TIP$TER is built on a foundation of TIPS. TIPS constitute TIP$TER's preferred and approximate proxy for the "risk-free" rate.
Every analysis is compared to an all-TIPS portfolio baseline: the sustainable retirement budget that a portfolio fully invested in TIPS – plus other user-anticipated retirement income sources – would support. Against this baseline, TIP$TER compares the simulated performance (including the supported retirement lifestyle) of a planned portfolio divided and annually rebalanced between TIPS and stocks.
NOTE: you can use any proxy you wish – for example, CDs – for your risk-free asset, and plug that value into the "Real Return on TIPS" input. But be aware that whenever TIP$TER's charts or reports discuss "TIPS" or a "TIPS baseline," it is in fact modeling your chosen proxy for a risk-free asset.
What are TIPS?
TIPS are inflation-adjusted U.S. government bonds. They are every bit as creditworthy as nominal U.S. government bonds. Measured by their ability to protect one's purchasing power, they are considerably safer than nominal U.S. government bonds. With TIPS, the interest payments and principal are adjusted to the CPI-U index.
For a basic introduction to TIPS, read the Bogleheads Wiki entry on that topic. There, you can learn how TIPS work and how to buy them. The U.S. Treasury Department also provides useful information on TIPS.
The Securities Industry and Financial Markets Association provides an instructive step-by-step example of how interest payments on TIPS are calculated. SIFMA also provides information on how TIPS are taxed.
Where can I buy them?
The easiest way to buy TIPS is through a mutual fund (like Vanguard's VIPSX fund) or an exchange traded fund (like Pimco's LTPZ ETF or I-Share's TIP ETF). Unfortunately, the average duration of the TIPS inside VIPSX and TIP is only about ten years or less. When the yield curve is steep, the real yields on VIPSX and TIP are considerably less attractive than the real yields on longer-dated TIPS. Also, with VIPSX and TIP, you are stuck with paying either a 0.25% (VIPSX) or a 0.20% (TIP) expense ratio. As cheap as those expense ratios are, it still eats up a big chunk of the 1% to 2% real yield.
Pimco's recently-launched LTPZ ETF has an expense ratio of 0.20% and concentrates in TIPS that have a maturity of 15 years or more. It is, however, a thinly-traded ETF, so beware placing a "market" order for one of these securities.
You can also buy individual TIPS at auction or on the secondary market. This is the best way to get some longer-dated and often higher-yielding TIPS into your portfolio. Fidelity has one of the best interfaces for buying TIPS on the secondary market, although their bid/ask ratios are a little bit wide. You can buy TIPS at auction directly from the U.S. government through Treasury Direct. The Finance Buff has a step-by-step guide for buying TIPS at auction.
There is, in fact, no such thing as a "risk-free" asset. Any asset can be lost, stolen, or destroyed. But some assets – such as Treasury Inflation Protected Securities (TIPS) or I-bonds – provide the closest practical proxy for a positive, "risk free" yield that an investor can hope for. They are backed by the U.S. government, so they carry very little credit risk. They are also inflation-adjusted, so they carry effectively no credit risk and less interest risk than nominal bonds. Although they experience some short-term volatility, they will – if carried to maturity and barring a default by the U.S. government – yield exactly what an investor expects.
I-bonds are even less risky, but don't yield much
The closest available proxy to a "riskless" asset are probably I-Bonds. I-Bonds are issued by the U.S. government, can be held for 30 years, automatically adjust for inflation, and can always be redeemed at their inflation-adjusted value. I-Bonds have no interest rate risk, no inflation risk, and practically no credit risk. Taxes on the earnings are deferred until the I-Bond is redeemed. Purchasers with greater-than-30-year time horizons have modest reinvestment risk.
But real yields on I-Bonds are terrible. For current I-Bond real yields, look up the "Fixed Rates" here.
TIPS' higher yields yet still relative safety make them a more attractive proxy for the risk-free rate
Because of their usually substantially higher real yields, long-term TIPS provide a more practical proxy for a "riskless" asset. Indeed, academics often use TIPS as their proxy for a "risk-free" asset in their papers. See, e.g..g., Robert D. Arnott and Peter L. Bernstein V, "What Risk Premium is Normal," Jan. 10, 2002.
But TIPS are not perfectly risk-free. They suffer, modestly, from the following types of risk:
The U.S. government could default on its debt, or fudge the CPI numbers. When combined with an open mind, it is OK to approach government statistics with a little bit of healthy skepticism and caution. But the conclusory, unsubstantiated and unteachable cynicism so common in populist discourse is unjustified. Read the Bureau of Labor Statistics's response to common misperceptions about the CPI.
Interest Rate/Financial Panic Risk:
TIPS are somewhat volatile, and reached unprecedented levels of volatility during the Financial Panic of 2008. So investors who don't hold their TIPS to maturity could lose money. However, an investor can largely avoid this effect by holding their TIPS to maturity and constructing a "ladder" of TIPS bonds to support their retirement needs. See TIPS ladder below.
Because the longest maturity currently being issued is 20 years, there is a fair amount of reinvestment risk – the risk that a young investor today will not be able to roll over the proceeds of maturing TIPS into new TIPS of equal real yields.
Here are several sources that provide the current real yields on TIPS of different maturities:
- Bloomberg* (provides 5, 10, and 20 year TIPS real yields)
- Wall Street Journal* (provides the closing real yield of TIPS of every maturity)
- Fidelity* (look up up-to-the-minute bid/ask prices (and corresponding yields) of all TIPS.
Important note: Before you enter the yield on TIPS into TIP$TER, make sure you take into account fund and transaction expenses.
What are the historical real yields on TIPS?
Here are some sources of historical real yield data:
Treasury Department (provides daily real yields on 5 year, 7 year, 10 year, and 20 year TIPS dating back to 1/2/2003)
Federal Reserve (provides daily, weekly, monthly, and annual data on 5 year, 7 year, 10 year, and 20 year TIPS dating back to 2003-2004)
Below is the Federal Reserve Bank of St. Louis graph showing how the real yields on 20-year TIPS have fluctuated since mid-2004.
What are the historical correlation of TIPS with other asset classes?
Find out yourself at the Asset Correlation website.
See Bob's TIPS ladder webpage. But realize that your ladder may end up missing a few rungs. As of July 2009, there were no TIPS in existence scheduled to mature between 2020 and 2024, between 2030 and 2031, or after 2032.
*Bloomberg is a registered trademark of Bloomberg L.P., with which Prospercuity
claims no association, connection, affiliation, or sponsorship.
The Wall Street Journal is a registered trademark of Dow Jones & Company, L.P., with which Prospercuity claims no association, connection, affiliation, or sponsorship.
Fidelity is a registered trademark of FMR LLC, with which Prospercuity claims no association, connection, affiliation, or sponsorship.