From S&P's Outlook:
"Like income taxes, junk mail, health
care reform, and Barry Manilow,
some things just don’t go away. For
investors, inflation is the guest that
won’t leave, reappearing unexpectedly
from some hidden recess at the
most inconvenient moment.
As it turns out, Wall Street has just
the thing for those made nervous by
the inflationary implications of the
government stimulating the economy
with $787 billion in new spending
while bailing Fannie Mae, Freddie
Mac, AIG, and two of the three U.S.
automakers out of bankruptcy.
Inflation-protected bond funds, also
called inflation-indexed funds or “real
return” funds, offer investors a defense
against accelerating inflation by investing
in Treasury Inflation Protected
Securities (TIPS), a type of bond issued
by the U.S. Treasury since 1997 in
which the principal amount changes in
line with the Consumer Price Index.
TIPS have attracted increased attention
recently, with the Treasury
Department announcing in August
that investors “can expect issuance to
gradually increase” during the 2010
financial year that begins in October.
The U.S. Treasury also said it is considering
replacing the 20-year TIPS
bond with a 30-year bond. Roughly
25 distinct funds are now being marketed
under this category to individual
investors, offering a wide variety
of investment styles, performance,
and costs. The group is generally
benchmarked against the Barclays
U.S. Government Inflation-Linked
Bond Index, which tracks the performance
of TIPS with maturities of a
year or more. As of early August, the
index gained more than 4% year to
date. That compares with a decline of
5.15% for Barclay’s U.S. Treasury
bond market index.
"So I guess a rule of thumb would be to try to buy TIP as close to $100 or below if possible since it will likely return to near $100 given enough time assuming there is not a complete government meltdown."
Just keep in mind that $100 is fairly arbitrary.
I just downloaded TIP's daily prices since inception and averaged the daily closes. As of today, the average is $102.60.
It's just trivia though.
I had seen some messages in which the poster seemed to think the share price of TIP would increase substancially, so that's why I asked the question.
It seemed to me that if TIP pays out all bond dividends and principle increases then there would be no reason for the TIP share price to ever rise much over $100 except for some of the other reasons you mentioned.
So I guess a rule of thumb would be to try to buy TIP as close to $100 or below if possible since it will likely return to near $100 given enough time assuming there is not a complete government meltdown.
You are pretty much right on base, although there are other things to think about.
TIP closed at 101.85 on December 3, 2003. It's 102.25 today. It would not surprise me in the slightest if it is roughly the same price in 10 more years.
Most people might look at that as a rather unimpressive return. However, TIP has made distributions totalling $28.06258 per share since December of 2003 (as seen in the iShares distribution history).
Those in TIP have actually done quite well.
There are quite a few things that can alter TIP's price though, other than just deflation bringing its price down (which we saw when the price of oil crashed from $140+ to $30+).
1. If investors think the government would default on its debt by simply refusing to pay it, then TIP's price would fall. This could happen even with inflation running high.
2. If investors think the government would default on its debt by allowing inflation to creep up, then TIP's price would rise. We saw this when oil was spiking to $140+ recently. Investors were willing to pay a premium for inflation protection.
3. If investors think the government would default on its debt by allowing Zimbabwe style hyperinflation to appear, then TIP's price would actually fall. Most people would be scrambling for the exits and buying hard assets instead. I certainly would not be happy getting 89.7 sextillion percent payouts on my TIP investment even if it did miraculously keep up with inflation. The taxes would be hideous, and they would be relentless. Outside of a retirement account, we'd be paying those hideous taxes each and every year. It would be much better in that environment to simply hoard a real asset and tuck it away. At least you'd only pay taxes on it once, when you sold.
4. If investors think stocks are vastly superior to TIPS, as they did during the dotcom bubble, then TIP's price could fall. I would say the downside risk is on the order of 5% to 10%. 10% would push inflation adjusted yields from the 1.5% they are at now to something closer to 3.5%. That's the yield TIPS had during the dotcom bubble. I doubt very much we'll see that again though. I can't imagine what would drive the next stock bubble at this point (unless you count the recent 50% gains in the stock market as bubble #2, which could very well be the case).
5. If investors think stocks are a sucker's bet and that wave two of the downturn is about to kick in, then TIP's price could rise as investors seek safety again. The very most TIP's price should rise would probably be 5% to 10%. That would push the inflation adjusted yields SO low that nobody should want them at that point. That said, we did see the real yield on the 5 Year TIPS drop all the way to 0% when investors were scared in early 2008. $110 is therefore a distinct possibility. Further, real yields were negative through much of the 1970s. TIPS real (inflation adjusted) yields cannot go below zero though. The absolute floor for a TIPS auction is 0%. Even if investors did bid less than that for some reason, the government will set the rate at 0% anyway.
