Bond Mutual Funds are getting Killed

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Jun 14, 2007 8:29 pm

[quote=Whomitmayconcer]All,

You don't have to explain to me why there are higher prices. From what I've seen of your reasoning, you only barely scratch the surface of where higher prices come from. It show that you understand the broad theory but not the practical application.

That's what "moving the goal posts" means. [QUOTE]

CPI is just an attempt to measure something that is unmeasurable, which is each person's experience of rising prices. It's going to be imperfect. And its just a benchmark that is closest to the goals of my portfolio construction technique. If you just wanted to beat CPI I'd be AllTIPS and not AllREIT. But I'm real greedy, so I/clients want more.

It's the same an equity manager trying to beat the S&P 500 etc. For a real return strategy, your benchmark is CPI or TIPS.

The practical application of all this is trying to design a portfolio who's price appreciation and income stream grow faster than inflation. That is IMHO an achiveable goal and one worth fighting for.

I've hashed over why rolling along portfolios of nominal bonds (without reinvestment!) will gradually lead to a decline in purchasing power all else being equal. The accretions on TIPS can be thought of as being the same as holding back some of interest income from a nominal portfolio and reinvesting it, thus keeping up with inflation. However nominal bonds can only produce a limited maximum amount of reinvestment (the coupon rate), while TIPS accretion is unlimited.

And so I'm not going to go over that again.

[QUOTE] I'm sure that clients that hear your rap are duely impressed. And then there are those who never take you phone call again (just like the rest of us). 

[/quote]

I've said its big world with lots of options for everyone. I've got my niche, and I think I do ok in it as do my clients.
Jun 15, 2007 1:04 am

 "However nominal bonds can only produce a limited maximum amount of reinvestment (the coupon rate), while TIPS accretion is unlimited"

In the real world though, by the time the accretion made any difference to the underperformance you have locked in the rest of your portfolio would be so far underwater that it wouldn't help your client in the least.

The reason for this sad fact is that if CPI inflation hits those sorts of numbers (you might remember I disproved your theory at 10% inflation for 5 straight years) the rest  of the economy would be in a shambles (real estate especially included.)

What's worse is that you clients would be forced to hold the TIPs to maturity because they would be trading at a major league discount to their accreted value, in no small part due to the practically zero coupon nature of their interest payments.

Further, further, if we enter into this sort of cycle, don't you think that the financial factories on Wall Street will start pumping out competing products which will dampen the demand for TIPs paper? If a company thinks it can make money grow faster than the  rate of inflation, they'll gladly give you most of it if they can use your money to do so. We'll wind up with a plethora of IPSecurities with a higher coupon and an inflation rider. Your TIPS will be dead in the water.

This is what I mean about you just scratching the surface. You haven't been through a cycle and you don't have a full vision of what can and will happen. But then again, it's hard to look at the factors that disprove what we want to believe (in you case that there is a proper mix such that you can set up a portfolio and then go look for more money to set up the same as last time and charge an ongoing fee for having done so. It's an admirable goal, but then so was looking for El Dorado, and the Fountain Of Youth.)

Jun 15, 2007 4:08 am

[quote=Whomitmayconcer]

 “However nominal bonds can only produce a limited maximum amount of reinvestment (the coupon rate), while TIPS accretion is unlimited”

In the real world though, by the time the accretion made any difference to the underperformance you have locked in the rest of your portfolio would be so far underwater that it wouldn't help your client in the least. [/quote]

1) I'm not sure what point you're trying to make.

If I understand what you are saying, it doesn't make sense (which implies that I don't under stand it)

That's just silly, the inflation accretions keep the par value of any single TIPS equal to $1000 in real terms and the interest payments equal in real value to what ever they were at the time of issue.

With a nominal bond, the real value of the initial $1000 is slowly erroded by inflation as is the real value of the initial coupon.

In order for a portfolio of 5% nominal bonds to have the same value as 2.5% TIPS @ 2.5%, the nominal portfolio would have to hold back 2.5% to recreate the CPI accretion on the TIPS, and pay out the other 2.5%.

But if inflation runs at 6%, the nominal portfolio would not (could not! ) generate income for reinvestment, much less any income payout. The nominal portfolio would lose real value and generate no income.

This is the precise reason why no one except the treasury issues inflation linked debt. They can't be assured that the income from their assets will match inflation.


