Thursday, January 8, 2015

Funding the Gap

I interrupt my current wanderings through Game Theory to re-address a question I have discussed in the past regarding whether a TIPS bond ladder held to maturity can safely be replaced by a TIPS bond fund.

Bond ladders can be set up in a couple of ways, fixed length and rolling. A 5-year fixed length bond ladder, for example, will be depleted in five years as each of the rungs matures. We replace the longest rung of a rolling ladder each year as the shortest bond matures, so a 5-year rolling ladder always contains five rungs.

Today I'll talk about short fixed-length ladders. A retiree might use a 5-year, fixed-length ladder, for example, to bridge the gap between retirement at age 65 and claiming Social Security benefits at age 70.

The key to this discussion is that a ladder of TIPS bonds held to maturity isn't a do-it-yourself bond fund. When held to maturity, TIPS bonds are risk-free assets that have more in common with cash than with bond funds.

A ladder of TIPS bonds held to maturity has no volatility, interest rate risk or correlation to the stock market, nor does it have inflation risk. These bonds are a contract with the U.S. Treasury to pay specified amounts of interest in each year (the "coupon") until maturity and then return the face value of the bond plus additional principle to compensate for inflation. In other words, you will receive the face value in inflation-adjusted dollars. You have no opportunity for capital gain or risk of capital loss with a ladder of TIPS bonds held to maturity; you would have both with a TIPS bond fund.

The absolute safest way to insure that you will have the cash you need for each of those five years is to purchase a ladder of TIPS bonds and hold them to maturity. That's the only way to automatically adjust your bond holdings' durations to match the dates when you will need the money.

A fund manager will try to keep its duration fairly constant, at about 2.5 years for a short term TIPS bond fund, for example. That won't precisely match the ideal durations of 1, 2, 3, 4 and 5 years in our example, as individual bonds could. An investor could mix portions of funds with different durations to better match the duration of the spending, but that seems like a lot more trouble than buying individual bonds without a lot of improvement. Still, bond funds are at best an approximation of expense durations.

Why would you consider alternatives to a TIPS ladder? Many people are unfamiliar with purchasing individual bonds and prefer the simplicity of investing in a bond fund. I don't find ladders difficult to purchase. I ask the bond desk at Vanguard, Fidelity or Schwab to find the bonds for me. Schwab charges $1 per bond and they all do the search for free, but I understand that some might find this daunting.

You might also figure that you could receive higher returns from the bond fund if interest rates increase. That is a possibility, but how much profit can you make by investing in a short term TIPS bond fund like Vanguard Short-Term Inflation-Protected Securities Index Fund Investor Shares (VTIPX)?

And, if this is money that you want to be truly safe, would you risk it to earn a little more interest?

VTIPX has a duration at present of 2.4, which is about the same as a 5-year ladder of zero coupon TIPS bonds (2.5). You can expect a 1% increase in interest rates of similar duration bonds to result in a capital loss of about 2.4% with VTIPX. That loss would be recovered by the additional interest in 2.4 years, assuming you hold the investment at least that long. A 1% decline in rates would result in a capital gain of about 2.4%. In other words, there isn't a lot of profit to be earned or capital to be lost whether you invest in short term TIPS bonds or a fund made up of them.

If that's the case, then why not leave the funds in a money market account or certificates of deposit? VTIPX has a current yield of 0.72%, Vanguard money market account yields are barely observable with the naked eye. You can buy a 1-year CD that pays around 1% and a 5-year CD can earn 1.8%.

(Don't spend it all in one place.)

The answer, of course, is that TIPS bonds and funds provide inflation protection. But, how much inflation risk do we expect for the next five years? The current rate in 2015 is only about 1.8% a year and many predict that we will experience low inflation for quite some time. If inflation averages 1.8% a year, the real return on the 1-year CD is negative 0.8% and the real return on the 5-year CD is zero, so there are worse things than a 0.72% return.

