Author Topic: Can someone explain TIPS to me please?  (Read 10240 times)

vieja

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Can someone explain TIPS to me please?
« on: June 13, 2013, 08:11:48 PM »
I posted recently that we are finally debt free.  I am looking for a very safe place to start investing money.  I always thought I would simply buy Cds and I bonds but well, even I understand what a poor investment that is these days.

Ok so will you please, in very simple English, explain what Tips are?  I don't understand how you earn interest on them or if they are a better choice than Cds.  I'm brand new to this shit and very, very ignorant.  I have spent all my time obsessing about debt payment and now I need to learn to use my new found cash to create a comfortable retirement.

I should add that dh would prefer that we have all our money stashed under the bed and to hell with banks/financial institutions/stock market/ etc.  No risks are going to be taken by the two of us regardless of how foolish that sounds to all of you.  (I know, I know!)

arebelspy

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Re: Can someone explain TIPS to me please?
« Reply #1 on: June 13, 2013, 08:33:33 PM »
TIPs are a security instrument you purchase.  They pay a fixed interest rate, and the face value of them fluctuates with inflation, so it is automatically inflation adjusted. 

I'm not sure what exactly you don't understand, as they're very straightforward.  I'm guessing you just haven't looked up what they are?

Here's some basic links:
http://www.investopedia.com/terms/t/tips.asp
http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm
http://money.cnn.com/retirement/guide/investing_bonds.moneymag/index6.htm

Once you read those, please post any questions you have about what you don't understand and we can explain, I'm sure.  :)
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vieja

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Re: Can someone explain TIPS to me please?
« Reply #2 on: June 13, 2013, 08:42:29 PM »
I had looked at the treasury direct site.  I'm confused by the inflation/deflation info.  It sounded to me that I could invest say $10,000 for up to 30 years and if there was deflation I possibly wouldn't receive anything but my original investment at maturity.

With cds its invest x amount for a period of time and receive  this amount apr and apy.   Z= the penalty for early withdrawl.  Very cut and dry.

vieja

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Re: Can someone explain TIPS to me please?
« Reply #3 on: June 13, 2013, 08:45:59 PM »
"When a TIPS matures, you are paid the adjusted principal or the original principal, whichever is greater."

I know this is simple but I'm not sure what it means.

John74

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Re: Can someone explain TIPS to me please?
« Reply #4 on: June 13, 2013, 08:48:42 PM »
TIPS protect you against inflation while CDs and other nominal treasuries protect you against deflation. In case of deflation over the next 30 years, a TIPS will pay you back your original investment. So if you invest $10K today, you get back $10K in 30 years. But because of deflation, $10K in 30 years will be worth more than $10K today.

arebelspy

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Re: Can someone explain TIPS to me please?
« Reply #5 on: June 13, 2013, 08:50:46 PM »
Gotcha.

What it means is it adjusts up to inflation.  If there isn't inflation (or deflation), you just get your principal back, plus the interest from along the way.

Let me make up easy numbers.

Say you invest 100,000, and it pays 1% APR (1000/year). Since they pay twice yearly, it'd pay 500 every six months.  That's the interest.

Now say inflation year 1 was 2%.  The face value of the TIPs would now be $102,000.  If it was a 1-year TIPs (which don't exist, they're 5, 10, or 20 year lengths, but for our example), you'd then get that 102k paid off at the end of the year, plus keep the interest you got along the way.

If there was deflation or no inflation, you'd just get your 100k back.

It adjusts every year based on that year's inflation.

Does that all make sense?  Please follow up with any questions you still have.  :)
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vieja

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Re: Can someone explain TIPS to me please?
« Reply #6 on: June 13, 2013, 09:04:40 PM »
Thanks.  Between the two of you and the Motley Fool I finally understand.  I knew it was simple.

Anyone have anything to add about the pros and cons of purchasing TIPS?  They sound smarter than cds and I Bonds. 

I'm sure I'm going to have lots of kindergarten level questions over the next few months.  I hope no one minds.

arebelspy

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Re: Can someone explain TIPS to me please?
« Reply #7 on: June 13, 2013, 09:09:44 PM »
Anyone have anything to add about the pros and cons of purchasing TIPS?  They sound smarter than cds and I Bonds. 

Depends on the rates, I suppose, and your thoughts about what inflation will be like.  Recently TIPS were paying a negative rate.  I.e. people were willing to take no interest just to keep up with inflation.  Would you rather earn interest?  Depends.