As a long-term TIP investor, I do not want the price of TIP to rise. The price moves inversely to inflation adjusted yields. As a saver, I want high inflation adjusted yields though. Scary to me would be seeing TIP's price rise to the point inflation adjusted yields dropped to 0% and stayed there. At 0%, once taxes are factored in my nest egg could no longer keep up with inflation long-term.
I am more than happy having TIP maintain a constant $100 price. That's what I hope for anyway.
One last note to everyone. When people speak of "real yields" it means they are talking about yields that are adjusted for inflation. It represents what you are really earning. In the 1970s, real yields went negative. Earning 8% when inflation is 10% gives you a negative 2% real yield. Not good.
Markm0722 said, "When you own TIP, you are paid both the interest AND the inflationary adjustments (on a monthly basis)."
Am I correct in thinking this would also have the effect of keeping the price of the TIP ETF near $100 regardless of how high inflation goes?
Both the bond dividends and principle increases are paid as dividends by the ETF so there would be no reason for TIP to ever go much above $100, correct?
But during a very prolonged deflation period perhaps this ETF could go below $100 if to much of the prior principle increase was paid out and then was evaporated by deflation.
Am I way off base?
First, I want to clear up something else about bond funds to perhaps take some of the mystery away.
A fixed income bond is just like a bank CD.
A bond fund is just a collection of bonds. If you are happy with the individual bonds then you should be just as happy with the collection.
Therefore, the first thing to decide is if you are happy with the individual bonds.
When you buy a CD at a bank, you don't tend to think that the price of the CD can fluctuate. You lock in a rate and you hold it until maturity.
The price of that CD does fluctuate though. You just don't realize it.
Picture locking in a CD for 5 years at 3%. Now picture the bank offering that very same CD the next day at 4%. You'd kick yourself. You'd earn 5% more (1% per year times five years) if you had simply waited a day.
If you had bought a bond instead of a CD and then tried to sell that bond to someone else then they'd be kicking you. They'd want you to cough up that 5% in order to want to buy it from you. How else could you get someone to buy your 3% bond when they can buy a 4% bond somewhere else?
If you had bought a bond fund (that holds a collection of those 5 year bonds) instead of that bond, then the bond market will kick you directly. You'd see the price of your bond fund drop 5% the instant rates rose 1%.
It's all the same though. If interest rates rise, bond investors get kicked. It's that simple.
TIP holds a collection of individual TIPS bonds. The same rules apply but the mechanism is slightly different. It isn't interest rates in general that we care about. It is inflation adjusted interest rates that drives our pricing.
If overall interest rates rise 1% because inflation is rising (or is expected to be rising) by 1%, then the TIP fund's price should not change.
On the other hand, if overall interest rates rise 1% because investors would rather pour money into stocks than bonds, then the TIP fund's price would drop.
This brings us to an interesting inflationary dilemma. You'd think that with an unprecedented 50%+ rise in the stock market, that TIP would be pretty beaten up. In comparison, TIPS were beaten up during the dotcom bubble. Nobody wanted safety. So let's look at where money is flowing now.
Money is flowing INTO treasury bills.
Money is flowing INTO fixed income bonds.
Money is flowing INTO inflation protected treasuries.
Money is flowing INTO stocks.
Money is flowing INTO gold.
Money is flowing INTO oil.
Money is flowing INTO commodities in general.
Money is flowing INTO foreign currency (falling dollar).
How is money flowing into ALL of those at the same time?
Just where isn't money flowing these days? I guess that just leaves housing. I cringe at the thought of how that's going to help our economy recover.
I see that Meredith Whitney is predicting that housing prices will drop another 25% from here. She correctly offered doom and gloom the first time around and made a name for herself. Few believed her at the time. Few believe her now. I don't think it is all that far-fetched to think housing prices could continue to fall. There's still massive inventory and unemployment continues to rise.
I may now lean towards stagflation again, but it is not a certainty. It's stagflation or deflation in my mind. I'm not a believer in this borrowed recovery.
The 1.8% rate I quoted is the interest TIPS pay. TIPS also appreciate in value based on the inflation rate (as seen in the Consumer Price Index). Let's say inflation averages 2.5% per year for the next 20 years. That means I will be earning 4.3% (1.8% interest + 2.5% capital appreciation).
I'll be paid 1.8% per year in interest. This amount will rise as the inflation adjusted value of the TIPS bond rises. At the end of the 20 years, I'll then be paid a lump sum (the initial amount I invested plus all the inflationary adjustments to it).
Unfortunately, there's taxes. I'm taxed on both the 1.8% I earn each year AND the inflationary adjustments. If inflation is high enough, I might not have the money to pay the taxes (since I'm only paid 1.8% per year but owe taxes on both that AND the inflationary adjustments).
That's where a TIPS fund like TIP has an advantage. When you own TIP, you are paid both the interest AND the inflationary adjustments (on a monthly basis). You should therefore have the money to pay your taxes no matter what happens.
Individual TIPS will still earn you more overall (due to the lack of annual expenses and possibly higher interest rate). They just may have a cash flow problem due to the way taxes must be paid.
