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Subject:  Re: 5 year fund vipsx and vfstx? Date:  12/22/2009  10:59 AM
Author:  trptrade Number:  29568 of 37023

I think it would be beneficial to move away from an overly general answer to the difference between bonds and bond funds. I believe it fails to address a major point. Quoting the FAQ: "The general expectation is that TIPS are less subject to interest rate risk than Treasuries of the same maturity, although there is no guarantee."

Concern over a drop in NAV due to the effectively infinite maturity of bond funds doesn't hold as much significance in a TIPS fund. It is not zero, but it is less significant. If you invest in anything that is not principal protected (such as an FDIC insured CD), you risk principal. This will be a difference between a bond and a bond fund, and one you cannot escape (the issue really is about the magnitude)

When you are investing in a traditional treasury, you are bearing interest rate risk in two forms. The major form depends on the *perception* of future inflation. If the perception changes such that higher inflation is expected, rates will rise. On a simple instrument like a zero-coupon bond, that means the price of that bond will drop (significantly for longer term bonds).

When you are investing in a TIPS, there is no perception risk. TIPS are not subject to a change in perception of future inflation, because their principal adjusts to real inflation (as measured by the CPI-U). There is a risk that the CPI-U is not accurate to your situation (it is for me, YMMV).

Both types of bonds also have another form of interest rate risk, and that is the required rate of real return. In a TIPS, this is the coupon, and if the required rate changes, then the value of a TIPS will also change in order to preserve that required rate for the buyer. As a magnitude, this interest rate risk tends to be a lot smaller than changes from the perception of future inflation.

TIPS are also subject to a form of "distortion" that is not present in normal bonds. TIPS are always guaranteed to pay out their face value at maturity. However, inflation or deflation may occur in the interim. In the case of inflation, the TIPS principal will increase, and the TIPS will continue to behave as a TIPS. However, in the case of deflation where the principal value drops below par, I would note that a TIPS will start to behave differently... because there is always a lower bound on the value (as the TIPS will eventually start to act as a traditional treasury bond because the CPI-U principal correction will become irrelevant to the value of the TIPS)

This "distortion" was part of what was acting up late last year into early this year. Since some TIPS had appreciated while other TIPS were new, the pricing of TIPS started to become inconsistent. Older TIPS deflated from their appreciated principal values, but stayed above par. Newer TIPS dipped below par, and their pricing started to be distorted by the "lower bound" value. Newer TIPS become much more popular (since they were perceived to be much less risky). The older TIPS dropped more in value. I think Wendy even managed to take advantage of this to her benefit.

As far as your Vanguard fund, remember that mutual funds mark their bonds to market every day. This means those distortions will show up in the NAV of the fund. The fund held more of the older TIPS, thus had more of an impact to their NAV (you can see this in the chart of the fund). Since it held more of the older TIPS, those dropped more significantly in value than the index or other funds, but when the concern over deflation reversed in 2010, the value of TIPS returned more to "normal", and the Vanguard fund's NAV returned more to what it was before the crisis. This return to "normal" is what you captured as your total return that you find "outsized".

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