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.
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.htmThe 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?
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.
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.
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.
