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Short-Term TIPS Fund vs. Intermediate-Term TIPS Fund

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?”

Costs

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.)

Inflation Protection

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.

Conclusions

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).

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Comments

  1. Mike, would you like to speak about the pros and cons of holding short-term TIPS vs. short-term nominal bonds?

  2. If inflation is low, then nominal bonds will win. If inflation goes crazy than TIPS will win. If it is somewhere in the middle then it won’t make much of a difference. A lot of people split their bonds 50:50 between nominal and TIPS to provide diversification and stability for whatever happens, this makes sense because that is one of the main reason for holding bonds in the first place.

    Personally, I think I would pick up some I bonds first before putting money in TIPS, but they aren’t exactly apples to apples.

  3. Larry,

    In addition to what Mark wrote, I will just add that one point potentially in favor of nominal bonds is that you can choose a variety of credit qualities, should you desire to do so in order to achieve a somewhat higher yield (e.g., you could hold a short-term investment grade nominal bond fund).

    With inflation-adjusted bonds, government bonds are pretty much the only choice.

  4. Actually, I was thinking solely in terms of treasuries when I posed the initial question. But I’ve tried to achieve the diversification you both are talking about by dividing my Vanguard bond funds between Total Bond, Short-Term (which is largely Treasuries), and the regular TIPS fund. No I bonds at the moment, but I have more in TIPS than the two other funds, so it works out close to 50:50 TIPS/nominal all told.

  5. Note: the short-term TIPS has a front “load” of .25% on purchases. This article helped me clarify that for the long term portfolio, probably not worth changing from the other TIPS fund – for short-term needs, then maybe worth the switch.

  6. The short term TIPS fund has an ETF equivalent (VTIP) which has no “front load” fee. It can be traded free of brokerage fees within Vanguard accounts (at least for now), the only cost being the unavoidable bid-ask spread.

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