[quote]

The reason for this sad fact is that if CPI inflation hits those sorts of numbers (you might remember I disproved your theory at 10% inflation for 5 straight years) the rest  of the economy would be in a shambles (real estate especially included.)[/quote]

You have done no such thing,

And high levels of inflation have been seen before in the US, and much higher levels in various industrialised countries in the past (Italy Israel, UK). Saying that 10% inflation won't happen is making a big that it won't happen. In fact CPI-linked bonds were first introduced in 1981 in the UK.

[quote] What's worse is that you clients would be forced to hold the TIPs to maturity because they would be trading at a major league discount to their accreted value, in no small part due to the practically zero coupon nature of their interest payments. [/quote]

No, because TIPS trade at a %age of accreted face value. High inflation may or may not have an impact on real rates. If anything demand for TIPS would increase in an inflationary enviroment.

Precisely because of the inflation accretion, TIPS are the only investment that has no default risk *and* no inflation risk. Quite possibly the worlds most perfect investment.

[quote]Further, further, if we enter into this sort of cycle, don't you think that the financial factories on Wall Street will start pumping out competing products which will dampen the demand for TIPs paper? If a company thinks it can make money grow faster than the  rate of inflation, they'll gladly give you most of it if they can use your money to do so. We'll wind up with a plethora of IPSecurities with a higher coupon and an inflation rider. Your TIPS will be dead in the water.[/quote]

Nope, IMHO very little risk of this. Here's why,

CPI linked debt contains an embedded call option on inflation. Think back to the series 7, whats the maximum possible loss on a naked call option?
 

Debt with a constant real value could become a crushing burden to any issuer that couldn't grow in real terms. Since there is no easy way to hedge inflation, companies shy away from issuing real debt, but love to issue fixed debt.

Only the government, (via its proportionate taxation) has revenues that deterministicly grow at the rate of inflation or can be increased if needed. No one else but the US Treasury/State Governments can afford the risk of the naked call option.

Which brings to mind an interesting question about the risks taken on by  insurance companies/pensions who are doubly exposed to logevity and inflation risk on inflation linked liabilties (CPI annuities/pensions/LTCi)

[quote]This is what I mean about you just scratching the surface. You haven't been through a cycle and you don't have a full vision of what can and will happen. But then again, it's hard to look at the factors that disprove what we want to believe (in you case that there is a proper mix such that you can set up a portfolio and then go look for more money to set up the same as last time and charge an ongoing fee for having done so. It's an admirable goal, but then so was looking for El Dorado, and the Fountain Of Youth.)

[/quote]

I want to be disproven! I want challenges to my thinking. If there is a better philosophy to help clients meet their income/capital needs than Liability Driven Investing; I want to know about it.

Living expenses are correlated with inflation/age, not the S&P500. So it makes sense to invest accordingly. Just my $0.02.
Jun 15, 2007 5:45 am

Maybe I’m crazy folks, but my first read would be that AllREIT is on to something here.  These suckers(TIPS) are hard to understand, and they aren’t especially attractive because the “cash on the barrelhead” yield is WAAAAY below what we think of as ‘the market’ at any maturity.

parenthetically
Either way, I think this is cool, because(aside from a few snarky comments) we have some of the senior members of this forum(lots of experience and some serious mental horsepower) debating this issue without turning it into a big food fight.
end parenthesis

I ask you, what other instrument with a ROCK SOLID GUARANTEE can you purchase that provides you with ANY guarantee against  increases in the cost of living(or some facsimile thereof)?

And then there would also be the question as to what is said investment’s correlation to the stock market and the bond market.  I would think the correlation for TIPS to either would be rather low.

I’m too tired and it’s too late for me to get into a long dissertation about this, but perhaps this idea merits some further consideration from all.  I can say that in my career some of the BEST ideas I’ve ever had(in terms of added value) were the ones that were hardest to explain and most frequently pooh poohed by clients and colleagues alike.

Too, I’ve never traded TIPS myself, but I’ve observed some smart money trading them over the years.  More than once the thought has occurred to me that perhaps I need to spend a little more time and effort to understand the instrument a little better.  The biggest negative I’ve heard expressed(by anyone I respect-Mike Ryan at UBS formerly PaineWebber) is that the spreads on TIPS are pretty big.  That only matters if you expect to trade them frequently, IMHO.

I DO question whether REITs are a good instrument to compliment TIPs in a portfolio, because I do think they have some vulnerability to high-inflation environments.

