This is a thoughtpiece, not a stance on whether its implementation is worth trying out. The goal is to convey the complexities to the layperson so they can understand some of the nuance rather than hold a generic ‘burn the rich’ view. There are many ways to implement this, though all of them have crazy complexities.

Steps

Definition of Unrealized Gains: Identify the unrealized gains as the difference between the current market value of the stock and its original purchase price (or cost basis).

Taxation Trigger: We can’t manage tax on a real-time basis so we have to pick events that lead to tax events. Holding periods would be one, and for this example we’ll tax once the holding period reaches one-year (long term gains holding period in the US).

Tax Rate: we’d use the same tax rate as long-term gains.

Payment Mechanics: 15% of the gain would be transferred into a government custodian account.

Exemptions and Thresholds: Gains would have to be above a certain level to warrant going through this operational headache. Let’s pick $1MM gain (i.e. a $150k taxed amount).

Anti-Avoidance Measures: Implement anti-avoidance measures to prevent investors from exploiting loopholes, such as: use of derivatives; stock transfers; ADRs; etc. Penalties would be required to incentivize compliance.

Revenue Allocation: The revenue needs to be allocated in a way that it can be subsequently clawed back in case the gain is reversed. Meaning, you can’t take that money spend it on a bridge then when the investor subsequently needs the money back due to a loss in their investment, you can’t say ‘whoopsie’.

Example

Suppose an investor, John, purchased 1,000 shares of XYZ stock at $500 per share in 2010. Today, the stock is worth $2,000 per share, resulting in an unrealized gain of $1,500,000 ($2000 — $500). If the taxation trigger is met (e.g., 1-year holding period), John would be subject to taxation on the unrealized gain.

Assuming a 15% tax rate, John would owe $225,000 in taxes ($1,500,000 x 15%). That amount of stock would have a lien place upon it and transferred to the US government. The DTC (the ledger for stock ownership) would be updated to reflect that.

The US government could sell the security to get the cash, or could leave the tax receivables in stock form.

Challenges and Considerations

The government as an investor: Essentially the government would have to sell the securities if they needed the cash and later buy them back to return them to the taxed entity. If they don’t sell the stock then its not very useful in terms of having these assets to fund government activities.

Tax Complexity: Implementing a mark-to-market tax system would add complexity to the tax code, potentially increasing compliance costs and administrative burdens.

Investor Behavior: Taxing unrealized gains could influence investor behavior, potentially leading to more selling; or simply more complex schemes that are legal but circumvent the legislation.

Passing legislation: Something like this is very complex to write let-alone get consensus to pass.

Technological Infrastructure: It would take time to build a system that could manage this reliably. By the time its built circumventions could have already been put in place severely blunting the returns on unrealized gains.

“Just tax them in cash”

You might be saying, just tax them in cash. You could do that, but it would essentially just be a cap on allowed unrealized gains. Most people that become rich through stocks do so via concentrated ownership in a single stock. So when they become successful their only source of cash will be through liquidating their stock (i.e. a realized gain).

Let’s say John makes a $1,500,000 gain and pays $225,000 in taxes from the ‘unrealized gain’. They will likely have to sell $225,000 of stock to fund that tax liability. In this example thats 112.5 shares of their stock. However, now they’ve realized gains on those shares, so now you have to go back, amend the unrealized/realized gains mix; and so on.

Let’s say the stock eventually goes to $0. The investor has given $225,000 (ish) to the US government. And to make the tax code consistent, that money should be returned to the investor.

So you still end up with the same complexity as my original example…

Conclusion

Taxing unrealized gains on stocks is a complex issue, and any implementation would require careful consideration of the challenges and potential consequences.

In my humble opinion, such an idea would never get passed through congress, and even if it did; would be fairly easy to circumvent.

Bonus Idea

An ‘easier’ alternative would be to have a financial transaction tax on asset-based lending. For example, let’s say Elon Musk borrows $10B against his Tesla stocks, you could force investors to register this transaction with regulators and charge a tax on the transaction size.

