The Superiority of TIPS Ladders

An example from my recent experience: In early 2022, my wife and I sold one home, with the proceeds earmarked to purchase a new construction home under contract, scheduled for completion and closing about a year later. Needing a virtual guarantee that the entire purchase amount be available at closing, I bought Treasury bonds that matured shortly before the closing date. Hindsight validated my decision to buy bonds instead of a bond fund. Nearly all bond funds of corresponding duration or longer had negative total returns during that period! Siegel concurred in an email exchange: "When you have a defined liability or bill to pay, the riskless strategy is to pay it in advance (‘defease’ the liability) by buying a bond that matures on the day the bill is due." He added that zero-coupon bonds are preferred so as not to have to deal with interest reinvestment.

Similarly, when one's goal is not to pay off a one-time liability, but to enjoy a sequence of pre-determined income payments, a bond ladder with cashflows matching the desired incomes is more reliable than a corresponding bond fund.

Siegel reminded us in The Dilemma That Isn't that "the apparent safety in a bond maturing and returning your original investment is an illusion, because only real returns matter." Indeed. A conventional bond is satisfactory for covering a liability for a fixed-dollar amount, such as the contract price of a new home. But inflation matters in a retirement portfolio, and therefore inflation-protected bonds are the preferred solution. Individual TIPS, when held to maturity, are as close as one can get to the ideal "risk-free asset" of finance theory. As long as Uncle Sam pays his debts, TIPS are guaranteed to deliver the real yield (based on the CPI-U measure of inflation) as of the purchase date². The caveats of individual bonds and held to maturity are necessary for those assets to be risk-free. TIPS funds and individual TIPS prior to maturity are sensitive to changes in real interest rates and therefore volatile, just as are conventional bonds and bond funds.

In The 4% Rule Just Became a Whole Lot Easier, published here in October 2022, Allen Roth wrote that at then-current yields, a 30-year TIPS ladder would guarantee real income at a 4.36% annual withdrawal rate. Real yields are slightly higher now than they were at that time. A similar TIPS ladder constructed at this writing would deliver a reliable 4.64% withdrawal rate! Such an outcome is certain only with a ladder of TIPS, not with a TIPS fund.

In the remainder of this article, I compare the historical outcomes of individual TIPS and ladders versus a low-cost TIPS index ETF and a slightly more expensive actively managed open-end fund. The punchline: The funds were risky assets, like other bond funds. While individual TIPS held to maturity are a dependable store of real value³, the TIPS funds were not – there were numerous holding periods where investments in the funds would have lost purchasing power. In some periods, the funds outperformed individual and laddered TIPS, but not in other periods. The performance of the TIPS ETF was superior to that of its peer conventional Treasury ETFs. If you want a portion of your retirement portfolio to provide annual cashflows with all but guaranteed purchasing power to cover some of your living expenses (and assuming that an inflation-protected annuity is unaffordable or unobtainable, as is generally the case) that portion of your portfolio should be in a ladder of TIPS held to maturity.

Historical experience with TIPS is limited. The Treasury issued its first inflation-protected bonds in 1997. No TIPS issue (and hence no ladder) with a term longer than 10 years has matured yet. TIPS with 10-year maturities have been issued in each of the years 2007-2024 inclusive. The first TIPS ETF was launched in 2003, at which time there were only a handful of open-end TIPS funds that have survived to the present.

I reconstructed historical bond yields and prices and inflation-adjusted TIPS cashflows using data from the Treasury and the St. Louis Fed. Fund data is from the Refinitiv Lipper database.

The table below shows the results of holding the various 10-year TIPS that were both issued and matured during 2004-2024, purchased with a face value of $10,000 upon issuance and held to maturity, versus comparable holdings in two different TIPS funds, iShares TIPS Bond ETF (TIP), average expense ratio 0.20%, and the actively managed American Century Inflation-Adjusted Bond Fund (ACITX), average expense ratio 0.48%. The funds would have been held to produce the same cashflows as the bond prior to maturity: An amount equal to the bond purchase price would have been invested in each fund on the issuance date. All fund dividends would be reinvested. Fund shares would be redeemed on the date of, and in the same inflation-indexed amount of every pre-maturity coupon payment. I compared the putative balance in each fund as of the bond's maturity date with the bond's final cashflow. The Nominal Value at Maturity column for the bond shows its inflation-indexed final cashflow (principal returned plus final interest payment). The Real Value at Maturity columns show the bond's final cash flow along with the fund balances on the bond's maturity date, all expressed in constant dollars as of the bond's issuance date.⁴

The figure below plots the ratios of the Real Values at Maturity of the funds to that of the bond for each issue (the horizontal line segments span from issuance date to maturity date). Lines above the green threshold at y=1 indicate instances where the fund outperformed the bond, and vice versa. The TIP ETF sometimes outperformed the bonds, but noticeably underperformed after the post-pandemic interest rate hikes. ACITX had low tracking error relative to the index ETF. Its lower performance was mostly due to its higher expense ratio.

Now we look at multi-year ladders of TIPS. The next figure illustrates a similar comparison as the above, except that instead of comparing an investment in a fund to a single TIPS issue, I compared the fund to TIPS ladders of different rungs (ranging from 3-10 years) formed each January between 2004 and 2021 inclusive. As above, the investment in the fund was the same as the entire ladder on the start date, all fund dividends reinvested, and fund shares redeemed corresponding to ladder cashflows. I plotted the ratio of the fund balance on the final maturity date to the ladder's final cashflow.