But this is interesting, either way…

Jun 15, 2007 12:11 pm

L share variable annuity for liquidity, and a 6.5% lifetime income rider.

Jun 15, 2007 2:10 pm

"On May 1, 2005, Public Debt is raising the fee it charges for its Sell Direct service.

With Sell Direct, an investor who holds Treasury bills, Treasury notes, Treasury bonds, or Treasury Inflation-Protected Securities (TIPS) directly with Treasury asks us to sell his or her security before maturity. Acting on Public Debt's behalf, the Federal Reserve Bank of Chicago gets quotes from brokers and sells the security to the highest bidder. The sale proceeds, less a transaction fee, are deposited into the customer's account.

Since Sell Direct's inception in 1997, the transaction fee has been $34. Starting May 1, it will be $45. The increase is attributed to higher operating costs."

That's a non compounded rate of 3.2%, The operating cost went up higher than the rate of inflation? Not to mention that this is an electronic medium and the rate has been deflationary in that segment as memory and computing prices have plummetted since 1997!

And yet some how I'm supposed to be doing MY work for less and less or I'm some sort of greedy bastidge!

Jun 15, 2007 2:41 pm

[quote=AllREIT]

This is the precise reason why no one except the treasury issues inflation linked debt. They can't be assured that the income from their assets will match inflation.
[/quote]

This is untrue.  There are CD issues that are tied to CPI, as well as Agencies that have CPI based coupons.  I help you out, here's a couple:

Inflation-Floater Certificates of Deposit (IFCDs) Corporate Notes with Inflation Linked Coupons

I have some Sallie Mae CPI linked debt on the books as a matter of fact.  It's okay, it would be tough to know whats out there being on the outside looking in, isn't it...your Scottrade account probably doesn't have these things listed.

Aside from all this friendly banter, the truth is CPI is a poor indicator for retirees.  Truthfully, there should be two CPI numbers

1)  Healthy, middle aged Americans

2)  Retirees

The rate of inflation on medicines, healthcare, and assisted living (large portions of many retirees current or expected future budgets) has FAR exceeded the overall rate of inflation.

Solving for CPI for a retiree simply erodes there purchasing power, because it isn't enough.  Hence the explosion of products geared toward retires that are equity based with guarantees (aka VA's with GMIB that can increase).

We will just have to agree to disagree, but I wholeheartedly believe that a TIPS based portfolio is inadequate in keeping pace with a retiree's inflation rate, and thus will not sustain their purchasing power.

Jun 15, 2007 3:07 pm

To be fair, the inflation bonds (non TIP) so far are generally just an adjustment of the coupon rate.

Talk about investments that don't trade well! They make a portfolio of bond funds look good!

With a static portfolio in a rising inflation market, Allreit is right, TIPS are plenty hard to beat.

With an actively managed portfolio, I believe that I can beat TIPs. With a normal yield curve and a proper ladder you will beat TIPs. With a competant bond buyer running a portfolio (I mean me) you will probably beat them senseless, however you cannot give the same guarantee as you can with a TIP because you are not the USGovernment.

Jun 15, 2007 3:50 pm

[quote=ezmoney]L share variable annuity for liquidity, and a 6.5% lifetime income rider.[/quote]

The guarantee is solely dependent upon the insurance carrier.  There are now some “wise men” who think that the insurance companies are underpricing their guarantees, and that there could be some issues in the  event of an extended market decline.

Jun 15, 2007 4:03 pm

[quote=joedabrkr]Maybe I'm crazy folks, but my first read would be that AllREIT is on to something here.  [/quote]

The adjustment for CPI increases is fine. The problem is that comes at the expense of a low coupon. That's how they've under performed short-term CDs and at times, money market funds. In a high inflation environment, they're dandy, otherwise they're doomed to under perform (and that's before you get paid). You can explain to your clients about the CPI kicker until you're blue in the face, but underperforming short term alternatives is all that really matters.

