In Conversation 9780, Ron asked: "Could you refer me to the right posts that got you to that 50/50 split between TIPS and Total Bond Index (TBM)?"

As far as I know, I'm the first to use this 50/50 combination. Here's why I think it makes sense:

The Efficient Market Theory recommends short-term bonds for the bond portion of a portfolio. This is because, by shortening maturity of a bond fund, we only slightly reduce long-term returns, but we greatly reduce risk. A neat trade-off.

Despite EMT theory, we have used Total Bond Market Index Fund as our core bond fund in the bond portion of our portfolio. I felt that the extra return of TBM in a flat, or deflationary environment, could not be ignored.

TIPS bonds were first issued by the U.S. Treasury in 1997. They are unique in several respects:

1. Unlike conventional bonds, a TIPS bond isn't worth less each year relative to inflation. It's purchasing power remains the same. I consider this a VERY important advantage of TIPS.

2. Because they don't correlate well with stocks and conventional bonds, they allow you to have a higher percentage in stocks for the same amount of risk.

3. TIPS are backed by the U.S. government with virtually no risk of default (safe, but you can still lose some money for other reasons).

Vanguard started their first TIPS fund in June, 2000. Although Total Bond Market Index Fund has been our core bond fund for many years, I purchased a small amount of this new TIPS fund in June to learn about it. After all, nothing focus's the mind like having your own money in a security.

At the end of the year (6-months) our TBM fund returned 10%; TIPS returned 9%; and Short Term Bond Index returned 8%. TBM and TIPS together out-returned Short Term Bonds--and this was in a flat or declining interest rate environment. I would expect TIPS to do relatively better in an inflationary environment. In addition, volatility should be less whatever happens to interest rates and inflation. This is why I think my 50/50 TIPS combo makes sense--more return with less risk. Both funds are tax-inefficient and should be in tax-deferred accounts if possible.

TBM: Morningstar writes--This offering is a solid core choice for the bond portion of a portfolio.

TIPS: Here is a good article: www.vanguard.com/cgi-bin/NewsPrint/971808006
Best wishes.
Taylor

Originally posted in thread: 9792

good analysis BUT- IMO are you really worried about deflation (only times bonds are good unless you can predict interest rates-and no evidence of that). Last time was depression and Fed learned from its mistakes-then it let money supply contract, exacerbating the problem. Now at slightest sign of weakness in economy they act quickly to increase money supply.

I have to admit that I am first to say that one of biggest mistakes investors make is to treat the highly unlikely as impossible. Having said that I just cannot envision any prolonged period of deflation of financial assets. Thus I think the risk reduction benefits of TIPS and Ibonds and short term fixed income is the way to go. BTW the highest historical returns have been at the 2 year maturity and the highest risk adjusted have been at about 9-12 months.

But throwing in bit of Total bond wouldn't hurt, just think it isn't necessary and does probably mean greater volatility and lower returns

Originally posted in thread: 9792

Taylor:

At the end of the year (6-months) our TBM fund returned 10%; TIPS returned 9%; and Short Term Bond Index returned 8%. TBM and TIPS together out-returned Short Term Bonds--and this was in a flat or declining interest rate environment.

As you note, interest rates decline in the last 6 months of 2000. For example, 10 year treasuries were approx. 6% in July and about 5% at year end. Therefore, it's not surprising that TBM with an average duration of 4.6 years outperformed ST with an average duration of 2.4. When rates decline, aren't longer bonds supposed to increase in value more than shorter bonds?

30 year TIPS had a real yield of 4.3% in January, 2000 and have a real yield of 3.5% today. TIPS have increased about 17% over this period (based on the change in value of the TIPS I bought in 1/2000). Inflation for 2000 was about 3.5% and 10 year treasuries went from 6.5% to 5%. Based on this, I am especially puzzled how Vanguard assigned its TIPS fund a duration of 1.4 years. A large increase in value in the face of rate changes of this magnitude would seem to suggest a higher duration.

I'm concerned about the reaction of TIPS to increases in real or nominal rates, based on their reaction to decreases in rates. Especially if the TIPS had to be sold, for income, rebalancing or whatever.

I'm curious what your thoughts are on these issues.

richard

Originally posted in thread: 9792

How appropriate a conversation, as I struggle with restructuring my retirement portfolio. At present (at 74) I'm facing several decisions. With a 33-40% equity vs. bond (67-60%) decided upon Asset Allocation, (thanks to info. from Taylor, Larry, Mel and personal study) I am looking, as is Taylor at a possible bond set-up of 50% TSM et al., and 50% in V/G Inflation Protect.Index Fund.

