[An updated version of this article appears in my new web site Explore Bonds, together with many other articles on investing in bonds.]
A reader asked about TIPS mutual funds in the comments to my action plan for TIPS. Just like there are mutual funds which invest in stocks, there are mutual funds that invest in TIPS. The Vanguard Inflation-Protected Securities Fund (VIPSX) is a popular choice because of its low 0.20% expense ratio. Similar funds from Fidelity or T. Rowe Price charge double what Vanguard charges. There is also an ETF iShares Lehman U.S. Treasury Inflation Protected Securities Bond Fund (TIP), whose expense ratio is also 0.20%, but it only makes sense if you have a no-commission brokerage account like WellsTrade or Zecco because otherwise you would have to pay brokerage commission for each trade. There’s another newer ETF SPDR Barclays Capital TIPS ETF (IPE) with 0.1845% expense ratio. Vanguard also filed an application with the SEC for an ETF based on its fund. It’s not on the market yet.
Buying TIPS through a mutual fund (or ETF) is a good idea, because it gives you a lot of convenience for a small price. Pros for investing in a fund include:
1. Buy at any time without a transaction fee. Although there is no charge to buy individual TIPS bonds at auctions through certain places (Fidelity, Schwab or TreasuryDirect), the auctions only come up a few times a year. If you want to buy individual TIPS bonds when there’s no auction, you must use a brokerage account. Some brokerage firms charge a commission for bond orders. Vanguard charges minimum $40. You also pay a higher price (“markup”) than the wholesale price when you buy on the secondary market. Or you will just have to wait until the next auction, but the prices will have changed by then.
2. Instant diversification. A mutual fund holds about 20 bonds with different maturities. You get all of them with one purchase. If you are buying individual TIPS bonds, they don’t come on auction at the same time. You must wait for the auctions or pay commissions to establish your positions.
3. Sell at any time without a transaction fee. If you have individual TIPS bonds, there is no fee if you wait until they mature. If you want to sell before they mature, you may have to pay a commission. TreasuryDirect charges $45. Vanguard charges at least $40. You also receive a lower price (“markdown”) than the wholesale price when you sell on the secondary market.
4. Buy or sell for any random amount. Minimum additional investment in the Vanguard TIPS fund VIPSX is $100. Want to buy $456.78? No problem. The individual TIPS bonds are in $100 increments at TreasuryDirect or in $1,000 increments in a brokerage account.
5. Reinvest interest payments immediately without charge. If you have individual TIPS bonds, you must hold the interest payments elsewhere. Reinvesting in another TIPS bond is also subject to the auction cycles and $100 increments at TreasuryDirect or $1,000 increments in a brokerage account.
6. Easy tax handling (for taxable accounts only). TIPS bonds in a taxable account have a unique phantom income issue. I won’t go into the details here. The fund shields that issue away from you. You receive regular dividends from the fund and you get a 1099 at the end of the year, just like any other mutual fund.
All of these convenience come at a cost of 0.20% a year for the Vanguard TIPS fund VIPSX. That’s $20 a year for each $10,000 invested. If you have $100,000 or more for TIPS, Vanguard’s fund offers Admiral shares which cut down the expense ratio to 0.11%, or $11 a year per $10,000 invested. It seems very reasonable to me. Why bother buying individual bonds then? Because,
1. Low expenses. If you buy at auctions and hold to maturity, there is no extra expense. If you buy a large amount of TIPS, you can save money by building your own fund with individual bonds. Fidelity, Schwab and TreasuryDirect charge no fee or commission if you buy at auctions and hold to maturity. Even if you buy on the secondary market, as long as you buy long-term bonds in large chunks and hold the bonds to maturity, a one-time commission and markup can be less expensive than having to pay an ongoing expense year after year.
2. Be your own fund manager. You get to decide what maturity you buy. When you buy fund shares you buy a basket. The fund’s (experienced) managers decide what to buy and when to buy. With individual bonds, now you become the (amateur) manager for your own fund. Want short maturities? Buy 5-year notes. Want long ones? Buy 20-year bonds.
I’ve bought all of these before, the Vanguard TIPS fund VIPSX, the iShares ETF TIP, and the individual bonds. They all worked the way they’re supposed to. Right now I’m buying individual bonds and holding them to maturity because I want to save the ongoing expenses.
Buying at auctions and holding to maturity is not that hard. I have a step-by-step guide for doing so. If you buy long-term bonds at least $10,000 at a time, the secondary market can also be cost effective. If the the yield becomes attractive between auctions, I will not hesitate to buy on the secondary market. After all, for a 20-year bond, paying a one-time 1% commission plus markup beats paying a 0.2% expense every year for 20 years.
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Jonathan says
Good post, thanks for linking back to it (wouldn’t have found it otherwise). Will have to check back in July to see if you buy again.
zanon says
Financebuff:
Vanguard TIPS have performed terribly.
