Treasury Inflation-Protected Securities are almost entirely risk free when bought and held to maturity. Default risk? As close to zero as you can get. Inflation risk? Covered. Duration risk? Hold to maturity and forget it. Downgrade risk? We’ve been through this and it actually caused TIPS values to rise. Liquidity risk? Hold to maturity and forget it.
But there is this one nagging thing: Reinvestment risk.
The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. – Investorwords.com
One way to minimize reinvestment risk is to build a ladder of bonds with maturities stretching out many years. Each year, as a bond matures, you buy another of a set maturity. My preference is to build the ladder with 10-year TIPS purchased at auction, because the 10-year maturity seems to be the ‘sweet spot’ for yield and term. I worry about the negative cash flow of taxable 30-year TIPS.
Reinvestment risk is something that longtime TIPS holders are facing right now. Each year, we have TIPS maturing with real yields of 1.5% to 2.5%. For most of the last two years, we faced replacing these with TIPS paying yields negative to inflation. That is a 200 to 300 basis point drop in return.
Depressing. My reaction was to stop buying TIPS from July 2011 to May 2013, but I continued buying I Bonds, which have an open-ended maturity date, up to 30 years. So here is what my TIPS ladder looks like right now:
My ladder actually remains pretty intact, with TIPS maturing in 2014, 2016, 2017, 2019, 2020, 2021, 2023, and then jumping out to 2029 and 2041.
But notice that I have ladder rungs missing in 2015 and 2018. I can’t do anything about 2015, but I can fill the 2018 spot with August’s reissue of a 5-year TIPS. Normally, I wouldn’t get too excited about a 5-year TIPS with a yield of about -0.47%, but I think this would a good investment to fill the gap.
It won’t return much, but it will set aside money for me to reinvest in 2018, probably into a TIPS maturing in 2028. When that matures, I will be 75 years old. I will have punted money forward to my 75-year-old self.