Currently hold: 31% Bond Funds (all in IRA's)
14% Total Bond Fund;
5% V/G Inflation Prot. Bd. Fund;
3% V/G Short Term Bond Fund;
9% V/G GNMA (I know Taylor, duplication, but in my wife's IRA, and she wants to keep it).

So most of these are in Int.Term Bonds. Was thinking of eliminating Short Term Bond Fund, and increasing Tips Fund, through transfer and additional M/M/ IRA funds transfers. But Larry raises a good point. A place for more Short Term Bonds?

As to equity portion of restructuring portfolio: Have eliminated most of duplicating funds, balanced funds, in favor of TSM. (But do wish, back in Aug.and Sept., I'd heeded warnings from Larry and J.Bogle about overemphasis of TSM on Lg. Tech and had devoted more of those transfers towards a gradual DCA.) Ah well.

At least I getting there, with a retirement portfolio which seems to make more sense, and if we can accept and live with more modest returns, sleep at night.
Thanks for all your assistance. Hope you get some rest from all the requests, Larry. Given the salt-air of your sea trips Taylor, I have confidence that you can stay-the-course through the numerous requests for guidance from you in seeking a safe port. Regards.

Bruce

Originally posted in thread: 9792

I appreciate your response to my question Taylor. Also,thanks for the Link.

As usual, you explain your reason for a 50/50 mix in a way that makes sense even to Novice investors like myself.

Thanks..........ron

Originally posted in thread: 9792

Thanks for your reply.

My concerns may well be exaggerated. It's hard to tell. As you say, performance history is short. I don't draw much comfort from the fact that TIPS were designed for a specific purpose. That a security designed by someone (especially a government someone) might perform differently from it's intended purpose would not surprise me.

Nominal interest rates should certainly correlate to inflation. Is there a similar relation between inflation and real rates?

As noted, the large movements in price of TIPS while I've been watching them causes me concern - I wish they were more like ibonds: a guaranteed premium over inflation, with no concern about principal volatility.

In any event, they've certainly been a good investment over the past year.

thanks again.

richard

Originally posted in thread: 9792

In this issue I lean toward Taylor's approach, rather than Larry's. In fact, I am leery of even speaking about specific types of risk. Truth is, at this point we don't know the full risks of TIPs, tips funds especially, relative to the better understood "total bond". So it makes sense to diversify.

jk

Originally posted in thread: 9792

does this still seem like a reasonable approach? me: 10 more years to work, funds would be in a retirement account.

thanks to everyone for their insightful opinions!

Andy

Originally posted in thread: 9792

Powerful stuff indeed.

I'm more conservative than many of the Diehards. My FI portfolio is 2:1 TIPS:TBM. IMHO, the real return on conventional bonds is risky even out to 30 years. BTW, I keep a small stash of IBonds too.

Ken

Originally posted in thread: 9792

Taylor wrote:

The Efficient Market Theory recommends short-term bonds for the bond portion of a portfolio.

We hear this opinion often here on Diehards, but it is not a given in the academic financial world. For example, in their book Strategic Asset Allocation, John Campbell and Luis Viceira argue with some good reasons that long bonds, not short bonds, are often best for long-term investors. Also see their paper "Who Should Buy Long-Term Bonds" in American Economic Review 91, 99-127 (2001).

John Norstad

Originally posted in thread: 9792

Larry and Rick have very different views on the fixed income portfolio. Larry's view is that the fixed portion should have minimum risk; therefore, he recommends short-term bonds and TIPS. Rick states that diversification is as important in the fixed portion of the portfolio as it is in the equity portion. Rick suggests of mixture of various types of fixed investments. Ultimately, are the two positions really that different? My understanding of the difference follows:

As I understand Larry's position, risk/reward is set with the initial split of fixed and equity. Risk tolerance, etc. is adjusted in the split - if you want more risk/reward, increase the equity portion. As I understand Larry's views, the fixed portion is not the place for adding risk so his recommendation is low risk short-term bonds and TIPS.

As I understand Rick's position, risk/reward should be considered in both fixed and equity so that a portion of the risk/reward is through the total allocation to equities, and a portion is in the mix of investments in the fixed portion.

