AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

 Hi Scott,

    I just finished "Spend Till The End", and I read "The Coming Generational Storm" when it first came out. Both books recommend TIPS as a safe choice. I am curious as to in what way investing in TIPS would be better than using  a 5 to 7 year laddered approach to investing in CDs. I've been doing this for some time, and my current average return is 5%. I use the web to check banks' financial health and get the best CD rates (still have once CD at 8%). Thanks.

Rich 

The reason I favor TIPS is that the inflation-adjustment provision eliminates one of the major risks in fixed income investing--- having a yield that is lower than the rate of inflation and losing purchasing power. I think this is very valuable, particularly for retirement planning.

The benefit of TIPS is particularly evident during periods of accelerated inflation--- such as we are now having. Today, conventional interest rates are miserably low and likely to be well below the official inflation rate. According to Bloomberg.com, for instance, a 2 year Treasury is now priced to yield 2.43 percent. The trailing inflation rate is about 4.5 percent and will likely increase when the CPI data for June is released. As a consequence, TIPS investors are doing much better than regular coupon investors. Will this always be the case? Not likely. But the odds favor TIPS doing better than conventional coupon investments much of the time.

Perhaps the best of all worlds would be to build a ladder of TIPs. That would give you the certainty of an inflation-PLUS return, and the security of regular maturities.

Scott

Does it make sense to try to build a 5-6 yr ladder of TIPS?  Treasury only issues 5-10-20 yr.  Can you go to some secondary market broker and purchase so much that matures in about 1 yr, 2yr, 3yr, etc.  Assuming I can find a broker who handles secondary TIPS in Austin,  how do I figure whether the price is right?  I have been researching TIPS on-line but the secondary market is a complete mystery to me.  Is there some web site where you can find the going rate for TIPS bonds of various rates and maturities or information on how they are priced ?   I imagine the buying and the selling price is different aside from any transaction fee ?

I suppose it all comes down to the price being what someone is willing to pay, given the current interest rates etc, but is there some way to estimate what price you'd get whether buying or selling?  We dont know what future interest rates will be but one might make guesses and weigh the alternatives if one knew the pricing algorithm (assuming there is one).

I have to set aside a provision for several years of nursing care for my wife starting a year or two from now and I'm trying to figure out the best place to put the money.  Surely not equities, and CD rates are so low right now.  At least TIPS should keep up with inflation but I dont know about all these other factors.     Maybe I should just put all the money in 5 or10yr TIPS via Treasury Direct at the next opening and eat the 3-month interest penalty as I cash out each year's need.    Appreciate advice.

If you could build a 5-6 year TIPS ladder with bonds purchased at issue, this would likely be better than CDs because it would assure you of capturing the inflation rate.

The problem is buying them in the resale market. There, the complexity of pricing TIPS is likely to have you skinned by the broker.

Scott

I see what you mean!!   I am worried about selling them in the secondary market too.

I found a site, www.investinginbonds.com , that reported on 26 july the ask/bid price and yield for about 15 or 16 issues but I cant make sense of it.   I exerpt two lines below:

BOND     MATURE     COUPON    BID/ ASK PRICE       BID/ASK YIELD

5YR        4/15/2010    0.875          100.348/100.469        0.618/0.600

10YR      1/15/2010    4.250          105.844/105.875        0.256/0.235

I take this to mean that if I wanted bond(s) maturing in early 2010 (less than 2 years away) I could buy, omewhere, either (1) bonds at a price of $100.469g per $100 of bonds or (2) bonds at $105.875 per 100.  (plus some commission charge).   It would seem to me that the first bond would already be worth ore than $100.47 due to about 3 years accumulated inflation and bond (2) would be worth a lot ore than $105.875 due to almost 8 years of inflation and it would be paying coupons based on that inflated alue;  the current total return being in the order of 8-9%.  I assume that I would be the owner of thebonds and could redeem them at maturity from the government for the full inflated value.

This seems to obviously be too good to be true.  I must not be reading the table correctly.  What is my error ?

