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Are Inflation-Protected Bonds Unnecessary in Mostly-Stock Portfolios?

A reader writes in, asking:

“I was recently reading an article on Investopedia, about using Vanguard ETF to build a commission free portfolio.

What was interesting to me is this author based his article on Vanguard Target Date Funds. One of the conclusions he suggested is that a portfolio that has a stock allocation of 65% and above doesn’t need inflation protected bonds in it at all. This seems to be validated by Vanguard when you check the Target Date Funds they offer, anything with an allocation of 65% stocks indeed has no inflation protected bonds. However Vanguard’s Life Strategy Funds have no allocation to inflation protected bonds no matter the stock allocation. Was just curious about your thoughts on this.”

The purpose of Treasury Inflation-Protected Securities (TIPS) is to provide a specific, predictable after-inflation return. And they are very effective at doing this, provided that you hold them to maturity.

This makes them a super neat tool for funding a specific expense in the future, or for funding a series of expenses over time (e.g., everyday living expenses in retirement, funded via a TIPS ladder). For this purpose, they’re pretty clearly preferable to regular nominal Treasury bonds.

As a part of a portfolio, they’re perfectly fine, but not nearly so powerful. That is, they still reduce the inflation risk to which you’re exposed, but they can’t provide your overall portfolio with a predictable after-inflation return if they’re only a small part of your portfolio.

Imagine, for example, that I have a 70/30 stock/bond allocation, and 15% of the portfolio (i.e., half of the bonds) is in TIPS. Sure, that 15% of the portfolio has a predictable after-inflation return. But who really cares? I’m concerned about the return on my entire portfolio, and the uncertainty that comes from the 70% stock allocation will absolutely dwarf the uncertainty (or lack thereof) that comes from switching 15% of the portfolio between TIPS or nominal bonds.

I often think it’s instructive to look at mutual fund return charts from Morningstar — not for showing which funds are better than others, but for showing how similar or different various funds are.

The following chart plots:

  • Vanguard Inflation-Protected Securities Fund (in blue),
  • Vanguard Intermediate-Term Treasury Fund (in orange), and
  • Vanguard Total Stock Market Index Fund (in yellow)…

…since the TIPS fund was first created in June of 2000.

Morningstar Performance Chart

Sure, you could make a case for picking one of the bonds funds over the other. But if the portfolio primarily consists of that stock fund, it wouldn’t have made a heck of a lot of difference which of the bond funds was used.

In other words, I don’t think it’s a bad idea at all to include TIPS (rather than just nominal bonds) in a mostly-stock portfolio. Rather, I just don’t think it’s likely to make that much of a difference.

This is markedly different from a situation in which the portfolio is mostly (or entirely) bonds. A nominal Treasury ladder and a TIPS ladder provide two very different levels of certainty in terms of the spending they can support.

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