“Last year I moved a small amount of my 401(k) into the Vanguard Inflation Protected Securities fund. Turned out to be a good move for the 5.7% I earned in 2021. Not such good news for the small amount I still have in Fidelity’s U.S. Bond Index, which lost 1.8% last year. I am thinking of moving all of that bond money into the TIPS fund as well as some cash.
“What do you think?”
Matt, New Jersey
It’s conceivable that 2022 will be another good year for TIPs. Conceivable, but not likely. No, I don’t think it’s a good idea to go whole hog into these bonds.
To make my case I’ll dive into two matters central to any portfolio decision. One is diversification: You need to diversify your inflation bets. The other thing is expected return, and you’re not going to like the news on that.
Diversification comes naturally to equity investors. They know it’s unwise to put all their money in one stock. Not so obvious is the diversification that should go into a portfolio of very high-grade bonds, that is, bonds that are extremely unlikely to go into default.
The two funds you cite are very similar. Both hold a heavy dose of U.S. government-guaranteed bonds, in Vanguard’s case because that’s all it holds and in Fidelity’s case because, in tracking the entire high-grade market, it winds up being mostly invested in the biggest borrower, the government.
Both funds have a duration of not quite seven years, a measure of interest rate sensitivity. That is, when interest rates jump up and down these funds are about as volatile as the price of a zero-coupon bond due in 2029.
Both funds have low fees. Both are good choices for the fixed-income anchor in a retirement portfolio.
The big difference is in what inflation does to them. The Fidelity fund has no inflation protection. The Vanguard TIPS fund is protected. It owns bonds that reimburse investors for any decline in the value of the dollar.
So TIPS must be the better bonds to own? Not so fast. Take a look at the interest coupons. The yield on the unprotected bond portfolio is a nominal yield and it comes to 1.7%. The yield on the TIPS is a real yield, which is nice, but it’s a ridiculously low number: minus 0.9%.
Putting both numbers in nominal terms for comparison, we get the following. The average bond in the Fidelity portfolio, if held to maturity, will deliver 1.7% a year in interest. The average bond in the Vanguard TIPS portfolio, if held to maturity, will deliver interest of minus 0.9% plus the inflation adjustment. If inflation averages 2%, the TIPS bonds will deliver 1.1% in nominal terms. If inflation averages 3% they’ll deliver 2.1%.
If inflation averages more than 2.6%, the TIPS come out ahead. If inflation averages less than 2.6%, you’ll wish you went for the unprotected bonds.
You don’t know what’s going to happen to inflation. A recession would make it low. Exuberant money-printing by the Federal Reserve would make it high. Under the circumstances, the wise course of action is to diversify your inflation bets.
You could put half your bond money in each kind of fund: one with, and one without, an inflation adjustment. You can, by the way, get both kinds of bond funds (TIPS and nominal) at either Fidelity or Vanguard. Vanguard’s fees are low and Fidelity’s, at least on these products, lower still.
Now look at the expected returns. It would be convenient if the recent past on Wall Street were indicative of the future. Tennis works that way; Djokovic did well last year, so he’ll probably do well this year. Stocks and bonds don’t work that way. If they did, we could all be rich. Why, we could beat the market by just buying whatever went up the most last year.
Just what will happen to either of those bond funds in 2022 is a roll of the dice, but to conclude from the 2021 results that TIPS are a better buy than unprotected bonds is naive.
Year-to-year price changes in bonds are a function of the blips up and down in market interest rates. Those changes are unpredictable. But the long-term return on a bond that doesn’t default is entirely knowable in advance. It’s the yield to maturity. YTM takes into account the interest payments as well as any difference between today’s price and the payoff at par value.
That yield to maturity is a very good estimate of the expected return on a bond fund—“expectation” meaning the sum of all possible outcomes multiplied by their probabilities. (If you win $20 for heads, nothing for tails, your expected return from a coin toss is $10.)
The yield to maturity figure for each of those bond funds is terrible. For the unprotected bonds, it’s 1.7% before inflation and probably a negative number after inflation. For the TIPS, it’s certain to be a negative number after inflation. In short, rational bond buyers expect to lose out in purchasing power terms.
With interest yields so low, why would anyone buy bonds? Not to make money. Bonds serve a different purpose. They usually preserve capital during stock market crashes. They are like fire insurance. You don’t expect to profit from fire insurance, but it makes sense to buy it.
To sum up: Move some, but not too much, of your unprotected bond fund into a TIPS fund, and don’t expect wealth from either.
Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, Roth accounts, estate planning, employee options or capital gains. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.
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