Jun 15, 2007 5:20 pm

[quote=BankFC][quote=AllREIT]

This is the precise reason why no one except the treasury issues inflation linked debt. They can't be assured that the income from their assets will match inflation.
[/quote]

This is untrue.  There are CD issues that are tied to CPI, as well as Agencies that have CPI based coupons.  I help you out, here's a couple:

Inflation-Floater Certificates of Deposit (IFCDs) Corporate Notes with Inflation Linked Coupons

I have some Sallie Mae CPI linked debt on the books as a matter of fact.  It's okay, it would be tough to know whats out there being on the outside looking in, isn't it...your Scottrade account probably doesn't have these things listed.[/quote]

The funny part about most(all?) non-TIPS inflation linked debt is that it doesn't have the principal accretion feature of TIPS. When the instrument expires you get your $1000 back, instead of $2745, as with TIPS.

http://lasallebonds.com/ifcds/index.html

[quote]IFCDs are an investment alternative created to assist in offsetting the effects of inflation. IFCDs pay a monthly coupon that changes periodically, or “floats”, based on the change in CPI over the previous year. Instead of adding the inflation component of the return to the principal balance, like CDIPs or TIPS, this type of investment simply pays it out as part of each coupon payment. A portion of each interest payment is meant to offset inflation, and the remainder is the real return.[/quote]

This kind of note would require you to do the reivestment yourself (but would always provide you with enough to reinvest, unlike a nominal bond.)

I don't know too much about Lassale's CDIP's but I wouldn't be shocked, if they always yeilded a few bp less than equal maturity TIPS. Lasalle specialises in issuing structured products which are surely good for the bank, but for the customers.....

[quote]Solving for CPI for a retiree simply erodes their purchasing power, because it isn't enough.  Hence the explosion of products geared toward retires that are equity based with guarantees (aka VA's with GMIB that can increase).

We will just have to agree to disagree, but I wholeheartedly believe that a TIPS based portfolio is inadequate in keeping pace with a retiree's inflation rate, and thus will not sustain their purchasing power.[/quote]

Going directly for CPI is trying to make a best fit with the inflation linked costs of seniors and anyone else with living expenses. Equity investments, and classic mixed stock/bond portfolios are not the best fit to this problem.

The big risk with equity linked payments is what happens if you have high inflation *and* the stock market tanks at the same time. The classic example being the Carter Administration 1977-81.

If you want to sell TIPS to people of a certain age, just bring along a glossy photo of Jimmy Carter.

There may be some Annuitisation schemes that can help with this, but I think the equity link is a distraction. For example AIG offers a very nice CPI-linked SPIA through vanguard.


Jun 15, 2007 6:17 pm

[quote=mikebutler222]

[quote=joedabrkr]Maybe I'm crazy folks, but my first read would be that AllREIT is on to something here.  [/quote]

The adjustment for CPI increases is fine. The problem is that comes at the expense of a low coupon. That's how they've under performed short-term CDs and at times, money market funds. In a high inflation environment, they're dandy, otherwise they're doomed to under perform (and that's before you get paid). You can explain to your clients about the CPI kicker until you're blue in the face, but underperforming short term alternatives is all that really matters.

[/quote]

One of my concerns is how the CPI is measured.  We all know that CPI is sort of a bogus measure.  When you are retired, what types of expenses are non-negotiable?....utilities, food, taxes, healthcare.  Unfortunately, these tend to be a larger part of seniors' expenses - many things which rise (or have risen this past decade) faster than CPI ("inflation").  And I don't think a period of low inflation keeps these prices down.  So, I guess what I am saying is that many expenses for retired folks rise faster than would the adjustment to the TIPS. 

Correct? No?

Jun 15, 2007 7:05 pm

I guess what I am saying is that many expenses for retired folks rise faster than would the adjustment to the TIPS.  Correct? No

Yes and no I think

These are the categories that the CPI takes into consideration.  Not all people use the same services. Older people use less of some and rural/non uban older people use less.

FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)

Older people tend to eat less quanties and less out at restaurants. So this might be a push.  Food costs go up but consumption is going down.

HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

My clients mostly own their own homes and second homes.  The cost of insurance is rising but even if they don't own outright most have a fixed mortgage which isn't rising with inflationary housing costs. The cost of furniture is a non issue. However, the cost of heating is a big inflationary bugaboo.  But couple that with the fact that they have no or low mortgage payments.

APPAREL (men's shirts and sweaters, women's dresses, jewelry)

Again. Not a big issue for retirees. Most already have their own jewelry and aren't normally big clothing buyers.

TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

Here is a biggie if the retirees plan to travel much or routinely buy new cars. 

MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

Another big inflation bite. Perhaps the biggest of all. But if your retiree is in good health and doesn't need these services, not so much of a issue.

