Two Types of TIPS

Started diving into the resources about TIPS but then realized there were really two separate universes of TIPS: 1) those held directly, and 2) and those in index funds. This post is all about setting the stage and clarifying things before proceeding.

This is the third post in my "RPC Investigates" series on Treasury Inflation-Protected Securities (TIPS). The first post introduced them and what I'm trying to do in this deep dive, and then the second was a Risk Parity Basics post explaining them from the ground up. More posts to come!

I was all set to start working on what I thought would be the next post in the series – a Risk Parity Resources post that gathered and summarized a handful of sources on TIPS like academic research, professional whitepapers, books, and the like. I did that with the REIT series, which was helpful for me before I started my portfolio backtests and asset comparisons.

But as I was reading these sources, trying to get a handle on them, I really saw how most of the sources were talking about holding TIPS directly, whereas most of my experience and knowledge about TIPS relates to TIPS index ETFs. Of course, I was aware that tehy could well perform differently, but wasn't prepared for just how unlikeeach other they actually are.

So, here I take a step back, cover this important distinction and lay out how my series on TIPS will adjust to the fact that we are really dealing with two separate animals. When it comes to recommending them (or not) in a Risk Parity portfolio, I’ll need to be specific with which type I’m talking about. Already in my research I’m seeing that benefits that exist for one type, are absent in the other, and vice versa.

First Type: Stand-alone TIPS

Quite simply, these are TIPS purchase on a individual basis, either at an auction or on the secondary market. One way to do this is go through the Treasury Direct website, where you can place an order to purchase one at an upcoming auction.

Generally, if you purchase this way, you’re probably going to want to hold until maturity, at which point the inflation-adjusted value of your original purchase would be returned to you. That's because if you want to sell your TIPS before maturity, you can’t do that through Treasury Direct and would need to transfer the bonds over to a broker. This is possible, but seems a bit clunky.

If you are going to hold an individual TIPS, it is probably best to go through a broker from the start. I checked out Vanguard’s process, and though it was a new part of the website I had never seen before, it seemed pretty straight-forward. You can buy TIPS sold at auction with no commission (so, just like Treasury Direct), or buy on the secondary market at a 1% fee. That then gives you the option of selling them on the secondary market, as well, and again for a 1% fee.

One aspect of stand-alone TIPS is that their taxation is a bit unusual. Just like other bonds, the semi-annual interest payments you receive are taxable in a regular, non-tax-protected account. In addition, though, TIPS generate what is sometimes called “phantom income” on which you are taxed as well. Since the principal of a TIPS is adjusted to match inflation, the amount it goes up is reported as income, even though it isn’t accessible to the investor. It is "phantom" in the sense that you can't actually access this extra amount, though it does benefit you as your interest payment will be higher since it is based on the larger principal value.

By the way, this does have a benefit later, as you aren’t taxed for capital gains on maturity since you’ve paid taxes on the increases as they happen. Of course, if you had just purchased a nominal bond and held it to maturity, you wouldn't have any capital gains to tax.

To avoid this issue, many sources will recommend keeping TIPS in a tax-advantage account so that you don’t need to worry about them. That may be a good solution for some, but personally, TIPS don’t usually have a high enough return to justify putting them under my limited tax umbrellas. I have a lot of other assets that I’d prefer to use my limited space in a traditional IRA on, and as for Roth IRAs or 401ks, they simply don’t make the cut.

One popular strategy with TIPS is to construct a ladder of them, so a series of TIPS you buy year after year that then mature in different years. If done with 10-year TIPS, you’d then have ten coupon payments every six months, and then once a year (after the tenth) you receive your inflation-adjusted principal back in full, at which time you would buy another.

I guess this strategy could make sense for liability matching, since you could guarantee inflation-proof payments at different points in the future, or if you were extremely worried about inflation eating its way through your living expenses in your retirement years.

To me and probably many others, this seems like a lot of work, so to take care of that we have the…

Second Type: TIPS funds

…where TIPS of various durations and purchases are packaged together and then traded either as a mutual fund or ETF. I count seventeen TIPS ETFs on the VettaFi screener, plus another handful whose titles indicate a similar objective, though they don’t mention TIPS specifically. In the past, I have held LTPZ, Pimco’s Long-term TIPS fund, and VTIP, Vanguard’s Short-term TIPS fund, though alternatives abound.

Compared to individual TIPS, this method is certainly more convenient, both in terms of when you trade them and in terms of tax reporting. TIPS in fund form are relatively tax-inefficient, just like holding them individually, pointing to the advice that you’d prefer to hold these in a tax-deferred account. Again, though, I would caution you that kicking out assets with much higher expected returns from a 401k to make room for a TIPS ETF may not be the smartest move.

One big issue for TIPS in fund form is whether they function like TIPS you hold individually. I know I’m at the early stages of my deep dive, but so far the answer seems to be no.

Basically, when you own TIPS in fund form, they seem a lot more like an index fund containing regular ol’ Treasuries. Since the value of a TIPS ETF changes throughout the day, their performance resembles the patterns of other bond funds, spiking when interest rates are cut, and sinking on announcements of rising interest rates.

Quick Diversion

Yes, a short-term TIPS purchased as a stand-alone asset may have a higher return than a regular short-term Treasury fund, but also, it may not. TIPS outperform regular Treasuries when inflation exceeds expectations for inflation, not always when inflation is “high.” If the market expects 10% inflation every year over the next ten years, then that should be reflected in the interest rate on those ten-year Treasuries. If inflation is instead 9% a year, then TIPS will underperform said Treasuries, even though inflation is high.

By the way, this is a common misunderstanding of TIPS. You see the name and think (quite naturally!) that you’re protected against high inflation, but really what they do is protect against inflation that is higher than expected, regardless of whether the inflation is high or low. If actual inflation happens to equal expected inflation, the TIPS and regular Treasuries will be equal. If bond investors have over-estimated future inflation in their purchase of normal Treasuries, then you’d actually be better off with those Treasuries. If the bond market isn't expecting high inflation, and keeps buying Treasuries with yields that reflect low inflation, then TIPS would be the better choice.

Two Different Animals

In sum, when speaking of TIPS, we really need to be focused on which of the two types we are talking about. They aren’t the same, don’t behave similarly, and this entire series on TIPS will have to keep clarifying what we are speaking about. When breaking down the basic question of the role of TIPS in a Risk Parity portfolio, we’ll proceed on two fronts:

1) Stand-alone TIPS will be evaluated in comparison to I Bonds, certificates of deposit, and even cash equivalents like money market accounts. These are all safe assets that will almost assuredly beat the returns on cash, though with less liquidity. We haven’t considered cash needs in a Risk Parity portfolio, but I’m planning a post as part of this series laying out my thoughts on that.

2) We’ll focus a lot more on TIPS index ETFs, which will be compared to index funds of regular Treasuries. ETF investing is the core of my approach to investing, with strategic asset allocations and rebalancing, so I’ll focus on how I would do this with suitable TIPS vehicles.