TIP ETF's remaining balance would have been larger than the ladder's final cashflow in most cases, and sometimes substantially more so, but not always. With ACITX the outcomes were more of a coin toss. Although the ACITX's expense ratio was only 28 bps higher than the ETF's, that drag made a substantial difference at the ladders' endpoints. It remains to be seen how TIPS funds will ultimately compare against today's outstanding ladders of longer duration.

The final figure illustrates the nominal versus real performance of the iShares TIP ETF (with reinvested dividends) from its inception at the end of 2003 to the end of 2023, with overlapping holding periods beginning and ending at every month during that period. The green dots indicate when the ETF's total return for a holding period was positive, and red for a holding period where the ETF lost value.

Investments in this fund would have kept up with inflation and preserved real value in most periods, but not in many other periods. And there were many periods when the investor had a positive return in nominal terms, but not after inflation. Caveat investor: Even though TIPS themselves are strongly protected from inflation, even the relatively efficient TIPS index ETF has not provided reliable protection against inflation. In fact, similar analysis shows that the iShares TIP ETF has not been a more reliable store of real value in the last 20 years than iShares conventional Treasury ETFs (TLT and IEF).

Conclusion

If one wants a guaranteed store of real purchasing power to pay off a future liability or to provide a multi-year income stream such as for retirement, then a ladder of TIPS, with each bond held to maturity, provides a much stronger guarantee than other readily available assets. TIPS funds are risky assets and do not provide reliable protection from inflation. If one chooses to invest in a TIPS fund, expense ratios matter a lot – the median real yield on 10-year Treasury bonds in the last 20 years has been 0.64%. Even a seemingly modest 0.20% in fees is a large share of one's potential return.

Practical considerations for constructing a TIPS ladder

• TIPS should be available from any broker that deals in bonds. They can be bought online at Schwab, Fidelity and presumably many other brokerages.

• Like other bonds, TIPS are denominated in $1,000 units. But if bought on the secondary market, the trading prices are indexed for inflation.

• TIPS are eligible to be "STRIPPED" into zero-coupon bonds, but zero-coupon TIPS don't seem to be available to retail investors, if at all. Any ladder will therefore include as cashflows the interest payments from the unmatured bonds. For this reason, it may be preferable to purchase low-coupon TIPS, to minimize the risk of incorrect or late reinvestment.

• There is at least one TIPS issue that matures in each of the years 2024-2034 and 2040-2054. There are no issues that mature during 2035-2039. The Treasury's current schedule is to issue 10-Year TIPS every January and July, so 2035-2039 should be "filled in" with available bonds during 2025 to 2029. In the meantime, if one desires cashflows during 2035-2039, a workaround that mitigates but does not eliminate inflation risk would be to hold a conventional zero-coupon bond maturing that year in an amount adjusted for estimated inflation. Another workaround that eliminates inflation risk, but not interest-rate risk, would be to add enough to, for example, the 2027 rung of the TIPS ladder to purchase the 2037 rung once the 2027 bond matures and the 2037 bond is issued, etc.

• TIPS have unpleasant tax consequences if held in a taxable account. Not only is the interest subject to federal tax, but as with zero-coupon bonds, the holder is taxed on the "phantom income" from unrealized principal appreciation. That means you would pay tax out of pocket on the supposed "earnings" from nothing more than inflation-indexing of a bond sitting in your account! Many investors would be best off holding TIPS only in tax-deferred or tax-exempt accounts. Check with your tax advisor.

I have created a free, easy-to-use page on my website that calculates the specific TIPS issues and purchase amounts to form a ladder, based on your requirements of coverage years, and annual income or investable cash.

Stefan Sharkansky is the founder of Personal Fund. He holds a PhD in statistics (econometrics concentration) from the University of Washington and an MS in computer science from Stanford University. He may be reached at [email protected]

¹ The Only Spending Rule Article You Will Ever Need

² The "guarantee" is not perfect, due to the Treasury's procedure for indexing TIPS cashflows for inflation. The Reference Consumer Price Index (CPI) values are lagged by three months. For example, the repayment at maturity on January 15, 2022 for the TIPS issued in January 2012 was indexed on the change in CPI from mid-October 2011 to mid-October 2021. If inflation is higher (lower) during the three months prior to issuance than in the three months prior to maturity, then the investor profits (loses) from the earlier (later) inflation. So high inflation during the three months prior to maturity could perceptibly diminish purchasing power at maturity. Less than ideal, but much better inflation protection than available elsewhere! The exact procedure for inflation-indexing is here.

³ You actually will lose purchasing power holding an individual TIPS to maturity if you buy it when real yields are negative, as was the case for much of 2011-2013 and 2020-2022. One would know before purchasing if the yield were negative. A known and tolerably small loss of purchasing power might be an acceptable form of insurance if one anticipated greater risks from investing in other assets.

⁴ The reader might wonder why the Real Value at Maturity for the bond is not precisely equal to the bond's face value (in these examples $10,000) plus the face value of the coupon payment paid upon maturity. The slight variance is due to the lagged inflation adjustment as described in footnote (2). My calculated Real Value at Maturity columns in the table are based on the investor's own experience of inflation, i.e. the change in CPI between the actual issuance and maturity months.

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