Two Ways to Look at TIPS

Thinking FrogTreasury Inflation Protected Securities (TIPS) protect investors from inflation by automatically adjusting the original face value of the bond for inflation.  What I have discovered is that this feature is used for different purposes by different people.  I tend to use TIPS as a method of saving principal, but there are those who use TIPS as a “hedge” against inflation within a larger portfolio of riskier investments.

The Saver’s View

I discovered that the way that I look at TIPS is much different than the way investors tend to look at them.  Since I look at TIPS as a way to save money for the future, I’m not very concerned about my returns.  I’m just trying to preserve the returns that I have already received.  I’m also trying to make sure that all of this money is available on a specific date.   I also intend for that money to be adjusted for inflation.

The Investor’s View

When investors use TIPS, they are usually trying to make sure that if there is a downturn in other investments that are sensitive to inflation, that they own something that counteracts inflation.  This allows their portfolio to lose less money or perhaps even gain money as a result.

Very Different Intentions

These two perspectives come from two very different intentions on the part of the bond holder.  One person is trying to preserve and the other is seeking opportunity.  This is why I recommend that you divide your money into two parts as I describe in the article: Stressed about Savings? Divide and Conquer!

The Investor’s Bond Market Focus

When we look at TIPS from the perspective of an investor, we are more concerned with counteracting inflation.  This can be done by trading bonds that are sensitive to inflation.  To TIPS traders, the current market value is more interesting than the adjusted principle.  An investor is less likely to hold a TIPS to maturity.  For TIPS investors, TIPS mutual funds or ETF’s may make sense.  Trading TIPS on the secondary market may also be useful.  Bond market traders are also very interested in Yield to Maturity (YTM).  That’s because they are concerned with the return on investment.  Without a good return, it isn’t a very good opportunity.  This may not be a big deal in some investor’s minds because the inflation protection may be worth a loss in that part of their portfolio, however.

The Saver’s Inflation Protection Focus

When we look at TIPS from the preservation of savings point of view,   we aren’t interested in the market value of TIPS.  We are interested in the adjusted principle.  Since we intend to be getting this principal someday when the bond matures, that’s all we really care about.  We are more interested in seeing how well our savings is being protected, rather than seeing our yield to maturity.  As preservers of principle, we are willing to pay some or even all of our yield to make sure that we have our money when we need it.

Taxes

Taxes are a serious problem for both the investor and the saver.  This is one place where the two views tend to come together.  Taxes can make it difficult for an investor by taking money away during a successful time causing the money to not be there for a time when things aren’t so successful.  This makes swings in income even worse.

For savers, taxes can actually cause us to lose money due to inflation as I explain in the article: “Inflation Protection and Taxes.”  Since we don’t make much interest on a savings style investment, taxation can make our preservation costs unpredictable and threaten our attempts to preserve once again.

Be Careful Not to Mix Views

It can really cause you to become paralyzed as to what to do with your money if you flip back and forth between the investing and savings views of looking at TIPS.  I find that it is wise to make a conscience effort to think one way or the other when choosing what to do.   I tend to use them for savings preservation.  I see very little help out there when it comes to looking at these bonds from this perspective.  By viewing TIPS in a way that matches your needs, you will be able to make more confident decisions with them.


Copyright © Troy Taft 2020

Building Your Own TIPS Annuity

Building a CubeI got an interest payment from one of my TIPS recently.  It feels pretty good to watch your income automatically go up with inflation.  As I mentioned in the article: “Introducing Treasury Inflation Protected Securities (TIPS)“, these bonds pay out interest on your inflation adjusted principle.  The percentage of interest stays the same, but the bond amount itself goes up as it is adjusted for inflation.  That means that your income goes up too.

What I feel when I get my inflation adjusted income, may be a result of the fact that I’m so used to being charged an inflation premium.  All I’m really experiencing is consistency.  I’m just getting the same purchasing power from my money as I had when I purchased my bond.  As I considered the fact that loaning out money is capable of producing an ongoing, inflation protected income, I realized that this could be used to create a reliable income and preserve the principal at the same time.

Considering the Possibilities

I don’t talk very much about the income from TIPS because I primarily focus on their ability to protect our savings, but if you have enough money and don’t want to risk it somewhere else, you could use TIPS as a way of getting inflation adjusted income for the rest of your life while also protecting your principal.

