2) I mentioned inflation expectations above. The result really should not be surprising (assuming you have the cash available to pay tax on the phantom income). The problem with the article is that it ignores other alternatives.

“I’m happy with a constant stream of real income, with a guaranteed real principal payment at the end. Why should I care about changing duration if I won’t sell?”

Good question.

I’m sure Felix or commentators can jump in with maths, but the reason why average bond duration matters goes something like this: if your TIPS bond expiration is exactly matched up to your desired inflation-protection period (and no ante- or post- considerations), then you are correct: hold-to-maturity = the inflation protection you imagined.

But if those periods differ: imagine that the value of the embedded inflation protection option varies over time, and you are forced to do a renewal market transaction at a high or low point on that curve, not when you want to relative to your entire portfolio: volatility in cash flows means that actual inflation-protection at any given time does not equal the average inflation protection desired over the time period.

I would guess that terms like gamma-hedge and delta are involved, but can’t speak to all of that business. But I’d be psyched if it turns out that my high-school calculus has something to do with it, because I just thought all that up.

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“TIPS in taxable accounts are no worse than nominal treasuries. Better if there is unexpected inflation. The trouble is you could lose on an after-inflation, after-tax basis”

Even better than that, so I just learned: “Are Treasury Inflation Protected Securities
Really Tax Disadvantaged?” http://www.frbatlanta.org/filelegacydocs  /wp0309a.pdf

“We find empirical evidence that the after-tax yields on TIPS and conventional bonds are close to one another when inflation expectations are taken from the two markets.”

(2) TIPS in taxable accounts are no worse than nominal treasuries. Better if there is unexpected inflation. The trouble is you could lose on an after-inflation, after-tax basis if you hold in a taxable account. Holding in a tax-advantaged account is much better.

The more interesting tax comparison is to short munis, which should adjust for inflation and which don’t lose to taxes. If they adjust enough, they beat TIPS after tax and inflation if there is high unexpected inflation.

As far as taxes, the problem isn’t as acute as you make it out to be. When investing in bonds directly, it is true that you are taxed on the inflation adjustment to the principal, even though the adjustment only goes into principal. It’s not tax efficient in that sense, because you are paying taxes on cash you don’t receive until you have sold the bond. It’s annoying, but I wouldn’t call it a “hassle” unless one is totally strapped for cash. However, bond funds do distribute both the inflation adjustment and the coupon quarterly, which solves the cash flow problem. In any event, these problems disappear if you have your TIPS in an IRA, which is probably where they should be anyway.

(1) as mentioned, you have to self-manage the constantly changing outstanding duration of one or many separate bonds. However, laddering would help, be close enough, and not too difficult.

(2) TIPS bonds owned directly, outside of a tax-deferred account, have tax implications that can be less than optimum (taxes on unrealized gains due to inflation adjustments). (but see http://www.frbatlanta.org/filelegacydocs  /wp0309a.pdf) ETFs can shield/defer that.