Monday, November 14, 2011

Are TIPS Really Safe and Worry-Free?

I'm fortunate to now be a monthly columnist at Advisor Perspectives on topics related to de-accumulation strategies and safe withdrawal rates.  Although I will make much more effort to focus on quality (as some of my blog entries tend to be rough drafts that end up getting re-written multiple times), the topics I discuss in my columns will be the same sorts of issues I've been discussing here.

My first column is available now, "Are TIPS Really Safe and Worry-Free?"  

My purpose is not to do a hatchet job on TIPS.  I think TIPS are very important and useful.  But it troubles me that the same people who will focus on how potentially dangerous and risky it is to use a well-balanced portfolio of stocks and bonds for retirement, will at the same time use terms such as "risk free" or "safe" or "worry-free" when talking about TIPS.  Let's not get our hopes up too much about TIPS.  They can be an important component of anyone's portfolio, and they are certainly an important component of my own, but I wouldn't want to put everything into TIPS.  Recognizing this is the point of the article.  Please have a look.

3 comments:

  1. Good article.
    I'd say the major risk is that the government will renege on the inflation protection promise in a sustained period of high inflation, such as we had in the 1970s. Next in order of worry about such bonds is interest rate risk. At least some reversion to the mean of historical average long term bond rates (i.e. towards 3-4%) would see yields rise and prices fall. Right now, stocks look like a better bet for long term inflation protection, though if TIPS (called RRBs in Canada) yields go back to 2% I would be buying some for the part of my retirement savings/spending bucket that is quite sure to be required no sooner than the bond maturity date.

    ReplyDelete
  2. Overall good discussion on the risks involved. What I think lets the article down is the comment that in the future real yields could be lower but since 1871, a stock/bill combination has been okay. Future stock returns may also be negative for an extended period. If you want to compare two strategies, use comparable numbers such as average real yields being over 2% since 1871. The comparison is still favourable but should be more like 16% saving rate for the risky approach against 22% for the inflation hedged approach.

    ReplyDelete
  3. CanadianInvestor and ADM,

    Thank you both for the comments.

    ADM, I think you are surely right that those with a risky portfolio for retirement planning in recent years may be pushing the limits of the "safe savings rate" and may get a new worst-case scenario. 16% may not be so safe after all.

    But at the same time, about TIPS, while I don't have any disagreement that the average real yield over time should be 2%, that is for conventional bonds.

    For TIPS, it should be:

    2% - the inflation protection premium

    which is the amount of yield investors are willing to sacrifice to ensure they receive a real return. It's protection against unexpected inflation.

    For anyone starting out with a savings strategy for TIPS now, they are probably doing it because they fear higher inflation in the future. If the rest of the population catches up with them in this belief, then the inflation protection premium will increase and real yields will stay low or get even lower.

    The only way I can see 2% as being a long-term average real yield for TIPS is if recent history continues in that investors are not so worried about inflation and not willing to pay a premium for protection.

    (real yields could go higher than 2% if there is deflation, because then there could be net-sellers of inflation protection)

    I think in the early years of TIPS, real yields were higher than 2% in part because of an illiquidity premium in that the market was new and investors were not immediately jumping in. With that being gone, I can't really imagine that for 30-year TIPS at least, 2% will represent a long-term average. I think it represents something closer to a long-term upper bound. And this will mean needing to use a higher savings rate.

    ReplyDelete