“Last year, I moved a small portion of my 401(k) into the Vanguard Inflation Protected Securities fund. It turned out to be a good move for the 5.7% I earned in 2021. That’s not so good news for what little I still have in Fidelity’s US bond index, which lost 1.8% last year, I’m thinking of moving all that bond money into the TIPS fund as well just a little money.
“What do you think?”
Matt, New Jersey
It is conceivable that 2022 will be another good year for TIPs. Possible, but unlikely. No, I don’t think it’s a good idea to go all out on those links.
To make my point, I’ll dive into two questions essential to any portfolio decision. One is diversification: you need to diversify your inflation bets. The other thing is the expected return, and you’re not going to like the news about it.
Diversification is natural for equity investors. They know it’s unwise to put all their money into one stock. The diversification that should go into a portfolio of very high quality bonds, that is, bonds that are extremely unlikely to default, is not so obvious.
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, following the whole high-quality market , it ends up being mostly invested in the biggest borrower, the government.
Both funds have durations of just seven years, a measure of interest rate sensitivity. In other words, when interest rates rise and fall, these funds are about as volatile as the price of a zero-coupon bond maturing in 2029.
Both funds have low fees. Both are good choices for anchoring fixed income securities in a retirement portfolio.
The big difference is what inflation does to them. The Fidelity fund does not have inflation protection. The Vanguard TIPS fund is protected. It holds bonds that reimburse investors for any decline in the value of the dollar.
So TIPS must be the best bonds to own? Not so fast. Take a look at interest coupons. The return on the unprotected bond portfolio is a nominal return and amounts to 1.7%. The yield on TIPS is an actual yield, which is fine, but it’s a ridiculously low number: minus 0.9%.
Putting the two numbers in nominal terms for comparison, we get the following. The average bond in the Fidelity portfolio, if held to maturity, will earn 1.7% interest per year. The average bond in the Vanguard TIPS portfolio, if held to maturity, will earn interest of minus 0.9% plus the inflation adjustment. If inflation averages 2%, TIPS bonds will yield 1.1% in nominal terms. If inflation averages 3%, they will deliver 2.1%.
If inflation is above 2.6% on average, TIPS come out on top. If inflation is on average below 2.6%, you’ll wish you had opted for unprotected bonds.
You don’t know what will happen to inflation. A recession would lower it. The Federal Reserve’s exuberant money printing would make it high. In these circumstances, the wise course of action is to diversify your inflation bets.
You could put half of your bond money in each type of fund: one with and one without inflation adjustment. By the way, you can get both types of bond funds (TIPS and nominal) from Fidelity or Vanguard. Vanguard’s fees are low and Fidelity’s, at least on these products, even lower.
Now look at the expected returns. It would be convenient if Wall Street’s recent past were indicative of the future. Tennis works like this; Djokovic did well last year, so he will 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 simply buying what rose the most last year.
What will happen to either of these bond funds in 2022 is a roll of the dice, but to conclude from 2021 results that TIPS are a better buy than unprotected bonds is naïve.
Year-to-year bond price changes are a function of upward and downward fluctuations in market interest rates. These changes are unpredictable. But the long-term yield of a non-defaulting bond is entirely knowable in advance. This is the yield to maturity. YTM takes into account interest payments as well as any difference between today’s price and the gain at face value.
This yield to maturity is a very good estimate of a bond fund’s expected return – “expectation” meaning the sum of all possible outcomes multiplied by their probabilities. (If you win $20 for tails, nothing for tails, your expected return from a coin toss is $10.)
The yield to maturity of each of these bond funds is terrible. For unprotected bonds, it’s 1.7% before inflation and probably a negative number after inflation. For TIPS, it is certain that it will be a negative number after inflation. In short, rational bond buyers expect to lose purchasing power.
With interest rates so low, why would anyone buy bonds? Not to make money. Bonds serve a different purpose. They generally preserve capital during stock market crashes. They are like fire insurance. You don’t expect to take advantage of fire insurance, but it makes sense to buy it.
Bottom line: 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? This could involve, for example, retirement lump sums, Roth accounts, estate planning, employee options or capital gains. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate useful analysis.
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Chronicle of advice from last week: