A reader writes in, asking:
“Could you share some thoughts on how the original Vanguard TIPS fund compares to Vanguard’s new short-term TIPS fund? For example is the inflation protection for both funds roughly the same? What about interest rate risk?”
As far as costs go, the funds’ expense ratios are almost identical. One slight difference is that the short-term fund offers Admiral shares starting at $10,000 while the regular TIPS fund has a $50,000 minimum for Admiral shares. (Though if we’re talking about amounts less than $50,000, a 0.10% difference in expense ratio is at most a difference of $50 per year — not really enough to worry a great deal about.)
All TIPS (whether shorter-term or longer-term) have their principal adjusted in keeping with the Consumer Price Index for All Urban Consumers (CPI-U). As a result, both bond funds should offer the same degree of protection against inflation.
Yields and Expected Returns
The short-term TIPS fund will earn lower returns over most periods of time because shorter-term bonds have a lower yield than longer-term bonds. For example, as of this writing, the short-term TIPS fund has a yield of -1.60%, and the intermediate-term TIPS fund has a yield of -1.10%.
It’s important to note that neither of these yields include the inflation adjustment that the TIPS will receive over time. For example, if inflation was 3% over the next year (and real interest rates didn’t move), the short-term TIPS fund would earn a nominal return of roughly 1.4% (that is, -1.6% plus 3%), and the intermediate-term TIPS fund would earn a nominal return of roughly 1.90% (that is, -1.10% plus 3%).*
Interest Rate Risk
The regular TIPS fund has an average duration of 8.5 years, whereas the short-term TIPS fund has an average duration of just 2.5 years. As a result, the share price of the short-term fund will fluctuate considerably less — less than 1/3 as much — as a result of changes in market interest rates.
In short, choosing between a short-term TIPS fund and an intermediate-term TIPS fund is much like choosing between short-term and intermediate-term nominal bonds. That is, if you can’t handle the price volatility that comes with intermediate-term bonds, you’ll want to use the short-term fund. And in exchange for that reduced volatility, you can expect to earn less per year (in this case, about 0.5% less).
Or, if you are convinced that real (that is, after-inflation) interest rates will rise in the near future, you might want to use the short-term fund. (Though, again, you’ll be earning about 0.5% less per year while you wait for rates to rise.)
*This is an approximation. To get the exact return figure for an individual TIPS, you need to do a calculation every 6 months (because TIPS pay interest twice annually) wherein you multiply the existing principal by inflation over the previous 6 months, then calculate the appropriate amount of interest (i.e., 50% of the annual interest rate).