Also the yields (which roughly correlate with the yield calculator on the site) seem kind of meaningless unless inflation is zero.  Am I right there? 

thanks

PS - I have some money from a real estate sale and I am trying to figure out where to invest it so it is hard to build the 5-6 year ladder buying at issue.  I may just put the whole thing in 5yr TIPS next issue if I cant figure out the secondary market.  But then I'll have to deal with it again in 5 years and I could get skinned if I am forced to sell some on the secondary market meanwhile.   I am a bit spooked about the markets in general right now.

The aftermarket pricing is clear as mud.

The bid and ask prices refer to the percentage multiple of the current INFLATION ADJUSTED  face value of the bond.  In addition you always pay accrued interest to the current bond holder in any bond purchase.

The TIPS bond in your example, 10yr,  due 1/15/2010, issued 1/15/2000, is currently priced on the Schwab web site at 105.89062.  The inflation adjusted value is 1.2869.  1.0589062 X 1.2869 = 1.3627064.  This means that the asking price for a single $1,000 face value bond is (1.3627064 X $1,000) = $1,362.71, plus accrued interest.  According th the Schwab website, the accrued interest on this single bond is $2.33 since the last semi-annual interest payment on 7/15/2008.  The asking price on the website is $1,364.94.

Bryan

Thanks Brian

That makes a lot of sense and is what one would expect looking back on it.  I dont know why I didnt figure that out myself.  It sure takes the bloom off the rose from a buyer perspective though I knew it could not be that good. 

I talked to a bond broker and he told me that the spreads I found on the site, www.investinginbonds.com were not real world and the speads are a lot higher than it shows.  I am going to poke around the Schwab site and see if I can find data there.   I may buy some 5 yr TIPS from Treasury Direct next chance.  But I still want to figure out how much it is going to sting if I have to sell any before redemption,  interest rate risk aside.  Anyway thanks.......

Rich,

Laddered CDs (or laddered Treasurys) are a very useful approach to fixed income investing. With a regular turnover of securities you minimize the danger of having to sell in an unfavorable market and you also gradually shift your interest income up or down. So I think ladders, particulary relatively short ladders like 5 to 7 years, are a great tool--- they allow you to capture most of the yield of longer term securities but avoid most of the risk. A ladder is a much better tool than an intermediate or long term bond fund.

The only short coming of ladders is that there is nothing in them to protect you from inflation. Your current average return of 5 percent, for instance, is lower than the current inflation rate. It is approaching 6 percent. While there are times that you will have a real return--- one in excess of the inflation rate--- shorter term maturities all too often fail to keep up with inflation. In TIPS you would capture the inflation rate plus whatever the premium is. Out at a 5 to 10 year maturity that is now running 1.16 percent to 1.70 percent, according to Bloomberg.com. You can check the current premiums over inflation here:

http://www.bloomberg.com/markets/rates/index.html

Scott

 Hi Scott,

    Thanks for your replies. I have a few related questions.

    The first is whether I-Bonds would provide the same benefits as TIPS.

    The second is the I'm not sure I understood the charts on the Bloomberg link you sent. How is the total interest calculated? Coupon interest + inflation rate? How often is it adjusted?

    And, finally, can one purchase new TIPS through a brokerage such as Schwab, or do ou purchase directly from the Treasury? I have to admit that purchasing them in the secondary market looked too complicated for me.

    Thanks so much for your help with all these questions!

Rich 

              Due to the complexities of pricing, I don't think most people should buy after-market TIPS. That means the shortest maturity you can buy is 5 years for a new issue TIP at auction. If you can buy in the after-market without getting skinned, then a 5 year ladder will involve 4 after-market purchaes and one auction purchase to start. But after that, you'll just be adding auction purchases. Similarly, a 10 year ladder will involve 8 after-market and 2 auction purchases--- but after that it will only involve an annual purchase of a 10 year note at issue.

              Those with a possible need to sell before that time, can either accept the cost--- as you suggest--- or they can take the market risk of buying a TIPS mutual fund or ETF. These portfolios typically have an average maturity that is in excess of 5 years so there will be a good deal more interest rate risk.