Design an investment plan and asset allocation, and decide how these safer, lower return instruments (CDs, TIPS, iBonds, etc.) fit in.

I'm sure I'm going to have lots of kindergarten level questions over the next few months.  I hope no one minds.

We don't mind at all, best way to learn. :)
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John74

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Re: Can someone explain TIPS to me please?
« Reply #8 on: June 13, 2013, 09:15:17 PM »
Thanks.  Between the two of you and the Motley Fool I finally understand.  I knew it was simple.

Anyone have anything to add about the pros and cons of purchasing TIPS?  They sound smarter than cds and I Bonds. 

I'm sure I'm going to have lots of kindergarten level questions over the next few months.  I hope no one minds.

If held in a taxable account, TIPS are a bit tricky because in any one year you have to pay taxes on both the interest income your receive and the increase in adjusted principal, which you do not receive. Hence you will have to pay taxes on "phantom income".

So say you buy a TIPS paying 1% at par. You invest $10K and the first year you receive ~$100 in interest income. But during the first year, inflation was 3% and you adjusted principal is now $10,300. The IRS will want you to pay taxes on $100+$300=$400. If you are in a high tax bracket, pretty much all the interest income your received and possibly more could go back to the IRS.


So it is best to keep them in your retirement account. That's the major con. Another con is that the TIPS market is less liquid than the nominal treasury market. But as a whole I like TIPS a lot, though not at the current prices and yields.

wannabfrugal

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Re: Can someone explain TIPS to me please?
« Reply #9 on: June 20, 2013, 11:11:17 AM »
I want to say thanks for this post, it was very helpful to me.  I knew TIPS hedged inflation but that was about it so the example of deflation vs inflation was insightful.

I have a follow-up question that might be as much about Vanguard Indexes and my inability to read a prospectus as about TIPS...  Does anyone know how the Vanguard TIPS index (VIPSX) works?  Does it continually buy TIPS as the ones it holds mature?  Or does it regularly buy and sell TIPS? 

At a higher level, I can understand a total market stock index, you own shares of all stocks... I can't model in my mind how a total market bond index like VBMFX or TIPS index like VIPSX works.  Does the index buy bonds from each issuance?  And keep buying more bonds and adding to the index w/o ever selling?  I'd love to understand more if someone understands this area.
 
I'd prefer to buy and hold for my regular bond and TIPS allocation and am interested in if an index is the best way to do that or I should I look at alternatives?

WageSlave

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Re: Can someone explain TIPS to me please?
« Reply #10 on: June 20, 2013, 11:33:31 AM »
A couple nice benefits of series I bonds over TIPS:

    (1) I bonds are tax-deferred (you don't pay taxes on the interest until you redeem them)
    (2) I bonds can be tax free if used for qualifying educational expenses

I wouldn't put all my investments into only one instrument or even class of securities.  You may think, "I'll choose the safest possible asset (class) and put all my money in there."  But are you sure it's truly "safe"?  Does it protect against all possible kinds of loss (e.g. I don't know if any one class of security simultaneously protects against inflation and deflation).  In general, the risk of "putting all your eggs into one basket" may be higher than the "safety" (real or perceived) of that one basket.

In short: diversify.
« Last Edit: June 20, 2013, 11:35:29 AM by WageSlave »

wannabfrugal

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Re: Can someone explain TIPS to me please?
« Reply #11 on: June 21, 2013, 08:56:44 AM »
Thanks for the thoughts.

I should clarify, I'm roughly following the Intelligent Asset Allocator approach from William Bernstein.  I am 100% invested through vanguard indexes and have roughly 60% total market index, 15% total intl index, 15% bonds (tips and total bond index) 5% REIT and 5% emerging market.

I'm just wondering if indexes are the best vehicle for my 15% bond allocation

arebelspy

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Re: Can someone explain TIPS to me please?
« Reply #12 on: June 21, 2013, 11:00:10 AM »
I should clarify, I'm roughly following the Intelligent Asset Allocator approach from William Bernstein.  I am 100% invested through vanguard indexes and have roughly 60% total market index, 15% total intl index, 15% bonds (tips and total bond index) 5% REIT and 5% emerging market.

I like it.

I'm just wondering if indexes are the best vehicle for my 15% bond allocation

As opposed to...?

