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Individual TIPS vs. TIPS Funds

TIPS (Treasury Inflation-Protected Securities) are U.S. government bonds that provide a specific after-inflation return (as compared to “nominal” bonds which provide a specific before-inflation return). Here’s the description of how they work, right from the source:

“The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.”

With municipal bonds and corporate bonds, the single greatest benefit of bond funds over individual bonds is that they diversify your money across several borrowers to reduce the overall risk of default.

With U.S. Treasury securities, however, that becomes a moot point, as they’re generally considered to have zero credit risk in the first place. (And even if the risk is greater than zero, investing in a fund made up exclusively of securities from the U.S. Treasury wouldn’t reduce that risk.)

So with the primary benefit of a bond fund no longer being relevant, is there still any reason to use a TIPS fund rather than buying individual TIPS?

Why buy a TIPS fund?

For the most part, the primary advantage of a TIPS fund is convenience.

Buying: TIPS funds can be bought at any time. Individual TIPS must be bought at auctions which only occur at specific intervals throughout the year.

Selling: You can sell a TIPS fund at any time (with no commission assuming it’s a no-load fund), whereas selling individual TIPS generally involves paying a commission ($45 if your account is with Treasury Direct).

Reinvesting: If you own individual TIPS, you’ll have to wait until the next auction date rolls around before you can reinvest the interest you’ve received. With a TIPS fund, you can have the interest reinvested automatically in the fund.

Why buy individual TIPS?

Lower expenses: Any TIPS fund will have to charge expenses. Yes, for good funds the expense ratio is quite low, but if you buy TIPS directly there will be no expenses eating into your returns.

Known return: With individual TIPS, you know precisely what real rate of return you’ll get over the duration of the bond. With a TIPS fund, you can’t be as sure because the fund is made up of an always-changing collection of TIPS with varying maturities.

Knowing your precise after-inflation return can be quite convenient when saving for situations where you’ll be making a cash outlay at one specific point in the future (that is, expenditures such as college, as opposed to retirement for which people spend cash on an ongoing basis over an extended period).

Which do you use?

For those of you who invest in TIPS, which do you use? A TIPS fund or individual TIPS? And was your decision based on one of the above factors, or are there some considerations that I’ve left out?

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Comments

  1. I buy individual TIPS for the reason you state — I want to know the return.

    I love TIPS, by the way. I think they are a better alternative to stocks than corporate bonds (which are usually put forward as the alternative). When I go with something other than stocks, I am seeking non-riskiness. I see TIPS as the least risky asset class imaginable because everything is known in advance — they have a government guaranty and inflation-protection.

    I don’t like bonds as much because they do not protect from inflation risks. Bonds might generate better long-term returns. But when I am looking for high returns, I prefer stocks to bonds.

    Rob

  2. Rick Francis says:

    >there some considerations that I’ve left out?

    Tax consequences? I suspect that the interest is taxed as ordinary income if that is the case then it really should be in a tax sheltered account.

    -Rick Francis

  3. Perfect timing 🙂 I too wonder about the tax consequences? I’ve been looking at TIP (Barclay’s ishares ETF for TIPS). Does anyone know what the difference is between this and the Vanguard fund that the Mike mentioned?

  4. Hi David (MoneyNing).

    As to the differences, a couple obvious ones:
    The ER for TIP is slightly lower than that of the Vanguard fund (0.2% rather than 0.25%).
    By their nature, ETFs are generally more tax efficient than regular index funds.

    Anybody else see any important ones I’m missing?

  5. Thanks Mike, it looks like I’ve done one better than the master oblivious investor himself by finding a super index fund? 🙂

    Also, anyone know why TIPS funds go DOWN in value? I’m trying to find an alternative to my short term savings (I need it in one year or so) and I don’t want to risk capital depreciation (although I rather have a higher return than 2% for savings accounts + taxable at ordinary income levels)

  6. “Thanks Mike, it looks like I’ve done one better than the master oblivious investor himself by finding a super index fund?”

    Hehe. 🙂

    “Also, anyone know why TIPS funds go DOWN in value?”

    Yep. While TIPS protect you from inflation, they don’t protect you from changes in market interest rates. Just like any other bond, a TIPS will decrease in market value if market interest rates increase. (And therefore the same thing occurs with funds that hold TIPS.)

  7. How can a TIPS Fund, e.g. Vanguard, yield larger returns than TIPS.
    How do the TIPS fund get 11% return when TIPS do 2%

  8. Hi Daniel.

    I wouldn’t count on it happening regularly. Basically, what happened to create the large returns from Vanguard’s TIPS fund was that interest rates declined significantly on treasury bonds, driving up the price of the bonds that the fund already owned.

    Of course, in any given year, the opposite thing could happen, which is what makes long-term TIPS an unsafe investment for short-term investing, even though they’re pretty much the safest thing possible for long-term investing.

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