Even this ‘simpler’ idea has challenges. If you charge a 15% rate to mimic long-term tax gains it would likely reduce the frequency of these transactions which would reduce the taxbase. However if you made it small enough that the transactions still continue (e.g. 1%?) you don’t get much tax receipt and don’t particularly change peoples behaviors.

“I don’t understand why we’re doing this”.

You’ve spent weeks fleshing out all the details of a technical project that is going to deliver massive business impact, you perform a review with your C-suite and they are left confused and you’re left disappointed. This happens all the time in big and small companies. My goal is to give you a framework to think about how to communicate effectively depending on the audience and stiutation. A great mental model is:

• Audience
• Message
• Data points

Audience: Who is the consumer of your communication? What is the technical/business capabilities that they possess? What is important to them?

Message: What is the essence of what you’re trying to convey? If you had to explain it in the title of an email or 20 seconds in the elevator, how would you get across the gist to garner attention?

Data points: What is the data supporting your position?

Understanding the Audience

Using the IC -> Manager -> Director -> VP -> C-suite org model, different actors think the same business with different mindsets and scope:

• Vice Presidents (VPs+): Focus on observable business metrics, such as revenue growth, customer acquisition, and ROI. Even a senior VP of engineering may be spending 80%+ of their time thinking about how to support these things.
• Directors: Concentrate on strategies that map to business metrics. They require insight into project organization, resource allocation, and timelines to ensure alignment with company objectives. Typically they’ll be thinking about the 1–2 year goal and how current work maps to those goals.
• Managers and Individual Contributors (ICs): Centered on detailed project execution, they need information on specific tasks, deadlines, and deliverables to drive tangible outcomes.

The theme here is that managers and ICs are inherently thinking much more about the details of a project; and this is the mark of a successful organizational design. However, it means they have very different needs when it comes to how they think about your message.

• VPs+: Does this align to business priorities and is it credible.
• Directors: Does this provably contribute to business metrics, and is it executable.
• Managers/ICs: Are the business commitments realistic given the time/staffing; does it actually meet the requirements.

Imagine you’re working for a SaaS tech company, and you are pitching a project to replace the account management system with another solution. The internal questions each have may vary:

• VPs+: What is the business hypothesis? Does it meet the return-on-investment bar? Is this a high enough priority?
• Directors: Do we have the right skills/structure for this project? What are the risks we’d incur? Is this initiative going to clash with others we have planned?
• Managers/ICs: Does the new system support the existing requirements? Is there a roll-out strategy? Are there clear workstreams/milestones we can use to track? Is the design comprehensive enough to feel enthusastic about he project.

If your ideas are big enough, you can’t use the same message/artifact for all these different cohorts. There are two main situations you can bucket into:

Strategic Planning/Pitching: You are pushing for big change in the organization that will require buy-in on all levels of the org

Firefighting: You are responding to immediate business problems that need remediating in a holistic way.

Getting everyone onboard

To effectively communicate with each level, take the following steps

1/ Start with the VP+ elevator pitch:

Figure out if your idea resonates with leadership:

• The business hypothesis
• Data to support your hypothesis
• Proposed Next Steps

Here’s a hypothetical example:

“Our operational efficiency is hampering ability to grow our business”

As we grow our business our onboarding processes gets overwhelmed and causes a back-up in onboarding. As a result some client abandon us in favor of our competitors. Our onboarding time increases from hours to days when we engage in online marketing. Essentially our conversion funnel from warm leads to signed clients drops from 70% to 40%. Our belief is improving this process will lead to x new customers; with an average liftetime value of $y, improvements will lead to $z of additional revenue.

Next steps:

• document the onboarding process in more detail
• perform a request-for-proposal (RFP) to compare potential off-the-shelf solutions
• estimate cost to improve to understand the return-on-investment of such a project.

By doing the above you will quickly get feedback as to whether this seems worthwhile to leaders. They may say they have bigger opportunities and that’s great because it gives you the ability to find the areas where you should lean into, and avoids you sinking lots of time into an idea that may not survive to implementation (i.e. fail fast).

2/ Create the strategy doc

As you go deeper you need to start fleshing out the idea in more detail.

