A Less Volatile Approach to TIPS Investing

This fund is suitable for investors looking for a long-term holding to hedge against inflation. TIPS returns are driven by interest-rate risk (like nominal bonds) as well as changes in the principal value when the Consumer Price Index is adjusted up or down. A third driver of returns is the change in inflation expectations (not inflation itself).

Inflation expectations are measured by the break-even rate, which is the difference in yield between nominal Treasury bonds and TIPS of the same maturity. The break-even rate was 1.58% as of May 13, 2016, well below its long-term average of 2.12%. This implies that TIPS are cheap relative to nominal bonds. When the break-even rate is above the average, it implies that TIPS are overpriced. In February 2016, the break-even rate went as low as 1.2%.

The fund takes a short-term approach to the TIPS market, so it will have a lower duration than many peers, which helps to reduce volatility and interest-rate risk. VTIP's 2.5-year duration has led to a trailing three-year standard deviation of 1.85 as of April 30, 2016. This is drastically below both the peer average of 4.27 and the 2.97 of the nominal Barclays U.S. Aggregate Bond Index.

TIPS combine the security of Treasuries with inflation protection in the form of an adjusting principal value. The principal of the bond is adjusted up or down based on changes in the CPI, which represents the cost of a basket of goods and services. When the CPI goes up, the value of the bond is adjusted up as well. The bond’s coupon rate remains the same, but it is applied to the increased value of the principal, which increases the dollar value of the coupon payments. The reverse is true during periods of deflation, when the bond’s principal value is adjusted down and the coupon payments drop in dollar value.

Fundamental View Yields on traditional bonds already account for expected inflation. For TIPS to offer better real returns, realized inflation would need to exceed the expected inflation that has been priced in—this is the break-even rate. Inflation needs to increase above the break-even rate for investors to earn higher returns with TIPS. It is possible to tactically buy and sell TIPS around the break-even rate, buying when it is below the long-term average and selling when it is above. However, this assumes that inflation will revert to the average and that the investor can time trades appropriately. If the economy enters a long period of deflation, this would create a new average and investors would lose that tactical bet.

Buying TIPS after inflation has gone up means it has already been priced in and investors are possibly overpaying for their TIPS exposure. In addition, nominal interest rates tend to rise along with inflation because investors will demand a greater yield to compensate for the risk and generate positive real returns. Rising rates negatively affect TIPS just like nominal bonds, and this loss could cancel out the inflation-hedging benefit.

Exchange-traded TIPS funds can be broadly separated into two groups: broad-market funds that have a longer duration and short-term funds that have durations of two or three years. VTIP falls into the second group. Broad-market TIPS funds can be attractive because they have higher yields than short-term funds and can benefit more from changes in long-term inflation expectations.

Short-term TIPS funds like this one can be attractive because they are a purer play on the realized month-to-month changes in the CPI. This means they will see gains when CPI goes up, but also experience losses when CPI goes down. Their short duration reduces interest-rate risk and the volatility that goes with it. With reduced volatility and increased exposure to actual changes in inflation, short-term funds like this are as close to a pure inflation hedge as investors can get.

Headline inflation was 1.1% for the trailing 12 months as of April 30, 2016. However, inflation minus food and energy (known as core inflation) was at 2.1%, just over the Federal Reserve’s target of 2.0%. Previously, dramatically falling energy prices weighed down headline inflation and dragged on the performance of all TIPS funds. However, energy prices have started to stabilize and even rise, which has given a boost to the inflation-protected bond Morningstar Category.

Portfolio Construction The fund uses a full replication strategy to track the market-cap-weighted Barclays U.S. Treasury Inflation-Protected Securities 0-5 Year Index. The index includes all inflation-protected securities issued by the U.S. Treasury with a maturity of less than five years. Between May 1, 2013, and April 30, 2016, the fund's tracking error was 0.15%. This is only slightly higher than its 0.08% expense ratio.

Fees

The fund’s net expense ratio of 0.08% makes it one of the cheapest TIPS funds available as either a mutual fund or exchange-traded fund. Only the

Alternatives

Like many Vanguard offerings, this ETF is also available as a mutual fund,

The largest ETF in the category is

SCHP is the cheapest fund in the category, including both ETFs and open-end funds, with a 0.07% expense ratio. Investors interested in more control over their duration exposure could consider

Silver-rated

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