If you bought earlier in the year, you would have gotten in at 13, and now it’s at 11. YTD down 5%, 3-mo down 10%. And this is an environment where yields have fallen and bonds should be more expensive.
Your money would have been better off in a bank.
Any thoughts on why this has been the case?
Harry Sit says
zanon – Supply and demand is the answer to all questions about price movements. In the summer of 2008, when inflation was high, there was great demand for TIPS because people were afraid inflation would go higher. The great demand pushed TIPS price high. In recent months, people are not so concerned about inflation any more. I’m sure you noticed the under-$2/gallon gas price versus > $4 in the summer. When the demand drops, price goes down. Yields on nominal Treasury bonds fell. The real yields on TIPS actually went up. Are we not going to have inflation any more? I don’t think so.
zanon says
TFB:
I hear what you say. I guess I thought that when you buy a bond, you get locked into a rate, or something. I was not anticipating this degree of volatility. Clearly I don’t understand investing in fixed income.
I guess that if I buy Treasuries now, given that they are in such high demand, if demand slackens I will lose money there too, I won’t just keep my principal and get the 0.004% or whatever they are yielding there days.
Harry Sit says
zanon – You lock into a rate if you hold on the bond until it matures. You can lose money in a bond fund like the Vanguard TIPS fund which never matures. You can also lose money in a bond before it matures even if you locked into a rate. So if you buy a 3-year bond, you can lose money in years 1 and 2, and make money in year 3 to make it positive overall. And that’s all before taxes and inflation of course. After taxes and inflation, you can lose money even if you hold the bond to maturity.
zanon says
TFB: that makes sense, thanks for your help.
Ignoring taxes and inflation, if you plan on holding to maturity, does it make sense just to buy the bond directly then (and essentially treat it as a long term CD). I guess the risk you would run if you need to sell it sooner than maturity is that it’s selling for less than you paid for it, so you lose $ just as you would lose $ in a bond fund.
Is that right?
Harry Sit says
zanon – That’s correct.
Bozo says
Here’s a copy of a query I posted on the Bogleheads forum today (March 3, 2009). A poster there suggested I paste it here, since someone here might have information for me. The general subject matter is “TIPS versus CDs”.
“As an additional comment/query on this thread. I don’t believe I have ever seen a study of how a ten-year CD ladder (with those CD rates being at “most advantageous” for each year of the ladder) has ompared to other federally insured (i.e., no risk) products, i.e., T bills, TIPS, I Bonds in a ladder of the same ten-year period. Specifically, if an investor bought 10 $50,000 CDs, one each year, would he or she have done better or worse than another investor doing the same, but with TIPS. I know the kicker is did the first person get a “premium” rate for any or all of those CDs by rate-shopping, so that’s why I used the phrase “most advantageous” rather than “highest possible”. A related question would be whether, on any given day, the net real return on TIPS is below, at, or above the “most advantageous” CD rate.
Anybody have any info, links, guidance. As I mentioned, I get confused when I read all the information about stuff other than CDs. My current ten-year ladder averages 5.45%. Could I have done better with TIPS? I’m really curious, since I have a rather substantial rung of my ladder coming due thus August and am trying to figure out whether to move it to PenFed in a long-term (but accessible – for folks over 59 1/2) CD or back to Vanguard into a TIPS (or similar) product.
TIA, Bozo
PS: I should add that I have read (several times) the TreasuryDirect detailed explanation on TIPS. Since liquidity is important to me, I am concerned that fees buying and selling on the secondary market might eat into yield. The more I read, the less I know, and all that.”
nrrrvs says
i believe you are understating the second advantage of being able to target maturities
for tax efficiency, you should be holding tips in retirement account.
if you are 20yrs+ out from retirement, there is little reason to own 3/5/7 maturies etc that you will get with a fund, you should be heavy in the long end.
Oleg Orel says
I checked what VIPSX is composed of, and very confused: Why VIPSX based on regular bonds rather than TIPS?
Does TIPS-only mutual funds exists? If so, does Fidelity have one?
Harry Sit says
Oleg – VIPSX is composed of TIPS, not regular bonds. What made you think it is based on regular bonds? The fund’s holdings show 25 TIPS.
Walter Degler says
I have a 4.25% CD about to mature. My financial advisor says that at this time, investing in TIPS is better than in CDs. Don’t both have similar penalties if withdrawn before the maturity date? How does one invest in TIPS anyway? He suggested I put half in VIPSX and half in PIMCO. Should I? How do I proceed?
Harry Sit says
Walter – If you are paying a financial advisor, you should ask him/her these questions. No, I’m not joking. That’s what a financial advisor is for, right? He/she should explain to you why he/she is making that recommendation and how the recommended product works. TIPS and CDs work differently. TIPS bonds and TIPS funds also work differently. Don’t invest in something you don’t understand. If your advisor cannot explain these to you, you shouldn’t work with him or her. I have more articles about TIPS on my bonds site Explore Bonds if you are interested in learning more yourself. But seriously, ask your financial advisor and get your money’s worth.