Buying TIPS On Secondary Market, Part 4: What to Buy

December 31, 2008 by TFB

This is part four of the Guide to Buying TIPS On the Secondary Market. In first three parts of this guide, we looked at Why Secondary Market, Understand Quotes, and When to Buy. Part 5 in this series will be about How to Buy.

Suppose you decided this is the time to buy some TIPS on the secondary market. But which one should you buy?

At the time of this writing, there are total of 27 TIPS bonds on the market, with maturities ranging from 2009 to 2032. Much like when you buy a flat screen TV you have to decide roughly what size you want: < 30", 30"-40", 40"-50", > 50" etc, when you buy TIPS, you have to decide what maturity range you want. A short-term TIPS (< 5 years) is less risky and it lets you deploy the money elsewhere if your plan changes, but it protects you against inflation only for a shorter period of time. A long-term TIPS (> 10 years) is more risky and you are locked in for a long time (we are only talking about buying and holding to maturity here, not trading bonds). But a long-term TIPS usually, but not always, has a higher yield and it gives you protection for a longer period of time. An intermediate-term TIPS (5-10 years) is just somewhere in between short-term and long-term. No hard and fast rules here. You pick the maturity range that suits you.

Of course price and yield matter as well. That's where the yield curve comes in. A yield curve is a chart with the bonds' maturity plotted on the X axis and their yield to maturity plotted on the Y axis. Fidelity produces a nice yield curve when you look up quotes on its web site.

FidelityTIPSYieldCurve

Each blue dot represents a TIPS bond. Right now the yield curve is "inverted," which means the short-term bonds have higher yields than the longer-term bonds, whereas when the yield curve is "normal," it's positively sloped like the other lines in the chart are.

By looking at the yield curve and the quote table, I see the long-term TIPS with 15 years or longer in maturity are yielding 2.2% – 2.3% whereas the shorter term 3- to 8-year TIPS are yielding 2.3% – 3.3%. If I were to buy TIPS on the secondary market today, I would buy in the 3 to 8 years range because I already have some long-term bonds. In addition, the yields on the long-term bonds are not high enough for me to want to buy more. I don't buy TIPS with less than 3 years in maturity on the secondary market because having inflation protection for only one or two years isn't very meaningful to me. Within the range of 3 to 8 years, I still have some tough choices to make. For example should I choose a bond maturing in 5.5 years yielding 2.84% or a bond maturing in 7 years yielding 2.47%? I calculate the so-called forward rate, which is the rate I must earn in the remaining 1.5 years after my 5.5-year bond matures in order to match the 7-year bond. It's done as follows:

((1 + 2.47%) ^ 7 / (1 + 2.84%) ^ 5.5) ^ (1 / (7 – 5.5)) – 1 = 1.1%

I think I have a reasonable chance of earning more than 1.1% real when my 5.5-year bond matures. So if I were to choose between these two bonds, I would choose the 5.5-year bond. Here's a spreadsheet that makes the forward rate calculation easier:

Spreadsheet: Bond Forward Rate

If deflation is a concern, you can also use the spreadsheet in my previous post TIPS During Deflation to see how the bonds behave under different inflation/deflation scenarios. I'm not too concerned about deflation more than five years out.

Finally, don't over-analyze it. The bond market is efficient. Prices and yields are formed by institutions trading millions of dollars a pop. Whatever calculation we can do with our primitive spreadsheets can be done a thousand times faster by bond traders with their sophisticated computer programs. So pick a bond you are comfortable with and go for it.

Software picked, likely related posts:

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Comments

8 Comments on Buying TIPS On Secondary Market, Part 4: What to Buy

  1. HueyLD on December 31, 2008 | permalink
    2.  

    I like the Forward Rate in this post because I always struggled to figure out which maturity to get given the YTM and the inflation factors. I do have a question given the different inflation indices among different bonds. Is there a way to incorporate the inflation factors into your formula?

    Thank you for your excellent work.

  2. TFB on December 31, 2008 | permalink
    3.  

    HueyLD – As I concluded in the previous post TIPS During Deflation, the inflation factor a.k.a. the index ratio becomes a factor only if you suspect there will be cumulative deflation from the date of purchase to the date of maturity. I'm not convinced that we should rationally expect cumulative deflation for 5 years or more. Because I'm also not very interested in buying short-term TIPS on the secondary market, the index ratio hasn't been a factor for me. I will try to join the two new spreadsheets I introduced in this series with the previous one in TIPS During Deflation and make one unified spreadsheet for comparing two TIPS. It will include the possible par floor boost, impact of brokerage commission, and the forward rate between two bonds.

  3. Dave on December 31, 2008 | permalink
    4.  

    When purchasing TIPs on the secondary market, do you recommend doing a market order or a limit order? When using a limit order, would I use the adjusted "ask" price or the un-adjusted price?

  4. TFB on December 31, 2008 | permalink
    5.  

    Dave – That will be in part 5 on how to buy. Use the unadjusted price for limit order.

  5. DJ on January 1, 2009 | permalink
    6.  

    TFB,

    Very informative series of posts on TIPS.
    I have two questions:
    1. Is taxable account suitable for holding TIPS?
    2. Fidelity seems to offer trading TIPS for free. Or am I missing some hidden fees?

    Thanks,

  6. TFB on January 1, 2009 | permalink
    7.  

    DJ – As I mentioned in part 1, I have never bought TIPS in a taxable account. I can't tell you about the intricacies about tax reporting for TIPS in a taxable account. Assuming that you have other bonds in a taxable account, TIPS are not that different. They are still bonds. You receive variable interests that go up and down with inflation. The inflation adjustment to principal is taxable but not paid out until maturity. If you need the income and you don't mind paying the tax, I don't see anything wrong with having TIPS in a taxable account. But if you don't need the income and you are in a high tax bracket, the tax drag can be quite high.

    All brokers' prices include a markup. Even if Fidelity itself doesn't make money from doing TIPS trades for you (which may or may not be true), the dealer from whom Fidelity gets the bonds and sells to you already included their markup in the price.

  7. DJ on January 4, 2009 | permalink
    8.  

    TFB, Many thanks for the reply. I am interested to know your opinion on the upcoming 20-year TIPS auction in Jan. At what yield level would it warrant a bid?

  8. TFB on January 5, 2009 | permalink
    9.  

    DJ – Yields are still thrashing around. Just a few days ago the 20-year was about 2.2%. Today it's close to 2.7%. The auction won't happen until Jan. 26. We will see more swings for sure. If the yield holds above 2.7% the day before the auction, I will buy some.

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