• Create a more detailed plan for execution
• Start listing the various stakeholders, their success criteria
• What you need from each person
• Success criteria for the program
• Risks/Mitigations
• Workstream definitions/etc

3/ Create the execution plan

The detailed execution plan covers the details; essentially you should be able to give it to managers and ICs and they have a reasonably clear understanding of what needs to be done. In any project there will still be questions but you need to have workstreams’ scope detailed out; key milestones; deadlines and resource allocations. This creates the accountability for others to execute.

Tools of the trade

The above didn’t call out the tools to use because there are multiple options and your organization may have some standardized approaches.

Small org

For a small organization you might be winning the executive leadership over with a simple conversation. Then simply writing a Google Doc for everyone else.

Larger orgs

When you’re aiming for large scale change that may take years, you need to industrialize your thinking and strategy to ensure that the goals and execution model are durable. If you don’t have an explicit outcome metric, for example, it’s easy for people to misunderstand the goal of the project later and divert its resources into something else, or deliver against a different metric.

An example toolset:

1. Concise high-level presentation (e.g. a pitch deck)

Though this is essentially a pitch to the VP+ team, you should incorporate their feedback into it and continue to invest in its upkeep beyond the initial ‘thumbs up’. As your program spins up this will dictate the ‘mission’. Without it, as your org grows it is easy for the mission to become diluted and/or co-opted by diverse perspectives.

2. The Strategy Doc

For smaller projects (< 1 year; < 20 people) you may not need this; for multi-year projects involving 100s you definitely need it. Some areas to add:

• Explicit stakeholders
• Detailed success criteria and measurement approach
• Resourcing needs & strategy
• Workstream breakdown (i.e. how resourcing will allocated to execute)
• Milestones
• Project management structure

3. Detailed project plan & design docs

The above will be living documents but focus on the how, not the status. Status of a large project tends to require intake from a number of people (e.g. a responsible party for each workstream). Many companies invest in a specific set of tools whether that’s giving everyone access to the same vendor product(s); or have their own homemade solutions. Some just make-do with Google Sheets, even!

Designs are also very critical for technology projects to ensure that shared context is created across members of the project; and for people years down the line to understand the thinking behind the solutions.

Other considerations

Maintaining Consistency

As project ideas evolve, ensure consistency across messaging channels:

• Regular updates: Schedule regular updates to keep all levels informed.
• Version control: Track changes in your docs/tools; and maintain version control.
• Clear documentation: Store all project documents in a centralized location.

Bond Auctions: A Temporary Fix?

The Treasury consistently uses bond auctions to fund the US deficit and has received some criticism for issuing so many short term bonds (maturities less than 1 year). When 30 year rates were at 1.35%, it would have been an ideal time to lock in more funding at higher rates. However tempting this theory is, it wouldn’t have worked cleanly:

• The amount of issuance of long term bonds required to make an impact on average Treasury financing rates would have been huge
• It would have required financial actors (e.g. banks) to absorb a huge amount of long term fixed rate securities.

This article delves into the shorter end of the curve and its dynamics!

Interest Rates and the Yield Curve

The dynamics of interest rates play a pivotal role in shaping the Treasury’s strategy. The US government is currently running a huge deficit and this has to be funded with bonds. This dynamic is exemplified by the Treasury issuing a huge amount of short term bills.

As I alluded to earlier using long term bonds isn’t so simple. Someone (e.g. banks) have to buy them, then manage the interest rate risk on them. As shown by the SVB, First Republic and Signature banks; even the ‘tech forward’ banks weren’t very good at managing the risk on it. The idiosyncrasies of this is outside the scope of this article, however.

Understanding Repo and Reverse Repo Facilities in Financial Markets

The Repo (Repurchase Agreement) Facility and Reverse Repo Facility are vital tools in the financial markets, enabling short-term borrowing and lending transactions between financial institutions. These facilities play a crucial role in managing liquidity, influencing interest rates, and supporting the overall stability of the financial system.

The Repo Facility is run by the Federal Reserve’s FOMC, and allows market participants to obtain short-term funding by selling securities with an agreement to repurchase them at a later date. In essence, it serves as a collateralized loan, with government securities, corporate bonds, or other high-quality assets acting as collateral. The party selling the securities agrees to repurchase them at an agreed-upon price, which includes interest, providing the lender with a return on their investment.