What are the alternatives you are considering?
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

John74

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Re: Can someone explain TIPS to me please?
« Reply #13 on: June 21, 2013, 11:08:15 AM »
I want to say thanks for this post, it was very helpful to me.  I knew TIPS hedged inflation but that was about it so the example of deflation vs inflation was insightful.

I have a follow-up question that might be as much about Vanguard Indexes and my inability to read a prospectus as about TIPS...  Does anyone know how the Vanguard TIPS index (VIPSX) works?  Does it continually buy TIPS as the ones it holds mature?  Or does it regularly buy and sell TIPS? 

At a higher level, I can understand a total market stock index, you own shares of all stocks... I can't model in my mind how a total market bond index like VBMFX or TIPS index like VIPSX works.  Does the index buy bonds from each issuance?  And keep buying more bonds and adding to the index w/o ever selling?  I'd love to understand more if someone understands this area.
 
I'd prefer to buy and hold for my regular bond and TIPS allocation and am interested in if an index is the best way to do that or I should I look at alternatives?

VIPSX is not an index fund. It is a managed TIPS fund and as such I am sure there is quite a bit of buying and selling going on (turnover is 33%).

Eric

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Re: Can someone explain TIPS to me please?
« Reply #14 on: June 21, 2013, 05:20:59 PM »
I should add that dh would prefer that we have all our money stashed under the bed and to hell with banks/financial institutions/stock market/ etc.  No risks are going to be taken by the two of us regardless of how foolish that sounds to all of you.  (I know, I know!)

It's ironic that you think keeping your money in a savings account is risk free.  You're taking the biggest risk of all.  You're risking your retirement.  You'll never be able to retire early, and you might not be able to retire at all if your money doesn't grow.

As an example, if you save $20K per year for 20 years, at a generous 1% savings account CD rate, you'll have $444,783.88.  That's $400K in savings plus $44,783.88 in compounded interest.  Alternatively, if you invest $20K per year for 20 years, at an historical average stock market return of 7%, you'll have $877,303.54.  That's $400K in savings plus $447,303.54 in capital gains and dividends.  And larger savings amounts only create larger discrepancies.

I'd do some soul searching if I were you about why you're so scared of something that every single one of us here are perfectly comfortable with, and something that's absolutely necessary if you want to retire before you're eligible to collect SS.

http://www.mrmoneymustache.com/2013/03/07/how-about-that-stock-market/
« Last Edit: June 21, 2013, 05:35:03 PM by Eric »

Green Manalishi

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Re: Can someone explain TIPS to me please?
« Reply #15 on: August 08, 2013, 03:18:47 AM »
I also have some basic questions on TIPS so thought I'd add them to this thread. I'm new to this so go easy on me!

My understanding is that in the case of say, a 30 year TIPS with a yearly interest rate of 2%, that 2% is fixed for 30 years. The principal is adjusted for inflation so if inflation occurs, the 2% is 2% of a larger number. At the end of 30 years you get your original principal or the adjusted principal back, whichever is larger. In the unlikely event that deflation occurs for 30 years, your principal that you get back in full will have more purchasing power than it did at the start.

The tax issue as mentioned earlier in this thread seems like a major one. But IF the 2% interest and inflation adjustement were untaxed and if your projected living expenses in retirement were no more than 2% of  the principal - would your 'stache then last indefinitely?

I have read about TIPS:

1) Having negative yields - is this apparent at the time of purchase, for example could someone buy a TIPS with an interest rate of -1% meaning that for the term of the investment the principal is adjusted for inflation but there is no interest payment and actually 1% of the adjusted principal is deducted?

2) Performing poorly in an environment where real interest rates are high - if the TIPS interest covers your living expenses and your are happy with this, how would this poor performance affect you?

3) Losing value if sold on the secondary market before maturity - think I understand that.

4) That the yield is affected by the yield on normal Gov. bonds - not sure what that's about.

Thank you!
« Last Edit: August 08, 2013, 03:20:43 AM by Green Manalishi »

fiveoclockshadow

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Re: Can someone explain TIPS to me please?
« Reply #16 on: August 08, 2013, 06:03:24 AM »
But IF the 2% interest and inflation adjustement were untaxed and if your projected living expenses in retirement were no more than 2% of  the principal - would your 'stache then last indefinitely?

No, it would last the term of the bond for sure but after that less certain.  When the bond matures you will have to reinvest the principal and at that point 2% might no longer be available.  Regardless, most people consider a TIPS ladder to be an extremely secure way of creating stable real income over time but don't forget you are still subject to reinvestment risk.

