Readers Ask: Should I Put All My Bond Money Into TIPS?

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“Last year I transferred a small amount of my 401(k) to the Vanguard Inflation Protected Securities Fund. The 5.7% I earned in 2021 proved to be a good move. I still have my hands on Fidelity’s US Bond Index.” Not such good news for the small amount, which lost 1.8% last year.I am looking to move all that bond money into the TIPS fund as well as some cash.

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“What do you think?”

Matt, New Jersey

my answer:

It is conceivable that 2022 will be another good year for TIP. Perceivable, but unlikely. No, I don’t think it’s a good idea to completely immerse yourself in these bonds.

To present my side, I’ll dive into two matters central to any portfolio decision. One is diversification: You need to diversify your inflation bets. The second thing is to expect a return, and you will not like the news on that.

Diversification comes naturally to equity investors. They know it is unwise to put all their money in one stock. What is not so clear is whether diversification should go into a portfolio of very high-grade bonds, i.e. bonds that are unlikely to go into default.

The two funds you quoted are very similar. Both have a heavy dose of U.S. government-guaranteed bonds in Vanguard’s case, as it is all, and in Fidelity’s case, because tracking the entire high-end market, it’s mostly invested in the largest borrower, the government. goes.

The tenor of both funds is not seven years, which is a measure of interest rate sensitivity. That is, when interest rates jump up and down, these funds are as volatile as the price of zero-coupon bonds in 2029.

Both funds have low fees. Both are good options for a fixed-income anchor in a retirement portfolio.

The big difference is what inflation does for them. There is no inflation protection in Fidelity funds. Is Vanguard Tips Fund safe? It owns the bond which reimburses investors for any drop in the value of the dollar.

So should tips be a better bond for yourself? not so fast. Take a look at interest coupons. The return on an unsecured bond portfolio is a modest return and comes to 1.7%. The yield on TIPS is a real yield, which is good, but it’s a ridiculously low number: minus 0.9%.

On coding both the numbers for comparison, we get the following. The average bond in a Fidelity portfolio, if held to maturity, will pay 1.7% a year in interest. The average bond in the Vanguard TIPS portfolio, if held to maturity, would yield an interest of minus 0.9% plus inflation adjustment. If inflation averages 2%, TIPS bonds will deliver 1.1% in nominal terms. If the inflation average is 3% they will give 2.1%.

TIPS come forward if the inflation average is more than 2.6%. If the inflation average is below 2.6%, you may wish you went for unsecured bonds.

You don’t know what will happen to inflation. A recession would reduce it. Exuberant currency-printing by the Federal Reserve would make it higher. Under the circumstances, the wise course of action is to diversify your inflation bets.

You can put half your bond money in each type of fund: one with inflation adjustment and one without. By the way, you can get both types of bond funds (tips and nominal) at Fidelity or Vanguard. Vanguard’s fees are lower and Fidelity’s, at least on these products, is still lower.

Now look at the expected returns. It would be convenient if the recent past on Wall Street indicated the future. Tennis works that way; 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 have beat the market by buying whatever went up last year.

What will happen to either of those bond funds in 2022 is a roll of the dice, but to conclude from 2021 results that TIPS are a better buy than unsecured bonds is naive.

The year-to-year price change in bonds is a function of fluctuations in market interest rates. Those changes are unpredictable. But the long-term return on a bond that doesn’t default is completely worth knowing in advance. It is a product of maturity. YTM takes into account interest payments as well as any difference between today’s price and payoff at par.

Yield to maturity is a pretty good estimate of the expected return on a bond fund—”expected” meaning the sum of all possible outcomes multiplied by their probabilities. (If you win $20 for Heads, nothing for Tails, your expected return from tossing a coin is $10.)

The return to maturity for each of those bond funds is terrifying. For unsecured bonds, this is 1.7% before inflation and probably a negative number after inflation. For TIPS, inflation is sure to be a negative number. In short, rational bond buyers are expected to lose out in terms of purchasing power.

With interest yields so low, why would anyone buy a bond? Not to earn 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.

In short: move some of your unsecured bond funds into a TIPS fund, but not a lot, and don’t expect money from anyone.

Do you have a personal finance puzzle that might be worth a look? This may include, for example, pension lump sums, Roth accounts, estate plans, employee options or capital gains. Send details to williambaldwinfinance—at—gmail—dot—com. Enter “Query” in the subject field. Include first name and state of residence. Include enough detail to generate useful analysis.

Letters will be edited for clarity and brevity; Only a few will be selected; Answers are intended to be educational and are not a substitute for professional advice.

Last week’s advice column:

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