The Best Third user Pablo asked:
What is your opinion on TIPS Maturity ETFs like IBID IBIJ and 30 year TIPS LADDER ETFS like Northern Trust TIPD ?
First, recap The Best Third reasoning and methodology for holding TIPS (Treasury Inflation Protected Securities) during retirement. TIPS are held to maturity in order to produce cashflows – semi-annual interest payments and principal repayments, in order to meet spending needs. When held this way, they provide essentially guaranteed and predictable purchasing power for years to come. This commentary on TIPS ETFs is strictly from the perspective of comparing them to a ladder of TIPS held to maturity for spending during retirement.
There are basically three kinds of TIPS ETFs and open-end mutual funds:
- Perpetual funds
Examples of this type include VTIP (Vanguard Short-Term Inflation-Protected Securities ETF) and SCHP (Schwab U.S. TIPS ETF).Similar to most conventional bond funds, these funds hold a basket of TIPS, typically defined by duration (the average time to maturity of the bonds in the portfolio). The funds distribute interest payments every year, typically quarterly, but do not distribute principal repayments. When a bond in the portfolio matures, the principal is reinvested in other bonds. These funds are volatile, fluctuating with bond yields. Unlike individual TIPS held to maturity, they do not generate guaranteed cashflows. They are not an effective substitute for a ladder of TIPS in The Best Third methodology. The funds that Pablo asked about are not perpetual.
- Defined Maturity ETFs
IBID (iShares iBonds Oct 2027 Term TIPS ETF) and IBIJ (iShares iBonds Oct 2033 Term TIPS ETF) are of this type.A defined maturity ETF holds all available TIPS issues that mature in the target year. The Treasury’s practice has been to issue TIPS that mature in different months, with October being the last month that any issue matures in any year. These funds distribute interest payments during the life of the fund. Principal repayments from funds that mature in the target year are held in the fund until October of the target year. At that time the fund dissolves and distributes its total asset value to shareholders in cash as non-taxable return of capital.
- Distributing Ladder ETFs
TIPD (Northern Trust 2055 Inflation-Linked Distributing Ladder ETF) is of this type.A distributing ladder ETF holds a ladder of TIPS issues that mature every year for which there are maturing issues, between the present and the target year. Interest payments are distributed during the lifetime of the fund. Whenever an issue in the ladder matures, the principal repayment is distributed to shareholders in cash as non-taxable return of capital.
Because defined maturity and distribution ladder ETFs return principal from matured TIPS to shareholders at pre-defined times, they provide close to guaranteed real income.
In The Best Third methodology, a defined maturity ETF is a plausible substitute for an individual TIPS with the same maturity year. Likewise, a distributing ladder ETF is a plausible substitute for a full ladder of individual TIPS with the same final year. In practice, given implementation details, some investors might find them an attractive substitute for individual TIPS, and others likely won’t.
Pros and cons of defined maturity funds
Detailed information on the iShares defined maturity funds IBID, IBIJ and similar ETFs with different target years is at
https://www.ishares.com/us/strategies/bond-etfs/build-better-bond-ladders
These invest in all of the TIPS issues that mature in the target year, for which, depending on the year, there are currently between 1 and 5 outstanding issues. In 2027 (IBID) there are 5 maturing issues, in 2033 (IBIJ) there are 2. In 2036 (IBIM) there is 1. IBIJ and IBIM are expected to buy new issues when the Treasury is scheduled to issue new 5-year maturities in April and October of 2028 and 2031 respectively.
What would be the advantages of buying ETFs that hold only a handful of bonds which mature the same year? The biggest advantage I can see is that if you buy the underlying bonds, you buy in whole numbers of bonds. The TIPS maturing in 2033 are about $1,069 each. But the IBIJ maturing in 2033 is about $26/share. If you want to invest less than the price of a single bond, or an amount that is not a multiple of the individual bond price, you can get closer to your desired amount with the ETFs. Another minor advantage is that the ETFs distributes interest quarterly instead of individual bonds paying semi-annually. But the coupon interest on TIPS is pretty low anyway.