Scott

I still working on trying to figure out how I'd know if I were being skinned on the secondary market for TIPS.  It looks like it is going to be choosing between two bad alternatives when placing money that will be needed over the next 5-6 years.  Right now 1 yr CDs are around 3.75% which is below inflation and apparently fairly low historically.  Even 5 yr CDs are probably returning a little less than the inflation rate.  But, if one built a ladder of CDs but kept to 1 yr and under there would be a chance of getting better rates later.  I suspect, however that CDs may always trail inflation rates.  Anybody got thoughts on that?

Thoughts about CDs always trailing inflation?  Sure. You won't stay ahead of inflation with CDs.  You buy CDs for the safety -- FDIC insurance. Inflation isn't the issue with CDs.  It's the interest rates.  The bank is like a casino -- it's always going to make money. 

If interest rates go up, so will CD rates, but the bank will stall raising them as long as it can without losing all its customers.  If interest rates are falling, the bank will be right there lowering them immediately.   The ladder just protects you from a catastrophe when interest rates are rising.  You don't end up sitting there stuck with a big chunk of your money in a 4% 10-year CD while you watch interest rates skyrocket to say 18% (and inflation go wild). Think it can't happen?  1970s.  The ladder also lets you keep the higher rates a little bit longer when rates are falling.

So how can you win with CDs?  Same as with gambling -- by being lucky.  By grabbing a huge long-term CD when interest rates are high, right before they drop like a stone.  Is there a chance you can do that today?  No way, interest rates are incredibly low from a historical perspective.   Rates are so low, it doesn't make much sense to get a long-term CD right now even in a ladder situation.

Where you get inflation protection is from TIPS and I-Bonds ,where the interest rate can actually INCREASE periodically based a number from some inflation index.  With I-Bonds you get a base interest rate which is fairly low, and the inflation rate gets added on to that.  You can cash the I-Bonds out after a year with a small interest penalty if you need to.   I've got some I-Bonds from 2002 where the rate is 6.89%.

I don't see why you are making life complicated for yourself by trying to figure out the TIPS secondary market, especially after Scott recommends against it.  If you have enough money, start a TIPS ladder  from Treasury Direct and hold them until they mature.  If you haven't got enough money for that, buy I-bonds.  Otherwise buy a fund of TIPS.   Now go out and enjoy the sunshine.

Thanks for your post.

There is enough sunshine around here; it was 105F today, so I'm staying inside.  

This is money I am  going to have to spend on medical care over the next 5-6years so it is not possible to build a ladder at Treasury Direct and keep the bonds to maturity.  One can only put 10 k (5k electronic and 5K paper) per person per year into I bonds and I need to stash more than that.

I am torn about a TIPS fund.  I already have a small TIPS fund and it has been doing well.  But interest rates are bound to rise and the value of the fund's holdings may drop.  On the orther hand inflation is probably going to rage and that should tend to boost the TIPS fund income.  Hard to tell what the net effect is likely to be.  I'll chew on your reply a while.  It galls me to put it into CDs at less than inflation but I cant figure out if I am likely come out with even less buying or selling TIPS on the secondary market and that is one reason to stay away. 

That information about needing to spend it in the next 5-6 years is kind of important.  You are parking cash, not investing or trying to hold the value of your assets over 20-50 years.  Why worry so much about inflation?

For absolute security you could put it into CDs but with no more than 100K in one banking institution, so you have the full amount insured by FDIC.

 For a little better return I like to stash cash in Vanguard Prime Money Market Fund and Vanguard GNMA Fund. 

I am probably obsessing about it.  Like I said it just galls me to have money earning less than inflation and I personally think that we are headed for high inflation for a few years.  I have about decided to park enough money to handle estimated needs for 5 yrs in staggered CDs to renew in 1 yr intervals and park enough for the next couple of years in a 5yr TIPS at the reopening in April.  I will consider the MM and GNMA though.