TIPS vs. the PP Barbell or iBonds: No Contest
Posted: Sun Sep 18, 2022 9:14 am
Excellent new post from David Enna at Tipswatch:
https://tipswatch.com/2022/09/18/this-w ... ious-look/
Enna is always wisely moderate in his claims and recommendations but reading between the lines here there really aren't any meaningful advantages to nominal Treasuries over TIPS going forward unless you believe the Fed will be able to get inflation down to ~2% quickly. IMHO (and Enna's - and Ray Dalio's) sustained 4-6% inflation is much more likely.
If nothing else the 10 year reissue and the upcoming 5 year one he discusses are certainly superior to iBonds due to having both a much higher coupon and no purchase limits. The only "but" of course is that you want to hold TIPS in a tax-deferred account if at all possible.
If you care to really go "down the rabbit hole" with TIPS vs. nominals you can delve into this epic-length thread on Bogleheads:
https://www.bogleheads.org/forum/viewtopic.php?t=382830
The gist of the thread though is in the OP's crystal-clear opening post, which pretty much every knowledgeable subsequent poster agrees with and amplifies:
We've seen a lot of discussion pertaining to the performance of TBM [Total Bond Market] and TIPS over the last year, which is understandable since TBM has experienced its biggest nominal drawdown in its history and inflation is at the highest levels seen in over 40 years. Many investors have chosen to retain their nominal bond holdings, especially TBM, while many others have chosen to (hopefully, permanently) move part or all their fixed income to TIPS.
An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.
My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.
With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.
But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.
Therefore, absent deflation, it is indisputable that nominal Treasuries are riskier than TIPS when it comes to funding future consumption in real dollars. But there's another way to consider this that further demonstrates the same point.
If we assume that inflation is highly unlikely to average below 0% over a given decade, we can assume then that the best possible real returns of 10 year nominal Treasuries is their starting nominal yield of 2.65%. But there is no limit to how low the real returns of 10 year nominal Treasuries can be. In other words, 10 year Treasuries have very long left-tail risk. With TIPS held to maturity, their real return is, again, known with precision at the time of purchase.
Some claim that nominal bonds like 10 year Treasuries, funds like TBM, etc. have a higher expected real return than do TIPS. This is debatable since TIPS have a slight return premium over Treasuries due to their slightly lower liquidity. But in any event, any such higher expected return of nominal Treasuries over TIPS appears to be widely agreed upon to be very small and possibly zero.
Therefore, due to the uncertainty surrounding future inflation, there is uncertainty regarding the future real returns of nominal Treasuries (and nominal bonds, such as TBM), whereas there is no uncertainty regarding the real returns of TIPS as these are known at the time of purchase. Given that the expected benefit of nominal Treasuries compared to TIPS is no more than tiny, I contend that the risks faced by nominal Treasuries (and other nominal bonds) compared to those of TIPS are asymmetric and tilted significantly in favor of TIPS. Nominal Treasuries and other bonds are exposed to significant risks that are absent from TIPS, and those risks are not accompanied by a corresponding expectation of higher returns.
While it's true that nominal Treasuries are preferred in the presence of deflation, TIPS have some, though not as much, protection in that regard also since, upon maturity, the bearer will be paid the greater of their adjusted principal or their original principal. However, given that inflation has been a far bigger historic risk to investors than has deflation, I do not believe the better performance of nominal Treasuries to justify the uncertainty regarding their future inflation-adjusted value."
https://tipswatch.com/2022/09/18/this-w ... ious-look/
Enna is always wisely moderate in his claims and recommendations but reading between the lines here there really aren't any meaningful advantages to nominal Treasuries over TIPS going forward unless you believe the Fed will be able to get inflation down to ~2% quickly. IMHO (and Enna's - and Ray Dalio's) sustained 4-6% inflation is much more likely.
If nothing else the 10 year reissue and the upcoming 5 year one he discusses are certainly superior to iBonds due to having both a much higher coupon and no purchase limits. The only "but" of course is that you want to hold TIPS in a tax-deferred account if at all possible.
If you care to really go "down the rabbit hole" with TIPS vs. nominals you can delve into this epic-length thread on Bogleheads:
https://www.bogleheads.org/forum/viewtopic.php?t=382830
The gist of the thread though is in the OP's crystal-clear opening post, which pretty much every knowledgeable subsequent poster agrees with and amplifies:
We've seen a lot of discussion pertaining to the performance of TBM [Total Bond Market] and TIPS over the last year, which is understandable since TBM has experienced its biggest nominal drawdown in its history and inflation is at the highest levels seen in over 40 years. Many investors have chosen to retain their nominal bond holdings, especially TBM, while many others have chosen to (hopefully, permanently) move part or all their fixed income to TIPS.
An aspect of the nominal bond vs. TIPS issue that is often overlooked is the asymmetric risk investors are exposed to with nominal bonds like TBM. Note that this assumes both that an investor's future spending and other liabilities will be in at least roughly real (i.e., inflation-adjusted) dollars and that the CPI used to derive TIPS' yields is a reasonably good measure of inflation. In general, these seem to be fairly reasonable assumptions, and I ask that we do not derail this discussion on questioning them as this is apt to get the thread locked.
My contention that there is asymmetric risk in the decision to allocate one's fixed income in nominal bonds, such as TBM, or inflation-linked bonds, such as TIPS.
With individual TIPS held to maturity, their real return known with precision at the time of purchase. There is no risk to the future buying power of TIPS given the stated assumptions in the first paragraph.
But with nominal Treasuries, their real return unknown with precision at the time of purchase. Only their nominal starting yield is known. They are completely exposed to the risk of unexpected inflation, which has historically been the single biggest risk to fixed income holdings.
Therefore, absent deflation, it is indisputable that nominal Treasuries are riskier than TIPS when it comes to funding future consumption in real dollars. But there's another way to consider this that further demonstrates the same point.
If we assume that inflation is highly unlikely to average below 0% over a given decade, we can assume then that the best possible real returns of 10 year nominal Treasuries is their starting nominal yield of 2.65%. But there is no limit to how low the real returns of 10 year nominal Treasuries can be. In other words, 10 year Treasuries have very long left-tail risk. With TIPS held to maturity, their real return is, again, known with precision at the time of purchase.
Some claim that nominal bonds like 10 year Treasuries, funds like TBM, etc. have a higher expected real return than do TIPS. This is debatable since TIPS have a slight return premium over Treasuries due to their slightly lower liquidity. But in any event, any such higher expected return of nominal Treasuries over TIPS appears to be widely agreed upon to be very small and possibly zero.
Therefore, due to the uncertainty surrounding future inflation, there is uncertainty regarding the future real returns of nominal Treasuries (and nominal bonds, such as TBM), whereas there is no uncertainty regarding the real returns of TIPS as these are known at the time of purchase. Given that the expected benefit of nominal Treasuries compared to TIPS is no more than tiny, I contend that the risks faced by nominal Treasuries (and other nominal bonds) compared to those of TIPS are asymmetric and tilted significantly in favor of TIPS. Nominal Treasuries and other bonds are exposed to significant risks that are absent from TIPS, and those risks are not accompanied by a corresponding expectation of higher returns.
While it's true that nominal Treasuries are preferred in the presence of deflation, TIPS have some, though not as much, protection in that regard also since, upon maturity, the bearer will be paid the greater of their adjusted principal or their original principal. However, given that inflation has been a far bigger historic risk to investors than has deflation, I do not believe the better performance of nominal Treasuries to justify the uncertainty regarding their future inflation-adjusted value."