RECREATION (televisions, pets and pet products, sports equipment, admissions);

Well other than possibly buying a new TV or set of golf clubs, this is also a non issue for most of my clients.  Except the ones who own horses

EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

By the time the retiree is retired they have no more college costs, if they ever did.  Not too many are heavy software users and I don't see that this is a big inflationary roadbump in retiree's lifestyles.

OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

These are things that retirees will continue to use, but possibly not as much as when younger.  Other than the funeral expenses, I expect retirees to use less.  Again probably a push.

I'm not saying we shouldn't plan for inflation and that CPI linked investements are foolish or the be all end all.  As advisors we need to look at our client's individual needs.  It seems to me that we are talking apples and oranges here.  Allreit is all numbers and theory. The rest of us deal with real people.

Jun 15, 2007 8:47 pm

[quote=mikebutler222][quote=joedabrkr]Maybe I’m crazy folks, but my
first read would be that AllREIT is on to something here. 
[/quote]

The adjustment for CPI increases is fine. The problem is that comes at the expense of a low coupon. That's how they've under performed short-term CDs and at times, money market funds. In a high inflation environment, they're dandy, otherwise they're doomed to under perform (and that's before you get paid). You can explain to your clients about the CPI kicker until you're blue in the face, but underperforming short term alternatives is all that really matters.

[/quote]

Mike, this is the difference between selling what is easy to sell and selling what is best for the clients.

The instantaneous cash return on TIPS vs Nominal instruments is less, but the total return is equal or potentially much higher.

In my experience most clients get this. Perhaps the clients who don't get this, don't work with me, so my sample is skewed.

Its pretty easy to explain to them. You can show in quick spreadsheet how the TIPS keeps its value while the nominal bond is worn to a stub by inflation.

I tell clients that you can put most investments into one of three categories.

Stable Cashflow, Growing Cashflow, and No Cashflow.

Stable Cashflow investments are naked to the risk of inflation, but they are stable. Hence I recomend owning some short treasuries.

Growing Cashflow investments, are your only defense against inflation and your best bet for real excess returns. But you have to choose wisely. TIPS are your only sure thing Growing Cashflow investment.

No Cashflow investments require that there be a sucker willing to buy when you want to sell. A risky proposition that requires the most careful analysis.


Jun 16, 2007 2:16 am
AllREIT:

[quote=mikebutler222][quote=joedabrkr]Maybe I’m crazy folks, but my first read would be that AllREIT is on to something here. 

The adjustment for CPI increases is fine. The problem is that comes at the expense of a low coupon. That's how they've under performed short-term CDs and at times, money market funds. In a high inflation environment, they're dandy, otherwise they're doomed to under perform (and that's before you get paid). You can explain to your clients about the CPI kicker until you're blue in the face, but underperforming short term alternatives is all that really matters.

[/quote]

Mike, this is the difference between selling what is easy to sell and selling what is best for the clients.
[/quote]

Newbie, please.

Making LESS than short term CDs and even money markets for the last three years (what's the return been, even before your fees, 3%?) so that your tiny coupon has the chance for CPI linked increases isn't "best for clients".

Jun 16, 2007 2:18 am

[quote=AllREIT] In my experience most clients get this. [/quote]

Yeah, I'm sure both of them are happy underperforming most every other short term fixed income investment. 

Jun 16, 2007 4:57 am

[quote=mikebutler222]

[quote=AllREIT] In my experience most clients get this. [/quote]

Yeah, I'm sure both of them are happy underperforming most every other short term fixed income investment. 

[/quote]

Mike, I'm going to let you have the last word on this one.


Jun 16, 2007 7:12 am

[quote=AllREIT]

[quote=mikebutler222]

[quote=AllREIT] In my experience most clients get this. [/quote]

Yeah, I'm sure both of them are happy underperforming most every other short term fixed income investment. 

[/quote]

Mike, I'm going to let you have the last word on this one.


[/quote]

A graceful 'retirement'.  I can learn from this!
Jun 16, 2007 4:00 pm

[quote=joedabrkr] [quote=AllREIT] [quote=mikebutler222]

[quote=AllREIT] In my experience most clients get this. [/quote]

Yeah, I'm sure both of them are happy underperforming most every other short term fixed income investment. 

[/quote]

Mike, I'm going to let you have the last word on this one.


[/quote]

A graceful 'retirement'.  I can learn from this!
[/quote]

We probably all can.