In theory, it is possible to have the same level of risk/reward using either Larry's or Rick's approach. Larry's portfolio would have a higher allocation to equities with a low-risk fixed portfolio, whereas Rick's approach would be to split the total risk/reward between equity and fixed. I would love to hear both Larry and Rick's comments relative to the merits of each point of view.

John

Originally posted in thread: 9792

For those that don't have access to the American Economic Review, I found this article on Campbell's Harvard website. John, does this look like the same article?

Alec

Originally posted in thread: 9792

>>The Efficient Market Theory recommends short-term bonds for the bond portion of a portfolio.

No it doesn't. If anything, EMT recommends an average investor hold a portfolio which mirrors the capitalization weighted available investible universe, which certainly includes long bonds.

Quick quiz, if you hold, say, Vanguard's total bond market fund and plan to hold for 25 years, should you hope that (1) interest rates plummet, (2) interest rates stay constant or (3) interest rates soar.

Originally posted in thread: 9792

Alec wrote:

For those that don't have access to the American Economic Review, I found this article on Campbell's Harvard website. John, does this look like the same article?

Yes, that's the one. I actually got a chance to listen to Campbell present this paper at a seminar here at NU a few years ago.

He has an interesting and I think valid argument - basically, MPT makes long bonds look bad because MPT (mean-variance portfolio analysis) focuses only on the short term, using short-term return and variance data. For long-term investors we need to use more appropriate (and significantly more complicated) analytic techniques, and when we do, long bonds are quite attractive - much more so than short bonds under many quite reasonable scenarios.

As a simple example he uses to make his basic point, most people think of "cash" (e.g., short US Treasuries, savings accounts, or money market funds) as the "safest" investments. But for a long-horizon investor there's huge reinvestment risk, and in fact for such a long-horizon investor long-term inflation-protected bonds are actually the "riskless" asset. In low inflation environments he also shows using his statistical and mathematical models that long-term nominal bonds are better for long-horizon investors than short-term bonds are.

It's certainly food for thought. Unfortunately, the math is really hard to understand even if the conclusions based on the math are not so difficult.

The book I mentioned goes into this in much more detail and covers many other interesting topics where "strategic" or "long-horizon" investing is often different and more complicated than the "tactical" or "short-horizon" investing modeled by simple MPT.

John Norstad

Originally posted in thread: 9792

Taylor, are you still maintaining this 50/50 TIPS/TBM allocation with today's lower yields?

Thanks

Originally posted in thread: 9792

Readers should note if they missed it that the original post is #9792, made in 2001. It was updated in O2, 03, 04 and now 07. Good history of bond AA and tips.

Paul

Originally posted in thread: 9792

.
Below is a look at Short Term Treasury vs Total Bond mixed with the 500 Index 1970-2006 including 10K Growth and Volatility details.

I think what Larry often suggest is that tilting to "Value" is a better bet than going longer on bond duration.

Trev H
======


60% 500 Index
40% Total Bond
380,974.34
10.91

50% 500 Index
10% Small Value
40% Short Term Treasury
368,385.44
10.23

45% 500 Index
15% Small Value
40% Short Term Treasury
393,249.05
10.17

40% 500 Index
20% Small Value
40% Short Term Treasury
418,979.68
10.17

35% 500 Index
25% Small Value
40% Short Term Treasury
445,538.26
10.23

30% 500 Index
30% Small Value
40% Short Term Treasury
472,878.84
10.35

Short Term Treasury = lower correlation to 500 Index than Total Bond.

Small Value is also quite disconnected from the 500 Index.

The combination of 500 Index & Small Value combined with ST Treasury did not excede the volatility of 500 Index & Total Bond until you reached around 43% exposure to Small Value.

17.5% 500 Index
42.5% Small Value
40% Short Term Treasury
544,286.23
10.89

Listing 500 Index and Total Bond again below...

60% 500 Index
40% Total Bond
380,974.34
10.91

In this backtest Short Term Treasury return is calculated using a 50/50 mix of 5 Year T-Notes & T-Bills. Total Bond is Lehman Agg & VBMFX.

Anyway what Larry usually stresses is that you should not take risk on the fixed income side... better off doing that on the equity side with value tilts.