Inflation would seem to be a bigger concern than nominal returns at present, since most nominal returns for short term, low-volatility investments are currently near zero. Even a low rate of 1.8% annual inflation means that the dollar you want to spend in 5 years will be worth only about 91 cents in today's dollars.

So, a TIPS bond fund makes sense to me right now. As I said, the absolute safest alternative is a ladder of TIPS bonds held to maturity, but the TIPS bond fund doesn't add much risk. You can't really lose much money (or make much) at this duration in a Treasury bond or fund. This is a situation in which we should probably be more concerned about not losing money than making more, anyway.

A fixed length (non-rolling) TIPS bond ladder is not the same asset as a TIPS bond fund. The former is a risk-free asset and the latter has volatility of returns.

Rolling ladders and longer non-rolling ladders have other risks that concern me more, but if you want to go the more convenient fund route, I don't see a compelling reason to buy individual bonds in this scenario with today's interest rates unless very small losses would make a difference in your situation.

I'll talk more about ladders and funds next time in First Moments and Second Derivatives.


  1. Thanks for the interesting comparison The rolling TIPs Bond ladder seems like a good idea but shouldn't it be in a tax deferred account? The annual tax reporting implications for TIPs has kept me in TIP index funds so far.

  2. As I said in the post, a non-rolling TIPS bond ladder is not a personal bond fund; it's more like cash. A rolling TIPS bond ladder, on the other hand, is arguably a personal bond fund. I will have more to say on the topic in a future post, but it isn't clear that you wouldn't be at least as well off in a fund as a rolling ladder.

    Taxes are an individual issue and I don't claim to be a tax expert. However, in my case, state taxes have been a much larger issue in my first ten years of retirement than federal taxes. Of course, that could change one day. But,Treasury bonds are taxed only by the IRS and escape state taxation, so they haven't been a tax issue for me. If you hold them in a traditional IRA, the distributions will be taxed. In a Roth, they won't be. Check with your tax professional on your own situation.

    I'll have to check your reporting issue. You may find that the large brokerage houses do most of the dirty work for you. Check back in a few days.

    And thanks for writing!

    1. I don't worry a lot about tax reporting because I have my taxes professionally prepared, so I discussed this issue with a tax professional. His opinion is that tax reporting shouldn't scare most investors away from TIPS bonds, even if they prepare their own returns. Annual interest will be reported on a 1099-INT and annual accrued principal will be reported on a 1099-OID (original issue discount). Both are reported on Schedule B of your Form 1040. These will be reported by TreasuryDirect if you buy original issues and should be reported by your brokerage firm if you buy TIPS on the secondary market.

      Schwab tells me that they report accrued interest and track adjusted basis for you. Vanguard's bond desk told me that they will not track adjusted basis of factored bonds until 2016, but they do report accrued principal now.

      By the way, I find the annual fee I pay for professional tax return preparation to be a wonderful investment when I consider the hours of my time saved and the confidence I have in my return.

  3. Scotty Jay from Cali-forn-i-aJanuary 10, 2015 at 9:10 PM

    From an economic perspective, it seems to me that individual bonds and bond funds are basically equivalent, aside from issues such as diversification, fees, etc. I think you may be excluding the concepts of "mark to market" and opportunity cost in your analysis. For reference, search on Cliff Asness's Top Ten Peeves; I think the one in question is #10.

    Overall, I enjoy reading your work. Thanks for publishing on a regular basis.

    1. Scotty, thanks for writing. I have not overlooked either of these arguments, they are fairly common; I simply disagree with them in this case.

      The “Mark-to-market” argument points out that the daily market price of individual bonds fluctuates the same as the NAV of a bond fund and that holding a ladder to maturity just means that we ignore the fluctuation of the bond prices but not those of the bond fund. That is correct, but there is a reason to do it. The individual bond can be held to maturity, in which case the price volatility does not matter, but the fund cannot be. This isn’t an unfair comparison, the characteristics of the assets are different.

      Ignoring underlying volatility is not uncommon in financial planning. If we had to sell our home, certificates of deposit, or a life annuity tomorrow (or any illiquid asset), we might have to sell them at a loss. In the case of the annuity, we almost certainly would. Yet, none of us has his home appraised on a regular basis, or considers what might happen if we should need to sell a life annuity. We assume when we buy a life annuity that we will use it to provide lifetime income, so we don’t worry about what it might bring on the secondary market daily. Unless we plan to sell our home, we don’t pay much attention to what we might get for it. We probably ignore the penalties for cashing in a CD early. Because we don’t plan to sell them, we don’t “mark them to market”.

      A non-rolling bond ladder held to maturity is not a fund. Annette Thau discusses this in The Bond Book and there is an excellent discussion on this topic at the <a href="”> Bogleheads </a> forum. William Bernstein is also an advocate of bond ladders held to maturity, though he frequently notes that funding all of retirement with one would be quite expensive. I agree that if we sell the bonds before they mature, or decide to sell a life annuity on the secondary market, that we can’t expect the same results as holding them, but that is not the strategy I am discussing in this post.

      As for the opportunity argument, it is true that investing in a fund provides upside opportunity (and downside risk) while a bond ladder does not. That simply makes my point that non-rolling ladders held to maturity are risk-free assets. However, this strategy is meant to provide certain cash at a future date, so the presumption is that the retiree would be more interested in avoiding losses with these funds than with the opportunity to earn a little bit more interest. If he is willing to take that risk, then he should buy the fund.

      A rolling bond ladder does, for all practical purposes, behave like a fund, and I have concerns even about long non-rolling ladders when the probability of forced sale increases. But, for a relatively short period like 5 to 10 years, a fund has risk but a TIPS bond ladder held to maturity has none. That would not be true if the investor sells before maturity, but if the risk of being forced to sell these bonds before maturity is significant, this isn’t the right strategy to begin with.

      Thanks again for writing.

    2. Sorry that link didn't work, here it is again: Bogleheads

  4. All things being equal, your note about bond funds following the heuristic that their NAV will drop in inversely to the rise in inflation multiplied by the fund’s average duration is approximately accurate—a 1% rise in interest will drive the NAV of a fund with a 4.5 year duration down about 4.5%.

    Beyond duration, coupon rate and YTM also affect a bond’s volatility—generally, the lower the more volatile. TIPS represent an even more select case since they deliver (low) real yield and their price is driven primarily by inflation expectations and the spread to corresponding nominal Treasuries.

    So in real life, results can be surprising.

    For example, BND, with a duration of about 5.6, fell 6.1% from 84.25 to 79.14 during the Bernanke rate scare 4/30/13 to 9/5/13.

    The 10-yr T-Note interest rate rose from a low of 1.61% on 5/1/13 to 2.98% on 9/5/13 before finishing at 3.03% at year end—about a 1.4% rise.

    Looking at TIPS, the Vanguard intermediate fund, VIPSX with a higher duration of 7.9, fell from 14.59 on 4/26/13 to 13.02 on 9/5/13, a 10.8% drop, significantly higher than BND.

    VTIP, the Vanguard short term TIPS ETF (a share class of VTIPX) with a duration as you noted of 2.4, dropped 3.6% from 50.38 on 4/1/13 to 48.56 on 6/24/13.

    Let’s look at the recovery since the trough. The 10-yr rate is now 1.8%, a -1.2% drop from the 2013 YE high.

    BND is at 83.83, up 5.9% from its recent bottom. VIPSX at 13.33 is up 2.4%. And VTIP at 48.52 is actually LOWER than it was at it’s lowest in 2013; at year end it had fallen to 48.14, a total -4.45% from its 4/1/13 peak.

    Inflation expectations, especially short term, have fallen. Short-term TIPS are cheap, and their resulting price action trumps the duration/rate change heuristic.

    Can’t do chart in Comments box so this summary:
    Item / Duration /Drop/ Recovery
    10-yr rate / NA / +1.4% / -1.2%
    BND / 5.6 / -6.1% / +5.9%
    VIPSX / 7.9 / -10.8% / +2.4%
    VTIP / 2.4 / -3.6% / now -4.45%!

    Further, in 2014 BND paid about 2.8% in interest on top of the 2014 2.9% price appreciation, so it realized a total return in 2014 of about 5.7%. VTIP, on the other hand, paid just .79% in interest in 2014 (while inflation ran at about 1.8%!), a negative real yield, on top of a 2.2% decline is asset value for the year!

    The bottom line is that the volatility of bond funds makes them a very different kind of holding than a bond ladder held to maturity.

    This is especially true of TIPS funds and TIPS ladders. TIPS funds are subject to high volatility around inflation expectations that do not follow usual bond valuation heuristics, while at the same time, for TIPS bonds, the real YTM is a known function of the term structure, making them uniquely safe, predictable investments.

    The difference between TIPS funds and bond ladders could not be more striking.

    1. I agree. Duration is a first-order approximation of a bond or fund's response to future rate changes. The convexity of both need to be considered and perhaps other risk metrics, as well, before one can be claimed to be equivalent to the other.

      Fund managers also have to deal with new money and redemptions which can change the fund's characteristics.

      Still, I believe that for a short ladder or short duration fund, the difference isn't going to make or break a retirement plan. For longer periods and durations, they are far more important. From my perspective, though, the convenience of a fund doesn't outweigh the safety of funding a brief gap with individual bonds.

      I would urge retirees not to over-think the ladder/fund decision in this scenario. Worry about getting the big decisions right.

      Thanks for the insight, Mike!

  5. For the less than sophisticated, like myself, I note that "A ladder of TIPS bonds held to maturity has no volatility, interest rate risk or correlation to the stock market, nor does it have inflation risk." is not exactly true IF the bonds in the ladder are purchased on the secondary market above par ... and then inflation does not continue as "priced into" the secondary market value.

    1. William, you raise an interesting point about which people should be aware, but I have a different perspective. If the market hasn't "priced inflation into the bond's price on the secondary market" and you decide to purchase it nonetheless, you have, by definition, overpaid for the bond. If it then underperforms, I believe that would be the result of a poor purchase decision and not a failure of the bond's inflation protection. If the bond isn't properly priced, don't buy it. The correct price would be one with current inflation expectations built in, not original issue expectations.

      Thanks for the comment.

  6. In what kind of account would the TIPS ladder be held? Is this a tax-sheltered account, or a taxable account? TIPS are notoriously tax-inefficient, so are there any consequences to holding the TIPS ladder for the gap years in a taxable account?

    What should a person do, if he retires early but is too young to take distributions from his tax-sheltered account?

  7. I generally leave tax discussions out of my posts for several reasons. First, I don't claim to be a tax professional. I have training on the subject, but IRS code is too difficult for anyone but a professional to follow closely enough, in my opinion. More importantly, tax situations vary widely among households.

    TIPS are often considered tax-inefficient because the inflation adjustment is added to the bond's principal each year and this "phantom income" is taxable even though it isn't received until the bond is sold or redeemed. Whether or not that is an important consideration depends on your individual tax situation.

    Treasury bonds are subject to federal taxation but not state, the opposite of municipal bonds. In my first 10 years of retirement, my state tax rates have been much higher than my federal tax rates, so TIPS have been tax-efficient for me, personally, while muni's have not been. Had I already claimed Social Security benefits, this might have been different.

    The "tax-inefficient" criticism of TIPS bonds is over-generalized, but probably true prior to retirement, when holding them in a tax-deferred account might be wise. You would need to speak to a tax professional about your individual circumstances. I can't make an across-the-board judgment for all scenarios.

    I would need more information on your "too young to take distributions" scenario to make a recommendation. Generally, withdrawals from an IRA before age 59½ generate a steep 10% tax penalty, but there are several exceptions. In particular, the §72(t) rule for substantially equal periodic payments might be useful.

    Of course, this assumes that you don't have adequate income in taxable accounts to fund to age 59½, which might be another option.

    Thanks for writing, Matthew. Great questions!