William Bernstein is a fan of TIPs bonds as a retirement income investment.
TIPS, or Treasury Inflation-Protected Securities, are U.S. Treasury bonds that compensate for inflation. The U.S. Treasury is considered the safest bond issuer in the world and many consider TIPS the safest of the safe, because unlike all other Treasuries, TIPs also protect against inflation.
TIPS bonds pay their coupon rate of interest semi-annually. At maturity, the Treasury increases the amount of principal you are repaid to compensate for inflation over the life of the bond.
My last post discussed why retiree's might want to own bonds, but bonds come in many different flavors. They are issued by financially sound governments, developing nation governments, government agencies, blue chip corporations and risky, small companies (junk bonds). They are also issued by cities (muni's) and many other entities. The more financially sound the issuer, the safer the bond and the lower the interest rate paid.
When interest rates go up, bond prices go down, and vice versa. Bonds that will mature soon are safer than bonds that won't pay back their principal for a long time. A change in interest rates will have a much greater impact on the price of long bonds than it will on short or intermediate maturity bonds. Longer bonds can be quite risky.
Bonds can be exempt from Federal income taxes (municipal bonds) or exempt from state taxes (U.S. Treasury bonds).
What would constitute a perfect bond for retirement income?
That bond would be nearly risk-free. As Bernstein says, the riskless portion of your portfolio should be totally riskless. Long bonds and junk bonds are examples of bonds with considerable risk. TIPS, particularly short and intermediate maturity TIPS, are the safest bonds available.
The perfect bond would be available in a wide range of maturities, as TIPS currently are, from short term to 30 years.
Since retirement may last a long time, the perfect bond would compensate for inflation. While perhaps imperfect in this respect, depending on how well you believe the CPI tracks actual inflation, TIPS compensate for inflation better than any other fixed-income security.
Long term investments with relatively low returns also need to have low transaction costs. Even a small recurring cost can be a significant percentage of the stingy total real return of a TIPS bond. You can buy TIPS bonds directly from the U.S. government at Treasury Direct for no fee. Several large brokerages will also sell them for no fee.
So, lowest risk, inflation protection, wide range of maturity dates and low cost. Why aren't TIPS the perfect retirement income investment?
TIPS have a tax problem, "phantom income", resulting from having to pay taxes on accrued principal as you go. The solution to this problem may be to hold them in a retirement account like an IRA or 401(k).
(TIPS are not subject to state income tax and if you hold them in a tax-deferred account, you will lose that feature. Withdrawals will be treated as ordinary income for tax purposes. So, if you have low Federal taxes but high state taxes, beware.)
TIPS are safe and that typically means low volatility, but TIPS have a strange volatility characteristic. TIPs can be volatile in the short term during an economic crisis because of liquidity issues, though they exhibit low volatility over the long run. This isn't a problem, of course, unless you are forced to sell them in a crisis. If you can hold them, the volatility problem will subside.
TIPS bonds may not be available in every maturity you desire. For example, there are no TIPS currently maturing in 2024, 2030-31, or 2033-2039. This problem can be mitigated by buying twice as many bonds maturing in 2025, for example, but I would prefer to buy half of my allocation to replace 2024 bonds in 2023 bonds and half in 2025 bonds to get the average duration and return.
TIPS aren't a perfect solution for secure income in retirement, but they are clearly the best alternative in my opinion, and apparently in William Bernstein's opinion.
You can decide which endorsement means more to you, but I'm personally going with Bill's.
Now, on to the original question: should you buy individual TIPs bonds or invest in a TIPS bond fund?