Trev H

Originally posted in thread: 9792

I have been following the ongoing discussions on bonds for a while now and have come up with a middle ground for my bond holdings. I use 1/3 Total Bond, 1/3 TIPS and 1/3 Short Term Index. Another way to Dublin? John

Originally posted in thread: 9792

Taylor wrote:

"Vanguard's Inflation-Protected Securities (TIPS) fund provided the highest return and lowest risk."

and

"Risk and return are highly correlated."

How do you reconcile these two statements?

Regards,

Doc

Originally posted in thread: 9792

There is lot of discussion about how TIPS might fare in an inflationary period, and I have done a lot of spreadsheet work examining this question. I agree with Taylor that a mix TIPS and Treasury Bonds make sense. Because there are so many possible assumptions as to how rates might play out in the future, there is no easy answer as to which is better.

There is a simple analysis based on real data that illustrates the power of TIPS as insurance in an inflationary era.

Assume it is June 1966 and you have a choice between buying a 10 Yr TIPS and a 10Yr Treasury. The conditions then were somewhat like today: Yr/Yr Inflation was 2.53%, the 10 Yr Treasury Yield was 4.81%. Inflation and Treasury rates had been rising slightly for some time. There was no clue as to the inflation spike to come. In the next 10 years inflation went above 12%, in the next 20 it went thru a 13% peak before the inflationary cycle was broken.

Let's assume a TIPS instrument was availible in June of 1966 and its Coupon Rate equalled that of the Nominal 10 Yr bond less the Yr/Yr inflation on that date (probably a reaonable assumption).

If you bought the 10Yr TIPS with a 2.278% coupon, accumulated interest in a MM account paying the prevailing historical rate, payed 25% tax on interest and OID gains, you would have an after-tax total return of 6.15%.

If you opted for the 10 Yr Treasury, accumulated interest payments in a MM Acc't and payed taxes as per the TIPS assumptions, you wound up with an after-tax total return of 0.95% (pretty shabby, but it gets worse).

The annualized inflation ran at 5.60% in that 10 year span. The TIPS option (had it been offered at that time) netted you a real annualized gain of 0.56%. Not too hot, but your principal was preserved. The 10 Yr Treasury left you with a real loss of -4.64% per annum.

Who knows what the future holds. This example from a long-term inflationary era in our history shows TIPS could preserve your real wealth & Treasury Bonds would consume it. Other analyses show, at worst, TIPS offer low-cost insurance against unexpected inflation.

Bulldog

Originally posted in thread: 9792

When we talk about risk and return being correlated we mean higher return implies higher risk. Yet you say the the TIPS fund had the higest return and the lowest risk.

Your two statements while maybe "correct" are in conflict with each other and that is what needs explanation.

Regards,

Doc

Originally posted in thread: 9792

The higher risk with TIPS so far has shown itself as higher volatility than other Treasuries.

Both despite TIPS higher volatility and because of it, at the moment TIPS are still ahead of conventional bonds in the time period mentioned.

The concept of correlated risk and return is just a concept and will not be true for every investment in every time period.

Surely you can appreciate the difference between a concept that will hold true over your investing life versus a specific report of 5 year returns.

Also, to paraphrase Swedroe, when the risk shows up, you don't get a high return.

Chris

Originally posted in thread: 9792

"Surely you can appreciate the difference between a concept that will hold true over your investing life versus a specific report of 5 year returns."

I am not the one who is advocating a mix of TBM and TIPS based on short term data. So I think you are directing your comment at the wrong person.

Regards,

Doc

Originally posted in thread: 9792

In Post #28, I was examining what would be the effect of choosing between a hypotherical 10Yr TIPS bond and a 10 Yr Treasury in June of 1966. I was being too clever with my spreadsheet, trying to accrue OID Tax liability semi-anually and pay it annually. Well I screwed that up and managed to tax a major portion of the MM account very 6 months! Sorry about that.

I made the needed corrections and recalculated the returns for the two options. Not surprisingly, they were better than I had indicated in my earlier post. The 10Yr Treasury had been more significantly affected by the error, owing to the larger MM account accumulation in Treasury option.

The corrected Real After-tax Total Return comparison: the 10 Yr TIPS real return was 0.47% and the 10 Yr Treasury, in real dollars, lost -1.81% anually.

My conclusion was unchanged. The TIPS option (if it had been offered at that time) would have been the superior choice. This example of an unexpected, long-term, inflationary era in our history shows TIPS could preserve your real wealth & Treasury Bonds would consume it.

Originally posted in thread: 9792