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TIPS and zero/negative interest rates

I've been thinking a lot lately about my positions in TIPs, and their place in a portfolio, and, of course, their current pricing level.
They are really purely an inflation hedge. At this point, with zero/negative interest rates, they are nothing at all more than a perfect hedge on CPI-U. They generate no income.
So when constructing a portfolio and including fixed-income exposure, there are generally two different reasons to include it. In a total-return view, they are there only partially for income/yield but very much more are there to provide asset-class diversification to provide uncorrelated returns against equity exposure. In that total-return context, the actual returns of the fixed income, and especially the cash-flow that it generates are less important than how they behave when stocks move one way or the other. This is generally a stronger argument for US Treasuries, even though they generally have lower yields than any other fixed income, they also have a lower correlation with equities and have had, especially through the last couple of disaster markets, great returns as yields have dropped through the floor.
The other place for fixed income is in a cash-flow/income oriented portfolio, where the bonds are there to generate a paycheck for the investor and the stocks are there to provide growth (and a smaller paycheck through dividends), especially over the longer-run and to overcome inflation. In this context, the correlations and even the potential for capital gains (ie. dropping interest rates) are less important than the dividends paid out.
So now where do TIPs fall in this? Clearly not in the latter income-oriented portfolio, since right now they don't generate any income at all.
But I'm also thinking that given the absurdly low yields of both TIPs and other Treasury bonds, maybe there's no place for either of them in either income or total-return portfolios. In essense, they don't fit into income due to the low to non-existent yields. But they may well not fit into a total return portfolio either given that the interest rates are at historic lows and seem unlikely to go down any more - so there really seems almost no potential at all for capital gains either - meaning that even if stocks drop again, I find it hard to believe that TIPs or Treasuries can perform the function that they are supposed to in a total return portfolio - they cannot zig *up* any more whether stocks go up or down. So even though I don't generally subscribe to market timing, can one justify keeping TIPs or any Treasuries in a portfolio right now?
Thoughts?
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David S. Meyers, CFP(R)
http://www.MeyersMoney.com
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David S Meyers CFP
Tips and especially Tbills (TLT) have been showing modest cap gains according to
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,PFD,PFF,TIP&a=v&p=s and I think the tbills do this because how you only need a decreasing amount of interest rate drop to trigger the same percent of cap gain? Anyway, I have no idea on how to build the traditional stock hedge with uncorrelated bonds.
But in today's crunch, what I do is settle for something partially correlated with at least some return. It raises risk and volatility, which I will deal with by waiting out lengthy cycles. A modest way to deal with this is corp bonds (LQD) which bumps up yield a bit over Tbills and has even been less volatile last couple years. A bigger step is preferreds (PFF) which gives you double the interest. The financial preferreds (PFD) additionally has been giving great cap gains, since they are still healing from armagedden in chart below (were preferreds never given a gov't imposed haircut, a la GM?).
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,PFD,PFF,TIP&a=v&p=s
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dumbstruck
dumbstruck writes:
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,PFD,PFF,TIP&a=v&p=s
My concern is that we're likely at a place in the yield structure where future capital gains in treasuries and TIPs are just astoundingly unlikely. The TIPs, at least, will continue to rise along with the CPI-U, which is a huge plus over nominal treasuries, but if/when rates do go back up, there are going to be cap-losses. At this point, the inflation hedge is probably a stronger influence - I don't see rates moving upwards a lot in the next year or two, given the Fed's strong public stance of keeping rates down. This, by the way, leads me to think more highly of TIPs (over nominal Treasuries at least).
The question of what they are there in the porfolio for is still an important one. As I said, TIPs cannot provide useful current income any more, but in a total return context, they are a pure - and short-term - inflation hedge. In the longer run, equities are a better inflation hedge, but short-run inflation whacks equities very hard. So in that context, TIPs may well still have a place in the portfolio to moderate overall portfolio volatility.
We are in a different world now than the one in which Zvi Bodie told folks that for "worry free" retirements, they needed portfolios built predominatly out of TIPs. He wrote that in '02 and '03, when TIPs real yields were like 3%. A guaranteed 3% *above* inflation is a spectacularly good arrangement. It's also no longer available.
I do like corporate bonds, at least relative to treasuries. Vanguard's got a short-term corporate index ETF, VCSH (I think), which us currently yielding something over 2%. And I've been using LQD for a while in combination with AGG or BND, in order to overweight corporates in the fixed income allocation (well, to underweight treasuries).
If I'm going to go that far down the credit quality spectrum, I'd rather just get some equity exposure directly. Financial preferreds are almost as volatile as financial equities, but with more limited upside. In more normal times, preferreds may have behaved more like bonds - perhaps more like junk bonds - but they've always had more of the risk chacteristics (volatility) of equities. They don't really balance out an equity allocation very well, since they are so highly correlated with equities. I'd rather just keep the asset classes more cleanly separated - equities on one side and fixed income on the other. Nevertheless, those two ETFs are well worth keeping an eye on.
Junk bonds may still be a good satellite holding in the fixed-income sleeve, especially to help increase cash-flow yields, but they really can't safely be the bulk of it. JNK (with a 0.40 expense ratio) may be a good way to go here, but like the preferreds, it's more like equity. If it can be bought at a discount to NAV (the discount/premium itself can be quite volatile), something like NHS (a junk-bond closed-end fund) may be a good way in, but it is a leveraged junk-bond play, generating a huge current payout yield, but with very severe risk. A better way in, though it's both expensive (high expense ratio) and still similarly risky, may be a good actively managed bond fund which can go well into junk territory when the manager is up for it. For example, Loomis Sayles Bond fund. But again, look at what it did in late '08. Top to bottom drop was something like 25% - less than the equity market, but that's a *lot* of volatility for a bond fund. With a 10yr total return annualized at nearly 10%, that trounced both the equity markets *and* the Agg.
After all this, I've still got some thinking to do about how to manage the fixed income sleeve. I definitely am leaning towards lowering the TIPs allocation, but not removing it entirely. And if I'm going to spend mental energy (and add risk) by actively moving between fixed-income sub-classes (TIPs vs. Treasuries vs. Corporates, and between short and long-term bonds), maybe there is some value in leaving some of that to an active fixed income manager (while, as usual, leaving a core position in BND or AGG).
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David S. Meyers, CFP(R)
http://www.MeyersMoney.com
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David S Meyers CFP
I have been considering the option to invest my money in Mutual funds but I don’t have any idea how much to invest first time in it? Can you suggest some tips on that. 'Orlando financial planner'
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gordondi


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