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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Re: SAFEHAVEN: Bondmarket Implosion! Date: 4/14/2004 10:35 AM
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"If one believes that the US total bond market is going to "suffer" from rising interest rates over the short and intermediate term, does it make sense to shift now from Vanguard Inflation-Protected Securities Fund (VIPSX) to cash or a dividend producing fund? How does one figure whether the inflation component of VIPSX will more than offset the decrease in treasury prices?

Also, I pose the same question regarding a total US bond market index fund."

It doesn't stick because if is bloody hard to understand, and even kinda understanding doesn't make decision making easier.

In a rising interest rate environment, especially with rising inflation, TIPS/TIPS fund has a couple of protections against drastic declines in value of the bonds (declining NAV of fund) not available for the equivalent Treasury Bond.Treasury Fund—in the case of Vanguard's TIPS Fund, the equivalent would be somewhere between their Intermediate Treasury and Long Term Treasury funds, exactly where is guesswork. The Total Bond Market Index fund has much shorter durations and a strong corporate component, so you're comparing apples and oranges.

The "protections" for the TIPS fund are:

1) The decline in value of the bonds, when interest rates rise, only comes from a decline in the "fixed-rate" component, in the inflation component. So, if equivalent regular treasury bonds see an increased yield of, for example, 200 basis points, but half of that is attributable to inflation and half to increase in yield over inflation, the fixed-rate part of TIPS would only increase by 100 basis points, so the loss in value (decline in NAV) would be half as much—let's say durations on both funds were 10, the Treasury fund's NAV would decline by 20% in this example, the TIPS fund 10%.

2) If there is a strong increase in yield over inflation of Treasuries, because the fixed rate component of currently held TIPS cannot go below zero, a TIPS fund's NAV can only decline as far as what would happen with it's TIPS having a zero fixed rate. So, if the current holdings of TIPS average 2% fixed rate (remember, Vanguard bought a bunch of these when there were still 30 year bonds and higher interest rates), the maximum decline in the TIPS fund NAV would be about 20% (assuming duration of 10). With a regular Treasury Fund, the decline in NAV could be much more: if yields went from 4.5% to 12.5% for a fund with duration of 10, in theory that is an 80% decline in NAV.

This still doesn't mean holding onto a TIPS fund (or buying into one) in a rising interest rate environment is a good idea—declines in NAV will likely at least lead to total returns of zero for a few years—but the risks are a lot less than with a regular Treasury fund.
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