An Inflation Spike Could Wreck Your Bond Fund. This Vanguard ETF Is Built for It
Rising energy prices and a Fed rate hike are squeezing conventional bond funds from both sides at once, and most investors have no idea how exposed they really are.
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Inflation is becoming a problem for bond investors again. The latest Consumer Price Index rose 0.4% in August and 3.4% year over year, while energy prices were up 16.3% from a year earlier. Gasoline alone increased 27.4%, while shelter costs rose 3.0%. Core inflation has been considerably cooler at 2.4%, but the headline numbers illustrate how quickly another energy-driven inflation shock can change the fixed-income outlook.
Conventional bonds are particularly vulnerable because their coupons are fixed in nominal dollars. Higher inflation reduces the purchasing power of those payments. It can also prompt the Federal Reserve to raise interest rates, which pushes existing bond prices lower as newly issued securities begin offering more competitive yields. That’s an uncomfortable combination for retirees who may have shifted a larger portion of their portfolios from stocks into fixed income specifically to reduce risk.
There is one major exception within the Treasury market: Treasury Inflation-Protected Securities, or TIPS. Rather than locking investors into a completely nominal stream of income, TIPS incorporate an explicit adjustment for inflation. For investors who want that protection without taking substantial interest-rate risk, I particularly like the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP).
How TIPS Protect Against Inflation
TIPS are U.S. Treasury securities whose principal value adjusts based on changes in the Consumer Price Index. Suppose you own $1,000 of TIPS and inflation subsequently increases the security’s inflation-adjusted principal to $1,030. The bond’s fixed coupon rate is then applied to that higher principal balance, increasing the dollar amount of interest you receive. At maturity, investors generally receive the greater of the inflation-adjusted principal or the original principal, subject to the Treasury’s terms.
That gives TIPS two potential defenses against inflation. The principal adjusts with CPI, and because the coupon is calculated using that adjusted principal, the dollar amount of interest can rise as well. There’s an important distinction between the coupon rate and the real yield. TIPS yields are generally quoted on a real basis, meaning the return above subsequent inflation. The actual nominal return an investor realizes therefore depends partly on what inflation does after the security is purchased.
TIPS remain bonds, so they aren’t immune to interest-rate risk. Their market prices can fall when real interest rates rise, even while their principal is receiving inflation adjustments. And like virtually every other corner of fixed income, you don’t need to buy individual securities yourself. An ETF can continually hold, replace, and rebalance a diversified portfolio of TIPS.
Why I Prefer Short-Term TIPS Right Now
Inflation creates another problem for bond investors because the Federal Reserve can respond by raising interest rates. That’s exactly what happened this month. On Sept. 16, the Fed raised its target range by 25 basis points to 3.75%-4.00%, explicitly noting that inflation remained elevated. Higher rates generally hurt existing bonds, and the damage tends to increase with duration. A bond fund with a duration of 10 years will ordinarily experience a much larger price reaction to a given change in yields than one with a duration of two or three years.
That’s where VTIP’s construction becomes useful. The ETF focuses on short-term TIPS and currently has an average duration of only around 2.4 years. You’re getting inflation-linked principal without taking anywhere near the interest-rate sensitivity of a long-duration TIPS portfolio. VTIP is also extremely cheap. Its 0.03% expense ratio means very little of the portfolio’s return gets consumed by management fees.
As of Sept. 17, the ETF had a 2.19% 30-day SEC yield. That can look underwhelming compared with conventional Treasury ETFs offering considerably higher nominal yields. But the comparison needs some context. The SEC yield doesn’t tell you what future CPI adjustments will ultimately contribute because future inflation can’t be known in advance. If inflation remains elevated, the principal values of VTIP’s underlying TIPS can receive additional adjustments, which in turn affect the portfolio’s income and total return.
That’s also why VTIP’s distributions can be more erratic than investors might expect from a Treasury ETF. Inflation adjustments vary with CPI rather than producing the same predictable nominal income stream you’d get from a conventional Treasury bond. VTIP is therefore less a prediction that inflation must rise, and more a relatively inexpensive way to insure the fixed-income side of a portfolio against inflation staying higher than the bond market currently anticipates.
Contact [email protected] for any questions or corrections.
Tony Dong is the founder of ETF Portfolio Blueprint. He also serves as Lead ETF Analyst for ETF Central, a partnership between Trackinsight and the NYSE.
Tony’s work focuses on ETF strategy, portfolio construction, and risk management, with an emphasis on making complex investment concepts accessible to everyday investors. His insights and analysis have also appeared in U.S. News & World Report, Kiplinger, MoneySense, and The Motley Fool.
Tony holds a Master of Science degree in enterprise risk management from Columbia University and the Certified ETF Advisor (CETF) designation from The ETF Institute.
