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Author: xcskier One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: TIPS funds vs straight bond funds Date: 1/17/2005 2:55 PM
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A nonprofessional investor, I wonder if/why I should buy a TIPS fund instead of a straight intermediate-term bond fund. Obviously the answer is their comparative returns. But we haven't had raging inflation for some years now and I'm even more interested in their comparative returns in the current environment of 1-2% inflation.

So here's the simplistic hypothesis I set out to check: the difference between the return of a TIPS fund of any given company and the return of that company's intermediate bond fund should depend mainly on the rate of inflation that year.

To test it, I compiled returns for 3 companies that have had TIPS funds back at least to 2001 (Vanguard, American Century, and TIAA-CREF). Smith-Barney has had a TIPS fund, but no intermediate-term bond index fund to which to compare returns. Here are average values of the TIPS-fund return minus the bond-fund return for each company, year by year:
1999, 2.1%; '00, 0.3%; '01, -1.2%; '02, 5.0%; '03, 3.9%, and '04, 3.7%.

Here are the CPI-U inflation rates from BLS, for 1st and 2nd halves of each year: 1999, 1.0% and 1.5%; '00, 1.8% and 1.6%; '01, 1.7% and 0.5%; '02, 0.8% and 1.1%; '03, 1.3% and 0.7%; '04, 1.6% and 1.0%. Not a single deflationary semester in this period, although 2001 and 2003 each had several individual months that were slightly deflationary (and during which a TIPS fund might have lower returns than a straight bond fund).

Of these 6 years, the most inflationary was 2000 and the least was 2002. Of these years, TIPS most outperformed intermediate-index bonds during 2002 and had their worst relative performance in 2001.

2001 did have several deflationary months, which may explain the negative difference that year. But so, too, did 2003, yet 2003 has the second-best relative performance for TIPS of these 6 years. I conclude that there is NO correlation of relative performance to inflation during this period. To me, then, this is an additional element of risk: it may be obvious that we can't reliably predict the future performance of bond funds, but shouldn't at least TIPS' relative performance depend on rate of inflation? So what are the additional complicating factors? The difference in auction price (ie, market desireability) of each kind of bond at the time of sale?
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