On the other hand, the Reverse Repo Facility allows financial institutions to lend excess funds to central banks or other counterparties by temporarily acquiring securities. This serves as a crucial tool for central banks to absorb excess liquidity from the financial system. The party engaging in the reverse repo transaction lends funds and receives securities as collateral, earning interest on the transaction.

These facilities exist to address short-term liquidity needs, facilitate the smooth functioning of financial markets, and implement monetary policy. The repo market, in particular, is a critical component of the financial system, providing a mechanism for financial institutions to meet their short-term funding requirements. Understanding these facilities is essential for participants in financial markets, as they directly impact interest rates, market stability, and overall economic health.

I bolded the point on absorbing excess liquidity because that is out current state of the market. Banks have more cash than they need on a day-to-day basis. This came about largely after the massive pandemic cash stimulus. To oversimplifiy there are cases where banks have excess cash, don’t feel comfortable about lending it out, and park it at the RRF for 1 day. The banking market is gradually having less ‘excess’ cash but as you can see from the chart, having zero excess cash in the system isn’t necessarily a problem. Before the pandemic it was a rarer occurrence.

Short-Term T-Bill Auctions: A Strategic Pivot

Coming back to the bond market, the Treasury’s pivot towards short-term T-Bill auctions is a response to the evolving interest rate landscape. There are two key reasons behind this shift: firstly, to avoid being locked into long-term high-interest rates that could worsen the deficit and interest expenses, and secondly, to entice capital back from the Reverse Repo market by offering yields slightly higher than 5.3%. This tactical move reflects the Treasury’s attempt to navigate a challenging financial terrain.

If the banks didn’t have this ability to earn a return on the cash it would incentivize them to search for return elsewhere (e.g. give out loans that may fail).

The Treasury’s plan seems to be progressing well. In recent months, the Treasury has successfully drained approximately $1.5 trillion from the Reverse Repo Facility. The Q4 refunding plan further solidifies the Treasury’s commitment to this strategy, indicating a willingness to stay well above the traditional ratio of T-Bills to Bonds.

An Unconventional Ratio: T-Bills vs. Bonds

Examining the composition of recent Treasury auctions, we see a departure from the norm. The Treasury has effectively inverted the standard ratio, auctioning around 65% T-Bills and only 35% Bonds over the past year. This unconventional approach suggests a deliberate effort to adapt to the evolving economic landscape.

Implications of Rapid Reverse Repo Facility Draining

Using the estimated $1.5 trillion of upcoming auctions between now and the end of the first quarter of 2024, the Reverse Repo Facility will soon be drained. If the Treasury maintains the current pace of auctions, the RRF could be depleted as early as January. This potential scenario raises questions about the Treasury’s contingency plans and the stability of financial markets.

Future Challenges: Falling Rates and Increasing Deficits

There is a critical question regarding the Treasury’s future moves: where will they turn when interest rates start to fall? With the government running annual federal deficits of $2 trillion, the Treasury finds itself in a challenging position. The article underscores that this situation is occurring before the potential onset of a recession, which could further exacerbate deficits.

What’s Next?

When the reverse repo facilitaty ‘runs dry’, meaning there is no demand for its use, it is likely going to be hyped by the financial press. Here I want to enumerate some options:

Banks have less cash

Financial conditions get tighter as banks are more discerning about who they lend to.

Banks are parking their money elsewhere

The RRF isn’t the only option for parking money, but it represents a good option. The 30 year bond yield topped at arount 5% and has been dropping. There is a small chance banks are opting for long term bonds, or other short term financing options like IORB.

Summary

In terms of what’s next there are two forces working against each other. The fiscal deficit is creating money that stimulates the economy, some of this can end up in banks assets and then into the RRF.

The fighting dynamic is the impact on bond yields as more are auctioned to fund the deficit. As the yields increase it causes financial conditions to tighten (i.e. harder to get loans; and loans make less sense to borrowers).

