(PUB) Investing 2015

distributing income at the end of each year. Since the end of October 2012, the fund is down 2.3%. With a yield of just 0.17%, I wouldn’t expect this fund to do much beyond preserving the pres- ent value of your money, in inflation- adjusted terms—and even that may be a tall order. Its older, actively managed sibling, Inflation-Protected Securities , also provides protection from inflation, but still holds long-maturity bonds and is extremely sensitive to interest rates—the average duration in the Vanguard fund is 8.1 years. Fast-rising interest rates knock down TIPS prices, and if interest rates increase faster than inflation does, TIPS will see their prices decline. Additionally, though TIPS are Treasury bonds, they are not as popular or as liquid as traditional Treasurys. During the 2008 credit crisis, despite holding high-quality bonds backed by the U.S. government, Inflation- Protected Securities ’ portfolio did not benefit from investors’ “flight-to-safe- ty” and lost money on a total return basis, down 12.5% at its worst. While both of Vanguard’s inflation funds can offer some diversification in an income portfolio, I favor Short-Term Inflation Index, which is less sensitive to changes in interest rates. That said, I prefer short-term corporate bonds over short-term TIPS. One final point to keep in mind is that TIPS are particularly tax ineffi- cient, since both their income and the periodic price changes are fully taxable. Both inflation funds are best used in a tax-deferred account such as an IRA. GNMA Hold. Mortgage-Backed Sec. ETF Hold. Mortgage-backed bonds are created by pooling mortgages with similar rates of interest and maturities. Monthly interest and principal payments on these mortgages are passed through to bondholders. Mortgage-backed bonds come in different flavors with different levels of guarantees depending on who pools together the mortgages and sells the bonds. The Government National

Protected Securities (or TIPS) are and how they work. TIPS are first and foremost Treasury bonds, so like traditional Treasurys, they essentially have no default risk. However, unlike typical Treasurys, there is an inflation-indexed compo- nent to these bonds. The price of these Treasury inflation bonds is tied to the recent rate of inflation, and adjusted every six months according to it. When inflation is rising, the price of the bonds goes up. Since the bond’s inter- est (or coupon) rate remains constant, the rising principal amount means your payout also increases. The idea behind these bonds is that investors’ real returns, or returns above and beyond inflation, should remain constant. When considering an inflation fund, one calculation that’s always worth looking at is the spread (or difference) between its current yield and that of a Treasury fund with a similar matu- rity. When the spread is small (i.e., the regular Treasury fund’s yield is only slightly higher than the inflation fund’s yield), you aren’t paying much of a premium for inflation protection, making the TIPS fund relatively attrac- tive. When the spread is large, you are paying a premium for that protection. Today, the difference in yield between Short-Term Inflation Index and Short- Term Treasury is 0.43%, or 43 basis points. The spread between Inflation- Protected Securities and Intermediate- Term Treasury is 117 basis points. Both spreads are below average, suggesting insurance for inflation protection is on sale. But before diving into either of Vanguard’s inflation bond funds, here are a few more things to consider. The younger fund, Short-Term Inflation Index , aims to track the Barclays U.S. Treasury Inflation- Protected Securities 0–5 Year Index and will turn three years old in October. As I said when the fund was first announced, investors can see it as a money-mar- ket alternative for cash that you don’t need to spend tomorrow. Given that the fund has sported a negative yield every month except for two, it’s been a slow first few years. The fund has not regu- larly paid out quarterly income, only

Long-TermTreasury Sell. Long-Term Government ETF Sell. Long-Term Bond Index Sell. Long-Term Corporate ETF Hold. Long-Term Investment-Grade Hold. Higher yields often make long-term funds tempting, but that extra yield comes with a cost—higher risk. And with current yields ranging from 2.57% to 4.84% among Vanguard’s long-term funds, there isn’t that much extra yield to be found here anyway. Double-digit durations mean it wouldn’t take much of a price decline to overwhelm the income these funds generate. In the bal- ance between risk and return, this group leans decidedly more towards risk. I’d rather stay shorter, and safer, than be sorry. But, if you’re of a mind to go for that extra yield, I’d still favor the corporate- oriented funds over the government- focused ones. Consider that Long- Term Treasury yields only 2.57% but has a duration of 16.3 years. Similarly, Long-Term Government ETF yields 2.70% with a duration of 16.9 years. In contrast, with Long-Term Investment- Grade you are at least getting more yield (4.09%) and a slightly shorter duration (13.1 years). It’s the same story of more yield and less duration with Long-Term Corporate ETF . Once again, the index fund holding a mix of government and corporate bonds, Long- Term Bond Index , lands somewhere in the middle with a yield of 4.01% and a duration of 14.7 years. I don’t recommend you buy any of these long-maturity funds, but if you have to, I’d pick Long-Term Investment- Grade. This is the only bond fund at Vanguard where both Wellington and Vanguard share management duties. Wellington’s Lucius Hill still is respon- sible for the bulk of the assets, and has shown an ability to take risk off the table at the right times. Yes, the fund’s 16.8% maximum decline in the credit crisis looks bad, but it’s a good deal better than Long-TermCorporate ETF’s 22.5% drop. Short-Term Inflation Index Hold. Inflation-Protected Sec. Hold. First, let’s get on the same page and understand what Treasury Inflation-

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The Independent Adviser for Vanguard Investors • September 2015 • 7

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