The TIPS fund has a duration of 7 years. Investors will be rewarded (relative to nominal bonds) for unexpected inflation over the course of that duration. Inflation running a bit hotter than expected in the 2nd quarter of 2022 isn’t going to produce a dramatic outperformance.
This is kind of right, but I wouldn’t interpret “duration” that way. The fund holds a variety of bonds with different terms, and the duration is approximately the weighted average cash flow in the total bond portfolio. The fund’s asset value will be responsive to longer term inflation expectations, well past 7 years because there will be a lot of bonds in the portfolio that have cash flows past 7 years.
I don’t think this is true in any helpful sense. The main risk factors for bonds are term and credit. If we assume Treasuries then we can just talk term.
Yes, holding a 5 year bond to maturity is less risky than holding a bond fund with a 5 year duration for 5 years. In the former case your term risk is reducing year by year, and in the latter case you are exposed to a constant term risk factor. To compensate, holding your 5 year duration bond fund for 5 years will have a higher expected return than buying and holding a 5 year bond to maturity.
There is actually a product called Bulletshares by Invesco that allows you to simulate buying an individual bond with known maturity via ETF.
Well buying the bond directly and holding to maturity might guarantee that but that’s not the way you can buy into TIPS in most people’s 401k plans.
I think it’s a pretty irrelevant distinction. There’s some shorter term bonds that will be more sensitive to current year unexpected inflation and some longer term bonds that will be less sensitive to current year unexpected inflation. The single most important metric to determining how that TIPS fund will perform relative to a nominal bond fund is what inflation does relative to expectation over the course of the next 7 years.
That may be so, but “duration” has a very specific meaning in bonds so it’s not a good idea to describe things that way unless you really mean “duration”.
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Yes I am referring to the very specific meaning of duration. I am not using duration in a colloquial sense.
Everyone else in the world uses duration to describe the interest rate sensitivity of the bond.
Not sure that I’m understanding the disconnect, but at every point I have used the term duration ITT, I am referring to precisely the textbook duration formula calculation applied to every future cashflow of every bond in the fund.
I the normal parlance, a bond or a portfolio of bonds has a duration. The duration is the percentage change in the market value of the bond or portfolio of bonds arising from a 100bp change in market interest rates. There isn’t any direct connection between bond duration and inflation sensitivity of TIPS, and most people don’t speak of durations of “every future cash flow”. It’s just a weird way of looking at things and it could really send someone off track because bonds and bond funds disclose their durations and that information could be misinterpreted.
No, that’s a rule-of-thumb way of understanding why you should care about duration.
Ok, but that’s literally how duration is calculated.
A shorter duration TIPS fund will have better relative performance (vs. longer duration) to a nominal fund when we experience present unexpected inflation.
Bond geek fight ITT!
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No, it’s the actual definition that me and all the bond traders use when we talk about bonds.
But this is getting a bit nit picky and I don’t really need to be right about this. You can use the words whatever way you want I guess. I will just say that people should be careful about how they use terminology for bonds and mistakes in interpretation will lead to incorrect understanding. Term and maturity and yield and duration and a bunch of other terms of art for bonds are not really open to interpretation.
Like, I’m not just making this up.
I’ll agree with this. I’m not a bond trader.
My experience with duration is limited to the 3F actuarial exam (Models for Financial Economics) and it looks like there is some nuance between Macaulay duration and modified duration that makes me wrong.
But I’m still not understanding why you think that (holding interest rates constant) the performance of a TIPS fund during unexpected inflation in the near term would be agnostic to that fund’s duration.
Agnostic is probably too strong, but the relationship is kind of incidental. Sure, a low duration fund also has more shorter term cash flows, and a lower duration TIPS would tend to be more sensitive to near term unexpected inflation. But when a fund or portfolio discloses that they have a duration of 7, they very specifically mean that the fund’s interest rate sensitivity is described by a duration of 7. It isn’t meant to be read as “this TIPS is sensitive to inflation rates over the next 7 years” and you could get tripped up thinking of it that way. As a extreme example you could have a portfolio that is 50% made up of a strip bond with a 1 year maturity and a strip bond with roughly a 15 year maturity. If those were both TIPS, the short term inflation would actually move the price a lot I think because half the portfolio is a short term inflation sensitive cash flow. On the other hand you could have portfolio with a single strip bond with a cash flow of duration 7, and it would be much less sensitive to the one year inflation because it’s actual payment is based on the 7 year inflation. Anyway, just one of the many ways that bond math can get pretty esoteric.
Well I’m 100x more confused than when I asked the question.
Let’s try a different tack. Let’s say you have a friend who’s 53 years old, and before the downturn he was at a pretty comfortable number to “semi-retire”. Which means still planning to try to make some money in the rest of his life, but w/o any pressure to do so for a while.
If we ever get back to the levels of the heady days of early 2022, this friend would like to put half his nest egg into something low risk but as inflationary-hedging as possible. Would you have a suggestion for him?
I don’t think this really exists. If you need to earn investment returns on your comfortable number, there’s nothing that is going to be inflation-hedging that is also “low risk”. Probably the best bet for a low risk inflation hedging retirement asset is an annuity indexed to inflation, but you will have to pay a lot to get that risk protection.
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Give this a watch
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