The decline in RRF usage means, in my opinion, that the effects of the financial stimulus are starting to drop off (e.g. stimulus checks are almost done across the US though still exist in a couple states), and we see less excess cash floating around. That said banks still seem well-capitalized (see below). It’s likely to be a grinding out of these two dynamics as congress battles whether to continue running a deficit or reign it in (reducing the supply of bonds thereby lowering rates), or they continue running the deficit (increasing the supply of bonds maintaining upwards pressure on rates).

Version control is a crucial aspect of collaborative software development, and Git has become the industry standard for managing source code changes efficiently. This guide aims to walk you through a comprehensive Git workflow, focusing on branching and pull requests. By following these steps, you can contribute to projects seamlessly and avoid common pitfalls.

Best practices for team projects:

Collaborating on GitHub projects with multiple contributors requires a strategic approach to ensure a smooth and efficient development process. This guide outlines a set of best practices aimed at fostering collaboration, maintaining code quality, and streamlining workflows for teams working on GitHub projects.

1. Use Branches Effectively:

• Create feature branches to isolate changes.
• Employ a branching strategy (e.g., Gitflow) for organized development.

2. Clear and Concise Commit Messages:

• Write descriptive and concise commit messages.
• Clearly communicate the purpose of each commit.

3. Frequent Pulls and Updates:

• Regularly pull the latest changes to avoid conflicts.
• Keep your local repository up-to-date.

4. Code Reviews:

• Conduct regular code reviews for quality control.
• Provide constructive feedback during code reviews.

5. Continuous Integration (CI) and Automated Tests:

• Implement CI to automate testing on pull requests.
• Ensure all tests pass before merging changes.

6. Use Issues for Tracking:

• Utilize GitHub Issues for task tracking.
• Reference issues in commit messages for traceability.

7. Documentation:

• Keep documentation up-to-date, including README files.
• Document the purpose and usage of code elements.

8. Follow Coding Standards:

• Agree on and adhere to coding standards.
• Use linters and automated tools for consistency.

9. Pull Requests (PRs) Guidelines:

• Create meaningful PRs with clear descriptions.
• Reference related issues in PR descriptions.

Setting the Stage:

Creating a New Branch:

To begin, create a new branch using the following command:

git checkout -b my_new_branch

This command not only creates a new branch but also switches to it in one step.

Committing Changes:

Commit your changes with a meaningful message using:

git add .
git commit -m "Your commit message"

You can also use git commit -am "Your commit message" to combine staging and committing in one step.

Pushing Changes:

Push your branch to the remote repository on GitHub:

git push -u origin my_new_branch

Collaboration and Pull Requests:

Pull Request on GitHub:

After committing changes, it’s time to create a pull request (PR) on the GitHub UI. This process initiates a discussion about your proposed changes and allows for code review.

GitHub will notify you of any merge conflicts. If conflicts arise, follow these steps:

Handling Merge Conflicts:

1. Fetch the latest branches from GitHub:

git fetch

2. Switch to the master branch and pull the latest changes:

git checkout master
git pull origin master

3. Return to your branch and merge changes from master:

git checkout my_new_branch
git merge master

Most Integrated Development Environments (IDEs) will assist in conflict resolution. After resolving conflicts, commit the changes:

git commit -am "Merging master into my_new_branch"

Finally, push your changes:

git push origin my_new_branch

Finalizing the Pull Request:

After pushing the changes, revisit the GitHub UI and retry the pull request. Before merging, it’s advisable to wait for automated tests (if configured) to ensure your changes don’t break the existing codebase.

Conclusion:

Mastering Git workflows enhances collaboration and ensures a smooth development process. By following these steps for branching, committing, and handling pull requests, you contribute to projects with confidence. Git, coupled with a well-defined workflow, empowers developers to build robust and error-free software collaboratively.

Text-to-image/audio/video: this is where most progress will be made in the ‘short’ term.

Text-to-code: will slow down

Questions / Answers: will slow down

Text-to-image/audio:

AI generated stories, music, images. This is moving in leaps and bounds. The creative process is one where bad ideas are part of the journey. AI can generate thousands of bad ideas but come up with the occasional gem.