The disadavantages: Although the ETF holds all TIPS that mature in the target year, it only returns the principal when the ETF winds down in October of the year. But the majority of individual bonds mature earlier in the year. So you’ll have to wait until October to get your principal repaid. The cost is that you pay 0.1% every year. Not a huge cost, if the advantages appeal to you, but if you have a large balance in these ETFs it adds up. The average The Best Third user plans for about $50,000 in TIPS income each year. 0.1% a year on that amount is $50 a year. If you buy a 2036 ETF today, you will pay that $50 every year for 10 years, or a total $500 in today’s dollars, since the nominal value adjusts with inflation. And that would be for only one of the ETFs you would own if you laddered these ETFs. Also, this series only goes out to 2036, and they only seem to issue new ETFs after a new 10-year is issued. So if you want a longer ladder than 10 years, you’ll need to buy individual bonds for the later years anyway.
Pros and cons of distributing ladder funds
Detailed information on Northern Trust’s TIPD is at:
https://www.flexshares.com/us/en/individual/funds/tipd
I looked at the Daily Holdings spreadsheet, which is downloadable from the page above. The fund holds equal numbers of bonds maturing every year between now and 2055, except that it holds extra bonds maturing 2034, 2035, 2040 and 2041, apparently to cover the gap years 2036, 2037, 2038, 2039 when there were no maturing TIPS issues when the ETF was created. Interestingly, it didn’t sell any of the extra bonds to replace them with the 2036s that were issued this January. I was unable to find in the prospectus the mechanics for producing income for the 2036-2039 years, or how they would reinvest the proceeds from the extra TIPS that mature in 2034 and 2035.
The equal numbers of bonds is an unusual choice, I think, because what it means is that in the early years, the sum of the coupon interest from all of the later bonds will be much greater than in the later years when there are fewer outstanding bonds to pay interest. So the payouts will decline steadily over time.
Advantages: it’s a lot more convenient to buy an entire ladder with one trade, than having to buy 25+ individual bonds. And one can buy an entire ladder in units of the roughly $100 share price instead of with $1000+ individual bonds.
Disadvantages: The payout structure is inflexible. If you want a stream of payouts that is meaningfully different from what the ETF provides, you’ll have to find another way to add to the ETF to create that. And the 0.1% every year adds up. A 30-year ladder that pays $50,000 a year takes about $1,075,000. The management fee for the first year alone would be $1,075. The total management fee over the life of a 30-year ladder would be many thousands of dollars.
How Popular Are These Funds?
One way to evaluate whether these products have resonated with investors is to look at their assets under management.
TIPS funds collectively hold about $266 billion, over 99% of which is in perpetual funds. The single largest fund is Vanguard’s VTIP and related share classes, which together hold approximately $68 billion.
By comparison, the entire iShares family of defined-maturity TIPS ETFs holds about $806 million. The Northern Trust TIPD distributing ladder ETF holds only about $4 million.
Of course, assets under management do not determine whether a product is useful. A small fund can still be a good idea. But the contrast is notable. Investors have overwhelmingly chosen perpetual TIPS funds, while defined maturity and distributing ladder funds have remained niche products.
The TIPD figure is particularly striking. Many users of The Best Third have retirement plans that call for larger TIPS ladders than the entire asset base of the fund.
Conclusions
If your assets or your need for guaranteed income are modest, the defined maturity or distributing ladder TIPS ETFs might be a good choice – they are convenient and can be bought in small quantities. On the other hand, if you look to TIPS for significant guaranteed income, I would be inclined to stick with a ladder of individual bonds. The ETFs are inflexible, and for a large balance, more expensive than the seemingly small 0.1% fee might suggest.
With individual TIPS vs. a defined maturity ETF, your principal is repaid upon maturity without having to wait until October. Although if you need the cash from a defined maturity ETF earlier in the target year, you could sell the ETF, and the proceeds would likely be close to what you would get in October.
What struck me most about TIPD is that the shape of its payout stream appears to be largely an artifact of the portfolio construction methodology. The fund holds equal numbers of bonds for most maturity years, which means the cash flows naturally decline over time as fewer bonds remain to pay interest. Some retirees may find that pattern suitable. Others may want income that remains level, rises, falls more slowly, or changes at specific points in retirement, or is exceptionally large some year for a one-time event. With a ladder of individual TIPS, those choices belong to the retiree. With a distributing ladder ETF, you have no choice.
The biggest challenge with a ladder of individual TIPS is the one-time inconvenience of having to buy all those bonds. I would rather pay a one-time hourly fee to a CPA or CFP to execute those trades for me, than pay many times as much in fees for otherwise unneeded management.
