
The inflation rate is adjusted to inflation, not the balance of hte bond itself... which, when you think about it, isn't that the same for any short-term bond... if the inflation rate is x, the bond will demand x+?.

Interesting, I've never gotten this interested in cash before.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:34 pm
by MediumTex
Adam1226 wrote: Very interesting...do they hold up during deflationary periods?  I saw in Nov of 09 (I think) there was negative inflation.
 
In periods of deflation, interest rates can go negative.

In the case of I-bonds, your principal will never be reduced, so negative interest rates would just result in no interest payments during the period of deflationary negative interest rates.

Contrast this to t-bills during periods of deflation, where yields can actually be negative under extreme conditions.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:37 pm
by moda0306
http://www.treasurydirect.gov/indiv/res ... dterms.htm

http://www.treasury.gov/resource-center ... &year=2007

Compare rates in previous years.  In Nov. 2007, even very ST treasuries were yeilding almost 4%, i bonds were at a combined 2.73%.

It varies, but often Ibonds seem to offer less than ideal ST rates.  Tax deferral only provides so much value, and really aren't all ST rates inflation adjusted for the reasons I mentioned before?

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:46 pm
by MediumTex
moda0306 wrote: http://www.treasurydirect.gov/indiv/res ... dterms.htm

http://www.treasury.gov/resource-center ... &year=2007

Compare rates in previous years.  In Nov. 2007, even very ST treasuries were yeilding almost 4%, i bonds were at a combined 2.73%.

It varies, but often Ibonds seem to offer less than ideal ST rates.  Tax deferral only provides so much value, and really aren't all ST rates inflation adjusted for the reasons I mentioned before?
Check your math.  I've got May 1, 2007, I-bonds yielding 5.31%.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:52 pm
by AdamA
So, why the higher yield for Ibonds?  Is it because you have to hold them for at least one year?  Is it b/c you lose 3 month interest payments if you sell them in under five years? 

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:52 pm
by moda0306
Crap, is each of those the payment for that 6-month period and therefore approx. half a year's interest?  That means it's basically doubled what I was calculating?

Amazing.  I-bonds are my new favorite security.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 12:54 pm
by moda0306
Adam,

Might just be a hand-me-out to the middle class.  If you can only purchase $5,000 per year in i-bonds, it was maybe designed to give the middle class a decent tax-deferred rate of return without giving a handout to wallstreet.

Re: TIPS held to maturity as "bottom" of cash component?

Posted: Fri Jan 28, 2011 1:01 pm
by MediumTex
moda0306 wrote: Crap, is each of those the payment for that 6-month period and therefore approx. half a year's interest?  That means it's basically doubled what I was calculating?

Amazing.  I-bonds are my new favorite security.
It's more complicated than that.  It's a screwy formula.