You’re intention would be to preserve the principal for the rest of your life.  Perhaps you already have a large sum that is intended for your heirs or for charitable giving in your will.  You could be using that money to generate an income while keeping the principle safe and adjusted for inflation.

Even if you don’t really need the income, you could generate it and give it away while you are still alive.

Making Your Own Annuity

There’s really nothing new to creating your own “annuity” with TIPS.  It’s just a frame of mind.  The only difference is that you are using TIPS for the purpose of generating income.  If you do plan to use them in this way, you might consider getting the 30 year TIPS.  Not only will the income stay consistent for 30 years, you usually get the highest amount of income from the longer term bonds.

Keeping it Real

You might be wondering why you wouldn’t just use CD’s for this purpose.  Remember, that the interest rate for TIPS is a “real” interest rate.  That means that inflation has already been calculated into the TIPS interest.  You have to subtract the inflation rate from your CD’s current interest rate and then compare it to the TIPS rate.

If, for instance, the interest rate on your CD is 2.04%, and inflation is currently at 1.90%, your real interest rate for the CD is only  .14%.  If you compare that to a 1% interest rate on a TIPS, you would see that you would earn .86% more “real interest.”  That’s a whopping 614% more income on the same principal.

Fee Considerations

There really aren’t any fees when you buy a TIPS, but I like to consider any bond premiums and taxes as fees when you make an annuity out of them.

A premium is when you pay more than the face value for the bond.  This happens when you buy a TIPS at auction and the price for the TIPS goes above the TIPS amount itself.  It can also happen when you buy a TIPS from someone else on the market.  For instance, you may end up buying a $1000 TIPS for $1100 at auction.  If you do, you are paying a premium of $100 to get a $1000 TIPS.  That $100 is like a fee because you had to pay it up front just to get the bond.  It could take a while to recover that fee, but if you are doing it to protect a future income stream from inflation, it may not matter much to you.  You are paying for a guarantee, just like you would with insurance.  As long as you are still working, you can pay that fee with current income.  This is a way of protecting future income while you have current income.

Taxes are a similar kind of thing.  With TIPS, taxes are like an annual fee.  You could think of it as a fee to the government for using their system to protect your money.  The fee is paid at your tax rate.  The bad thing about this fee is that it goes up with inflation.  That makes this fee pretty expensive in a high inflation environment.

These fees may still be acceptable to you for protecting your income stream.  With a commercial annuity, you may end up in the same place when you calculate in the loss of principal to your heirs.

If you were to put this annuity in an IRA or 401k, you would completely remove the tax “fee” and if you were careful to only buy your TIPS at a discount instead of a premium, you would also not have to pay the premium “fee.”

You’re the Boss

The thing that makes this so much better than a commercial annuity, is that you have complete control over the principal.  The terms are very clear and your investment is backed by the full credit of the United States.  All of the money is still under your control.

If you are wondering why you’ve never heard of this before, it might be because there is no money in this kind of annuity for anyone else but you.  When you build your own TIPS annuity, you get to decide what to do with the principal and your heirs get it all back in the end without any exposure to the markets.


Copyright © Troy Taft 2020

Why Bonds are Smart for Savings

Colorful Eggs in Small Colorful BucketsBonds are one of the easiest and most common ways to save money for the long term.  There’s a good chance you already own one.  If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond.  CD’s are quite a bit different than other kinds of bonds, but they have many things in common.

Rather than going over different kinds of bonds, I’d like to explain why  they are a good investment for those of us saving for future needs.  In a previous article, I described two ways of looking at our investments.  Bonds are very useful for the part of our savings that we intend to preserve.

Bonds Eliminate Timing Risk

I mentioned back in my introduction to TIPS that bonds are actually a  type of loan.  CD’s are loans that you make to the bank.  If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how.  If you have had a CD before, you know that it has an end date.  That’s how bonds work.  They “mature.”  When they do, you get your money back.

Because bonds have a due date, they are great for eliminating timing risk.  Bonds come with a promise to return your money on a specific day.  If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account.  When the CD matures, you get your money back and all the interest right when you need it.

You can imagine what might happen if you put that money in a mutual fund for two years.  If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans.  It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.