Oasis: https://www.billboard.com/music/music-news/liam-gallagher-response-oasis-ai-album-aisis-1235310076/

Drake: https://www.npr.org/2023/04/21/1171032649/ai-music-heart-on-my-sleeve-drake-the-weeknd

Artists have mixed responses, but it is undeniable that the creative process has become less human-dependent. Imagine a site that generates millions of songs and then lets users surface the best ones. There will be a few bangers in there, and we wouldn’t have to pay for artists’ Lambos or houses in Calabasas.

That said, art is a passion for most and not an occupation. People do it for free anyway, so will machines doing it for free make that much of a difference. When I walk in Central Park I see people singing, playing drums, mandolins, and so forth; mostly for love and partly for the few dollars they make from donations. Will AI make that much of an impact?

That said, if you’re making money making logos, elevator music; or generic wall art; perhaps that process will be done by a much smaller cohort of AI-augmented professionals.

Text-to-code:

There are a few co-pilot add-ons for IDEs which will make developers more efficient, but won’t replace developers entirely. Most major productivity gains are already being unlocked. In order to keep the LLMs up to date, they need new data. StackOverflow has already got wise and wants to charge companies for the training data:

https://www.wired.com/story/stack-overflow-will-charge-ai-giants-for-training-data/.

Without new data, these LLMs will be providing incorrect results. For a layperson, imagine asking ChatGPT for instructions on your iPhone and getting answers for the iPhone 6. Still useful for some people, but not most.

Removing the developer completely is a huge leap from here. There are a number of impressive demos where a website can be generated from an instruction to a LLM. This will be powerful for experimentation. Say you want to see if there is demand for a specific D2C product, you can quickly generate the website, advertise and gauge the traffic.

Making websites fully functional, and more importantly, adding new features is much harder, especially if they become popular. It’s not to say that LLMs won’t help a lot, but think of it as an equivalent of Full Self Driving (FSD) for cars. There are use cases that are easier (e.g. smooth highway with clear lanes) and others that are REALLY hard (a deer running out onto a dirt road).

In my view, there will be net positive demand for engineers. LLMs will allow non-technical people to get their feet wet with creating technology. It will lead to a lot more websites/apps/etc, and more demand for maintenance/improvement/etc of them.

Questions / Answers:

Similar to StackOverflow, data ‘owners’ will get wise and put their data behind accounts/licenses/etc. In slow moving data spaces the horse may have already bolted. Imagine you run a horticultural website and your data has already been scraped. ChatGPT can already answer questions like “Do I need to stratify oak tree seeds?”. The answer to that question is unlikely to change.

However in industries with rapid data change or regulatory barriers LLMs’ progress will slow.

“Who are the best teams in the English Premier League” or “Is fasted training a recommended approach for achieving sports performance gains?”. Over time the answers change, and data owners will gradually put up barriers, many will be legal such as restrictive redistribution rights, put more data behind paywalls/licenses/etc. This will force LLMs to be more proactive in sourcing licensed data (increasing costs), or by sourcing data from lower quality sources (e.g. open chat forums).

In regulatory spaces there are various asymmetric payoffs, i.e. a small benefit for getting something right, and a large downside for getting something wrong. Health advice, financial advice, legal advice, and so on. Here there is a fight brewing. Should the LLMs offer ‘correct’ answers, or should the person providing the answers to the user ‘filter’/‘correct’/‘validate’ answers before passing to reader. This will slow down progress in many parts of life.

Primer on TIPS

I’ll assume you’re familiar with US treasury bonds already; basically; you lend money and you get back a coupon regularly. At the end of the loan you get the lent money back.

TIPS stand for Treasury Inflation-Protected Security. The rationale for the security is baked into the name.

A TIPS bond has very similar reference data as a regular bond: there is a face value and a coupon. Let’s say you buy $1000 of TIPS bonds with a 5% coupon rate. You’ll make $2.50 twice per year ($5 annually) for the life of the bond if there is no inflation. There is a bunch of nuance around how the coupon rate is designated during the auction, but that’s largely irrelevant for this article.

The “inflation protection” comes with adjustments to the face value. When the bond is first issues the CPI index ratio is associated with the bond. Let’s say it is 100.0 for simplicity. If inflation is 2% over the next year, the index ratio will be 102.0 at the end of the first year of the bond. The face value of the bond increases to $1020. That means when the bond matures you’ll receive back $1020 vs. your $1000 investment.

