AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

Thanks for the couch potato formula.  But even though bond yields have fallen 13 points as the stock market plunged in the last 2 days, VIPSX has lost money.  Can you explain?  Thanks.

I too am looking for Scotts answer.

Thanks,

Gary

I think the reason for VIPSX's fall is due to lower near-term inflation expectations.  As the economy slows, price inflation should come under control (or even drop).  This will mean the inflation portion of TIPs yield will be lower in the near future, resulting in lower value for TIPs holdings.

Thank you. But since there are only bonds and cash in the account, what part of it is the "inflationary portion of the TIPS yield"?

 My understanding is this: the value of the TIPs bonds owned by VIPSX are dependent on two things. Future interest rates and future inflation expectations.  When yields fall that increases the value of existing bonds, and VIPSX's NAV should go up.  But when future inflation expectations go down (as is happening now), that decreases the value of TIPs.  The inflation portion of all TIPs bonds are adjusted every 6 months, so even existing TIPs will lose value based on expected lower inflation (or even deflation).  I am not an expert, but this is my understanding.  Basically, when deflation or lower inflation is expected, people are less likely to want TIPs, meaning their value goes down.

Scott, would love to hear from you on this. 

Also, how would you compare TIP and VIPSX?

Lastly, you've said that TIPs (like TIP and VIPSX) are better bought in Roth IRAs.  Does the same hold true for global inflation-protected securities, like WIP?

Thanks.

The earlier responses that discussed inflation expectations have captured the difference between the price performance of traditional coupon bonds and infaltion adjusted bonds.

Here are the specifics. In the last year we've seen inflation expectaions rise. We now have a trailing inflation rate of about 6 percent--- that's why I reported in July that seniors were going to get the biggest COLA adjustment to their Social Security benefits in 25 years come January.

Because of that increase, TIPS were priced up so that their non-inflation yield approached ZERO on shorter term instruments. Why? Because a 6 percent adjustment to principal was still way better than a 2 percent coupon on a short term Treasury.

In July the CPI increased a sturdy 0.5 percent. But in August it dropped by the same amount. And I don't think anyone will bet against me when I say September is likely to be another negative to neutral month for the CPI. That means the CPI component of TIPS return is declining so the future "return" is likely to be smaller. Hence, the price will fall.

Global inflation protected securities, like the WIP ETF, work on the same principles as TIPS but they are priced in other currencies. So you have a lot more going on--- currency differences, inflation differences, and basic coupon differences.

We've now had quite a few years of fundamental decline for the dollar. But the dollar is still the global settlements currency and the world is short of cash. As a consequence, the dollar has been very strong. Whether it will continue to be strong will depend on which governments resort to printing money.

Scott

Thank you.  So do I hold the VIPSX protion of the couch potato or dump it?

It hurts to lose the money in the stock market index, and then have what was supposed to be the counterbalance get hammered too.  It's a double dose of misery.

As I see it, TIPS are still a very good choice, even though their returns are volatile because of changing inflation expectations. Over the last 5 years the Vanguard TIPS fund provided an annualized return of 4.16 percent, beating the 3.55 percent return of the Vanguard Total Bond market index fund and the 1.59 percent return of the average intermediate term bond fund--- those figures are as of yesterday from the Morningstar website.

I think that long term out-performance will continue, in spite of the substantial underperformance in the last 3 months, YTD, and 12 months. Remember, right now inflation is running at a trailing rate of nearly 6 percent. It will surely decrease in the coming 3 to 6 months but the increment should easily beat the current yield on short term Treasuries, about 1.2 percent for a 6 month T-bill.

Scott 

Scott:

1.  How would you compare TIP and VIPSX?

2.  You've said that TIPs (such as TIP and VIPSX) are better bought in Roth IRAs.  Does the same hold true for global inflation-protected securities, like WIP?

Thanks.

TIP (iShares Treasury Inflation Protected Securities) is an ETF that tracks the Lehman inflation protected bond index. It has an expense ratio of 0.20 percent and the additional cost of a brokerage transaction to buy or sell the security.

VIPSX is the Vanguard mutual fund that invested in Treasury Inflation Protected Securities. It has an expense ratio of 0.20 percent but is a managed fund with a minimum purchase of $3,000.

Although one is an index fund and the other is managed, their performance shows very modest  differences. Over the last three months, for instance, TIP has declined 8.87 percent while VIPSX has declined 9.18 percent. That's a material difference, but the period is only three months. Over the last three years, TIP has returned an annualized 2.93 percent while VIPSX has returned an annualized 2.94 percent.

I think they can safely be treated as virtually interchangeable. So which you use depends on the size of your portfolio and whether you are building your portfolio with mutual funds or exchange traded funds.

Funds of any kind that invest in inflation protected securities are best held in tax deferred plans such as IRAs or Roth IRAs. The reason for this is "phantom income." The return on inflation protected securities comes in two forms, the inflation adjustment which is added to the principal amount of the individual security and the coupon rate of the security that is added to the inflation protection.

Both portions of the return are treated as taxable events but you only receive the premium over inflation in actual cash. That can put you into a bit of a squeeze if you hold the securities in a taxable account.

Scott