Certificates of Deposit and Inflation

Taking out a two year CD might not be that bad.  At the time I write this, CD rates are still quite a bit lower than the rate of inflation.  When that is true, you end up paying the bank to hold and protect your money.  That’s not always a bad idea.  Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?

I Bonds vs. CD’s

You might consider I Bonds for a two year holding time or more.  You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea.  If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest.  It’s still better than most bank CDs at the time that I write this.  After five years of waiting, you can take the money out any time.  If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one.  You can find out more about I Bonds in another article.

The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation.  There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point.  The problem with that is that interest rates and inflation are not really linked.  The will of the government is in between.   Governments occasionally force interest rates lower as a way to “fix” the economy.  As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.

Using a Bond Ladder

Ladder with fruitYou may have seen an article or heard someone at your bank talk about putting some money in a CD ladder.  This arrangement helps you take advantage of changes in interest rates over time.  It’s another way to attempt to deal with inflation issues as well.

The idea is that you split up your money, and buy CD’s or bonds with different maturity dates.  For instance you might buy one for six months, another for one year and another for two years.  The idea being that every six months you would have a CD coming due.  When it does, it allows you choose whether you need to use some of the money or put it back into another CD.  It also allows you to take advantage of changes in the interest rates as they go up.

When you are trying to save your money for later, bond ladders have much different purpose.  When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates.  Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing.  When we are dealing with the preservation side, what we concern ourselves with is timing.  We just need to ask ourselves: When do I need this money?  In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.

Here’s an example.  Suppose you need your money in 15 years.  It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures.  You can think of your needs like buckets of money.  Let’s say that you have one bucket for each year during your retirement.  You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.

Beware of Bond Mutual Funds

Bond mutual funds don’t have a maturity date.  Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds.  That’s because the fund share prices change every day based on market forces, not inflation.  I plan to explain that more in an article about mutual funds.

A Smart Way to Plan

Bonds are a great way to plan because they are based on time commitments.  Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.


Copyright © Troy Taft 2020

10 Articles About Inflation Protected Bonds

Tree Under Umbrella

source: freeGraphicToday (Pixabay)

Here’s a list of 10 articles I found that provide information about Inflation Protected Bonds.  Learn more about how I Bonds and TIPS work and good reasons to use them for long-term savings.

Zvi Bodie: I Bonds Are Best for Most Investors

by ThinkAdvisor.com

This is an interview with Professor Zvi Bodie about the safest way to invest for your retirement needs.  He explains the clear benefits and why he believes that more people need to hear about this ultra-safe way to prepare for retirement.

What are I Bonds?

by www.ibonds.info

This overview of I Bonds briefly explains their benefits and how they compare to other investments in general.  It describes I Bonds as a safer investment than other kinds of investments.  It has some very helpful graphics.  I believe is the best site about I Bonds I have found.  You might want to spend some time here looking around at all it has to offer.  This site also sports an up-to-date display of the current interest rate being offered by I Bonds in the upper right hand corner and contains great quotes that people have made about the benefits of I Bonds.

Fixed income that isn’t fixed

by Fidelity Viewpoints, Fidelity Investments

This article provides a good overview of TIPS from an investment perspective.  It also has a discussion about ETFs that give smaller investors access to something called Floating Rate Loans.  I’m not a fan of those at this time, but this article does have a discussion of those as well.

Hedge Your Bets With Inflation-Linked Bonds

by Christina Granville, Investopedia

This article give some great background on the history of Inflation Linked Bonds and provides a brief overview of how they relate to investments in an investment strategy.  I tend to not care about investment strategies in that I use inflation protected bonds for long-term savings.  This article also provides the names the inflation protected bonds available in other countries.  Don’t get too concerned about the discussion about deflation.   She mentions at the end, it doesn’t apply to those of us using it for long-term savings.  I intend to address that issue in another article.

The Investment TIPS You Should Care About

by Wade Pfau on Forbes

This article is directed toward those of you who already think in investing terms.  It’s a bit technical compared to some of the other articles.  The author discusses some of the oddities regarding TIPS and their relationship to other bond investments.  He briefly discusses the idea of real and nominal yield and the difference in thinking that goes along with investing in TIPS.