For TIP, you should ignore the yield quoted in Yahoo. It is virtually useless. The best way to know how much you can expect to be paid is to go to the "iShares" site and look for its real yield. As of 9/10/09, the real yield was 1.43%. Next, you'll need to come up with a guess on what you think inflation will do in the future. If you think inflation will be 0%, then you can only expect to be earning 1.43% (1.43% + 0%). If you think inflation will be 10%, then you can expect to earn 11.43% (1.43% + 10%).
"Let's say I buy 10K worth of IEF with the yield of 4% next Monday. IEF is around $91 so I buy 110 shares. Is this yield rate for IEF locked in for me for the duration of my holding like a dividend rate would be (assuming the dividend rate isn't cut)?"
Once again, forget the yield you see on Yahoo. That's pretty much useless. That "ttm" next to the yield means "trailing twelve months". That's history. Instead, you need to go to the "iShares" site again and look to see what the "Average Yield to Maturity" is. That's the future. It's currently 3.2%.
If you buy IEF then you can expect to earn 3.2%.
Now to your next question. Is that yield locked in? The answer is yes and no. It's sort of locked in.
In order to know how locked in it is, you need to once again go to the "iShares" site and look for the "Effective Duration". It says 7.18 years. Here's what that means. You are effectively buying a 7.18 year bond that pays 3.2%.
The effective duration determines your interest risk and safety. If interest rates were to rise 1% tomorrow, then you can expect IEF to drop in price by roughly 7.18%. If interest rates were to fall 1% tomorrow, then you can expect IEF to rise in price by roughly 7.18%. In any event, the fund will be paying you interest at a 3.2% rate though.
Bond yields are paid out monthly. IEF pays very predictably. TIP tends to pay in spurts. TIP attempts to pay us each month, but when the inflation rate is falling there isn't anything to pay us (since the payouts are based on both the interest AND the inflation adjustment).
markm0722 - Thanks for dispensing your know-how to us bond noobies.
What is the advantage / disadvantage to buying an ETF for your bond exposure? You mentioned getting 1.8% on your 2008 purchase...I see the yield on the ETFs below are all in the 4% range. Is this a real 4%? I guess you also contend with the fluctuation of the ETF price unlike buying from treasury direct?
Why not buy into an ETF like TIP (TIPS ETF), IEF (iShares Barclays 7-10 Year Treasury or TLT (30 year Long bond ETF)?
Let's say I buy 10K worth of IEF with the yield of 4% next Monday. IEF is around $91 so I buy 110 shares. Is this yield rate for IEF locked in for me for the duration of my holding like a dividend rate would be (assuming the dividend rate isn't cut)?
Are these etf bond yields paid out quarterly like a stock dividend?
Lots of questions here thanks for your time.
"I'm not necessarily endorsing secondary market purchases but it is a way of filling out a ladder if you're too impatient to wait for the auctions."
I hear that. My TIPS ladder isn't all that balanced yet. I jumped the gun a bit in January of 2008 by putting a good chunk of my nest egg in a 20 Year TIPS. I felt the need to lock in a rate before others did. I got 1.8% (a 1.75% rate bought at a discount). That rate has moved up to 2.1% today. Oops.
I don't have any regrets though. The rising rate didn't really hurt me much since I'm holding until maturity anyway. All I lost was an opporutnity to do better. I don't mind being locked into 1.8% for the next 18 1/2 years. It's still a decent rate, especially when compared to today's 0.85% rate on 5 Year TIPS or the 1.57% rate on 10 Year TIPS.
The rates on I-Bonds dropped from ~3.5% in 2001 to just 0.1% today.
The rates on 10 Year TIPS have dropped from ~3.5% in 2001 to just 1.6% today.
These are trends that have not rewarded patience. I certainly felt impatient in 2008.
Unfortunately, they are also trends that help support rising commodity prices. Sigh.
I also think there is a valid reason for real rates to fall. It is becoming harder to actually make money off of money. As I look forward, I do not see a good environment for savers.
"If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations." - The New York Times, It May Be Time for the Fed to Go Negative, Gregory Mankiw, April 18, 2009
Gregory Mankiw doesn't seem to care much about how inflation and inflation expectations affects the price of oil apparently, and that a significantly higher price of oil will do nothing to improve our employment situation.
No disagreement with anything you observed. Fidelity's listing shows:
Adjusted Price Bid/Ask
For currently avaiable TIPS, the inflation factor ranges from 0.99956 to 1.31115 (for an 30 yr offering that matures 4/15/2029 with a coupon rate of 3.875%). You can view the inventory on Fidelity.com (Go to Investment Products then Income Products then Bonds then TIPS (Secondary). I'm not necessarily endorsing secondary market purchases but it is a way of filling out a ladder if you're too impatient to wait for the auctions. (Also, the bid/ask fluctuations can be interesting---so far I've only bought not sold.)