Tuesday, February 7, 2012

Harvesting Gains from a TIPS ladder

I received this question as a comment to a past blog entry:

Very interesting discussion. One of the assets you mention for constructing the "floor" is a ladder of TIPS. A question about that:

What do you do when the TIPS you are holding increase significantly in value, as they would have done in 2011 for no particular reason (certainly not inflation)? Do you continue to hold them till maturity, or do you do something to harvest your good fortune?

Charlie B

Here is my answer (and please feel free to add comments):

Let me preface this with: I am not a financial planner, so this is just my opinion, and also you may have some unique circumstances which call for another answer...

But generally, I would advise against trying to harvest gains from your bond ladder.

You must have created a TIPS bond ladder because you wanted to safely protect a floor of spending.

By selling it off and not keeping it until maturity, you expose yourself to risk. If you sell and interest rates go up, then you will benefit from the move. But if you sell and interest rates go down, then you will lose from the move. That's because, you still want to protect your income floor, and rebuying the bond ladder after further interest rate declines will become even more expensive and you will be ensured a reduction to your future spending.

I think TIPS yields are just as likely to continue going down, as to go up. That's not a prediction, I'm just saying I wouldn't be surprised if TIPS yields continue decreasing. I wrote about this in a column at Advisor Perspectives:

Are TIPS Really Safe and Worry-Free?

When you talk about harvesting gains, you still have to buy something. TIPS have gained, but likewise any other fixed income product that you might switch to will also be rather expensive, so you don't get any particular benefit from the move.

You are just adding risk when you don't need to.

You were specifically talking about a TIPS ladder. If you own a TIPS mutual fund and it has grown to represent a higher percentage of your assets than you desired to have, then rebalancing some by selling some of the TIPS fund is no problem. But I don't think you were talking about this.

2 comments:

  1. I agree with your answer on this one, Wade. I think another way to look at this is that a TIPS ladder is typically set up to meet future expenses that will increase with inflation. So it's like an immunization exercise in matching assets (TIPS) and liabilities (future expenses). One matches them, sets them aside, and then doesn't have to worry about them. When interest rates fall and the value of the assets goes up, the value of the liabilities goes up by an equal amount so there really hasn't been a gain in a total portfolio sense.

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    1. Joe,

      Thanks! Yes, that is a good way to think about it too. Your liabilities here are your future spending needs. When you calculate the present discounted value of these spending needs, the value goes up when the interest rate used for discounting is lower. Because yields have declined, the assets in your TIPS ladder have increased in value, but also the cost of funding your funding your spending needs have increased in value. So you really don't have any "gain" to take advantage of. I think I'm just reiterating your point. Thanks again.

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