TIPS: Understanding Treasury Inflation-Protected Securities

by Dan Caplinger on The Motley Fool

This is a great article that covers the history that the United States had with the bond market and inflation during the 1970s and 80s.  It does a great job of explaining the benefit and protection that TIPS provide.  The article concludes by recommending ETFs and Mutual Funds.  I’m not a huge fan of funds.  I hope to explain my viewpoint in a future article, but I have held them at times because I believe that they are some of the safest ones to hold.  This article is not very technical and a great one to read to get some background on TIPS.

Negative TIPS Yields

by Thomas Kenny at The Balance

One of the most alarming and confusing things to discover about investing in TIPS is that they can show a negative yield during certain times in the economy.  This article explains why that happens.  This is another topic I hope to make more clear in the future as well.  It’s good to note that your bank account has been giving you negative yields for several years in a row when you adjust your returns for inflation.  TIPS are just more easily exposed when this happens.  You can choose to not buy TIPS when they go negative.

Tracking Inflation and I Bonds

by TIPS Watch

This is a page on a site all about TIPS that tracks the interest rates of I Bonds.  It also explains how I Bond rates are calculated.  If you want to see the history of I Bond rates, you can see that on this tracking page.

Series I Savings Bonds

by Treasury Direct

This is the United States Treasury Department’s information on I Bonds.  You can get all of the most accurate and latest information here including the current interest rates and how they are calculated.   If you want to buy them, you are only a few clicks away.

Treasury Inflation-Protected Securities (TIPS)

by Treasury Direct

Here is the United States Treasury Departments description of TIPS.  This is where you will find the most up-to-date information on them.  It’s not that hard to understand but you may need to invest a little time reading and thinking about it.  I don’t think you need to know much about investing to understand what it said here.  You can also buy TIPS directly from this site.


Copyright © Troy Taft 2020

Thinking of Retirement as Standard of Living Insurance

Professor Zvi Bodie of Boston University said something that really shaped my thinking about retirement savings.  He said that we should think about retirement savings more like we think about insurance.  When I tried that, I realized that it caused me to challenge the advice about retirement that I often hear and read about.  It exposed something that I was seeing that I knew didn’t seem right as I was planning for retirement.

Assurances are not Guarantees

Fund managers want you to invest in their products, but they don’t give guarantees.  They are careful to have disclaimers so that we understand that we could actually lose our money.  That’s worth taking time to consider.  Professor Bodie says that these management companies are in a far better position to understand risk management than the common person, yet they refuse to guarantee that you will even have your retirement savings when you need it.  They give assurances, but they refuse to give a guarantee.  Professor Bodie says that the reason they don’t give a guarantee, is that they can’t.  Instead, they leave the risk of the investment with the person who is least knowledgeable about what they are doing.

A good thing to ask ourselves is: “Why can’t they give a guarantee when they are managing the money?”  The answer is: “Because the investments they use are risky and they know it.”

Professor Zvi Bodie does a great job of explaining the problem here in his video:

Is it really Savings?

I think that there is terminology that retirement fund salespeople should not be using.  They often refer to the money that we put into mutual funds or the stock market and other volatile investments, as our “retirement savings.” In my opinion, the money we are putting into those kinds of investments are actually “retirement ventures.”  Since no one is committed to maintaining a specific amount of money in those accounts, I don’t think that it can legitimately be called: “savings.”

When we use the word “savings” we naturally think of money in a piggy bank or money in a banking institution.  In those places, our money is insured in some way.  Our piggy bank is locked in our house and our bank accounts even have deposit insurance from the federal government.  We naturally expect that when we return to our bank, we will find the same amount or more than we left in it, but that’s not how most “retirement savings” accounts work in my experience.

Unfortunately, we need to be on guard when money managers use the term: “savings.”

Guaranteeing our Savings

There are ways to guarantee savings, and some of them come at a cost.  We know that insurance has a cost because many of us have insurance for other things like healthcare,  our cars or a house.  Insurance costs something because someone else is bearing a risk for us.  When we think of something as important as our retirement, doesn’t it make sense to insure that it will meet our basic needs?  Sure there are things in retirement, like golf or fancy vacations, that we don’t really need.  I’m not talking about that necessarily, but what about food and medical needs?  What about the power bill or visiting family for Christmas?  Do we want to become a burden on our adult children when it can be avoided?