Additionally, as the coupon is a % over the face value, there will be a step-up in the coupon. Once the face value is moved to $1020, the coupon payment will step up to $5.10, versus the $5 previously.

On the face of it these features add up to some inflation protection. But, keep reading.

Low coupons

Whilst TIPS have the feature of resetting the face value, the coupon (i.e. the cash it is generating) tends to be really low. In early 2022, the 30 year TIPS was issued with a coupon of just 0.125%. Basically nothing, right?!

So whilst the face value is going to increase year-on-year, assuming we have inflation, the coupon value is going to barely move.

Inflation “Protection”

Given the coupon is going ot be so low, you essentially get minimal protection of cashflows against inflation.

If you’re retired with a pension, and lucky enough to have cost-of-living-adjustments (COLA) your cashflows will adjust based on inflation. However, if you have a 401k and looking for an investment with similar characteristics, TIPS will not be a good replication. I-Bonds are an alternative but they have VERY restrictive maximum investment levels.

The shortest dates TIPS are 5 years. If you were sure you wanted TIPS as an inflation hedge you could ladder them. Say, you wanted semi-annual cashflows that had inflation adjustments, you could do the following:

• Identify the amount of money to invest in these bonds
• Every 6 months when a new 5 year is issued, invest 10% in the latest 5 year
• After 5 years you can ‘roll’ your oldest bond which will mature into a new one.

The downsides of this approach is:

• It’s very labor intensive to manage
• The term of the bond is 5 years, so the market value can fluctuate, if you need to sell to fund an expense
• The principal adjustments are TAXABLE(!)

The upside is the adjustments to face value will come back to you more frequently, than say having a single position in a 10 year TIPS bond.

Taxation on TIPS

TIPS principal adjustments are treated as interest income. In the above example your principal went from $1000 to $1020, so you’ll receive a tax bill on the $20 of gain, in a 1099-OID form. So if you put these in a taxable account you’ll be paying tax on these increases even though the bond may not be maturing for years in the future.

This creates more challenges if you’re trying to be tax efficient. You will need to find losses in other investments to offset the interest income (hopefully you won’t have that), or you have to pay cash out of pocket.

The offset is that the cost-basis of the trade increases. When you initiated the position at a face value of $1000, that is the tax basis. When you receive the $1020 at maturity, there is no tax impact on that repayment.

Mark-to-market losses, vs. taxable interest changes

The other kicker is that TIPS are marketable securities in that they can be traded in the secondary market. The value of the bond is impacted by prevailing interest rates.

In 2022 we saw TIPS lose significant value despite CPI being elevated. Many TIPS bond ETFs (with varying maturities) lost 10% of their market value over the last 12 months.

So let’s say you invested $10k in the Feb 2022 30 yr TIPS. Since then:

• The market value dropped from ~$98 to ~$68 due to prevailing rate changes. That’s a 30% loss
• The principal has been adjusted up 6% due to CPI.

This sets you up for some very unhappy statement viewing. At the end of 2022 you’ll look at your investment statement and your custodian will tell you that your position has lost $3k. However, they will also send you a 1099-OID form saying you gained $600 due to the face value adjustments that you will receive in 30 years time.

Net net; this is not a simple investment

Unfortunately TIPS are an investment vehicle that sound good on the face of it but have very challenging characteristics for the layperson investor. It should be clear from the 30 year TIPS example that this specific position would have been a terrible inflation hedge in the short/medium run.

For shorter maturity bonds the mark-to-market loss will be less pronounced, however you will still have the same taxable gain. This is not an investment vehicle for novices.

As with many investments, price is everything: buy low and sell high. TIPS start becoming interesting now they have been smashed by rates. However, just because rates increased, it does not necessarily mean they won’t increase more.

If you do decide to buy TIPS, do some research on how the prices change as treasury rates change so that you understand the market risk you’re taking. If you’re very sure you will hold onto the bond until maturity that simplifies the situation but make sure you understand the tax journey you will be undertaking:

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