Quote
1) Having negative yields - is this apparent at the time of purchase, for example could someone buy a TIPS with an interest rate of -1% meaning that for the term of the investment the principal is adjusted for inflation but there is no interest payment and actually 1% of the adjusted principal is deducted?

They can have negative real yields but they still pay a coupon (albeit a very small one in those cases).  See here:

http://www.treasurydirect.gov/instit/marketables/tips/tips_negative.htm

The way the yield ends up negative is that the bond is sold at a premium - i.e. above face value.  For example, assume inflation is zero and for a $100 5 yr TIPS that paid 0.125% coupon at the auction you might actually pay $110.  You will get 10 coupons of $0.0625 each over the life of the bond.  But at maturity you will only get $100 back not the $110.  Thus the real yield was nearly negative 2% even though you got coupons along the way.

Note this is very similar to how bonds sell on a secondary market.  When interest rates fall older bonds with higher rates sell at a premium, above face value, and thus even though they have a high coupon over the remaining life of the bond the real yield will match the current yields because of the loss in principal.  Basically for TIPS when rates effectively go negative the same thing happens at the auction - the bond is sold at a premium and it is that premium that generates the negative yield.  The same rules hold for nominal bonds as well - if yield were to be negative they'd still pay a coupon but sell at a premium.

Why on earth would people bid at negative rates?  Well deflation would be one reason.  The other would be "flight to safety" - if you think all other investments are too risky you might accept a slight negative yield compared to the other options.  Consider for an institutional investor you might not have a mattress big enough to hold $100M and a negative treasury yield might cost a lot less than security and insurance on $100M in cash :)  Weird things happen in deflationary environments...

Clear as mud?

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2) Performing poorly in an environment where real interest rates are high - if the TIPS interest covers your living expenses and your are happy with this, how would this poor performance affect you?

It wouldn't other than you are getting lower interest than you could with other investments.

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3) Losing value if sold on the secondary market before maturity - think I understand that.

The only additional thing to consider is TIPS are even more volatile in the secondary market than nominal treasuries.  If I understand correctly this is because the inflation adjustment to the principal is essentially like a zero-coupon bond.  That effectively extends the duration of TIPS compared to their equivalent nominal treasuries which thus increases volatility.

Quote
4) That the yield is affected by the yield on normal Gov. bonds - not sure what that's about.

I think just that TIPS aren't sold in a vacuum, but are auctioned just like nominal treasuries and so their yields are tied to nominal treasury rates combined with the market estimate of inflation.


livetogive

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Re: Can someone explain TIPS to me please?
« Reply #17 on: August 08, 2013, 11:58:10 AM »
Stated above, but TIPS probably need to live in a tax advantaged account

Also, there is some debate as to whether they accurately track inflation. I advised my mom, who is very close to retirement, to hold some as part of a larger strategy but I personally don't own them.

Green Manalishi

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Re: Can someone explain TIPS to me please?
« Reply #18 on: August 08, 2013, 01:07:19 PM »
Thanks fiveoclockshadow and TurboLT. Very clear and helpful - particularly the explanation on the negative yields, I was having real difficulty figuring that out for myself!

Will

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Re: Can someone explain TIPS to me please?
« Reply #19 on: September 28, 2013, 10:31:05 PM »
I just recently discovered that Vanguard has a short-term inflation-protected securities index fund (VTIPX or VTAPX).  Wondering if it might be better to switch to that than keeping VIPSX/VAIPX.  Thoughts?

grantmeaname

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Re: Can someone explain TIPS to me please?
« Reply #20 on: September 29, 2013, 12:24:37 PM »
Better for what? Why is VAIPX in your portfolio, and what do you want your bond holdings to do differently?

Will

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Re: Can someone explain TIPS to me please?
« Reply #21 on: September 29, 2013, 12:37:42 PM »
Well, I'm not looking for the value of my TIPS to go down, and some gains would be nice.

The Financial Lexicon

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Re: Can someone explain TIPS to me please?
« Reply #22 on: September 29, 2013, 12:40:25 PM »
Hello Everyone,

I'd like to add one point about TIPS.  TIPS provide complete protection from inflation to the extent that the CPI tracks your personal inflation experience.  If you think one way the government might attempt to reduce its future liabilities is to change the manner in which CPI is calculated (CPI is the basis for cost of living adjustments for several gov't programs), then TIPS might not provide the type of future inflation protection you would expect.

Regards,

The Financial Lexicon
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