Zvi Bodie brings up an interesting point in another place.  He suggests that we consider the fact that we are willing to pay $1000 for fire insurance for our house even though it is very unlikely that our house will burn down.  The chances are very small, yet we still pay for it.   That’s because we believe that the seriousness of not having a house outweighs the fact that it is unlikely to happen.  What good a house if I am unable to live in it in because my retirement savings has disappeared?  It doesn’t really make sense to protect the house and not protect my income.

Two Categories of Retirement Funds

Thinking about retirement in this way leads to dividing our retirement funds into two parts.  One part is the part you reasonably believe you can’t do without in your old age.  The other part is for things that you hope for, but that are not critical to your survival.  When we divide it up like this, and get insurance for the critical part, it can lead to peace of mind knowing that our critical retirement needs are guaranteed to be there for us.

Guaranteed Retirement Options

When it comes to ways to guarantee the critical part of your retirement, you might be imagining a large piggy bank or perhaps a bank CD.  If you have been reading my blog, however, you know what I think about that.  Both piggy banks and CD’s are not usually inflation protected, which means that they are not a guarantee.  They fail to be a guarantee because you don’t know what the contents of your piggy bank will buy in 30 years when you need it.

There have been CD’s that were “inflation-linked” in the past but I have not seen any in the last few years.  Hopefully, demand for them will increase and they will be offered again in the future.

Social Security

One obvious form of retirement insurance is Social Security.  It is inflation protected and it’s definitely something to consider when thinking about your critical retirement savings.  Social Security is likely to go through some changes in the future, but I expect that something very similar to it will be available for a long time to come.  There’s more about this investment in the article: Possibly the Most Popular Inflation Protected Investment.

Company or Government Pensions

If you happen to have a job that offers a pension that adjusts your payments for inflation, you are in a good position.  When I say pension, I mean the old fashioned kind that doesn’t require that you manage the money and that does provide a written guarantee.  Pensions that don’t adjust for inflation, are helpful but they don’t guarantee that you won’t run out of money to pay your expenses in the distant future.

Be Careful With Insurance Annuities

Other insurance products are provided by insurance companies by way of inflation adjusted annuities.  I would just make sure that the inflation adjustments are connected to actual inflation and not a flat percentage increase each year.  It’s important to understand how much you are paying for that insurance up front too.  Beware: Insurance companies use the word “guarantee” in a similar way that fund managers use the word “savings.”  Make sure you know what they are actually guaranteeing.  Guaranteed percentages are not the whole story.  You also need to know the exact amount of principal the percentage is calculated against.  If the principle goes down with something other than inflation, it’s not much of a guarantee.  Also remember that if the guarantee isn’t in writing, it’s still not a guarantee.  Insurance companies do and have gone out of business.  Zvi Bodie recommends splitting up your funds between companies.

Home Equity

The Equity in our homes really is a form of inflation protection.  Because a house is a physical thing that represents one of our important needs, it’s automatically inflation protected.  Its value goes up with inflation because a house is still a house no matter what the value of money is.  Just having your home paid off is big part of insuring your retirement.

This presents an option for those who have no heirs or have no other choice.  Many of us spend our lives paying the bank to own a house.  The tables can be turned.  It is possible to sell the equity to the bank and have them pay you to live in your own house.  That’s what is called a reverse mortgage.

Once again caution is needed.  Make sure to read everything in any contract to make sure that the bank isn’t taking too much for themselves in the deal.  They may woo you with assurances that the remaining equity will go to your heirs, but I am told that this is often not the case because of high fees.  Again, there’s no guarantee.

Another thing to consider is selling your house to your heirs, with permission to continue living in the house as long as you can.  Working a deal with your loved ones could be a practical option and it can be a win-win situation with them.

Inflation Protected Bonds

My favorite option is to use Treasury Inflation Protected Securities and I Bonds for savings that I want to insure.  I do have to do a bit more work myself, but fees are low or non existent.  These are just boring government bonds that usually don’t make a whole lot of interest, but they do one thing very well: they protect long-term savings from inflation and that’s what I’m looking for when it comes to protecting the critical part of my retirement savings.


Copyright © Troy Taft 2020