Vanguard’s new short-term TIPS funds: Better than cash?

Vanguard this month launched a family of mutual funds investing in short-term Treasury Inflation-Protected Securities. While investors could duplicate this strategy by simply buying and holding 5-year TIPS to maturity (at zero cost with Treasury Direct), these low-fee funds are intriguing as a possible substitute for cash in your portfolio.

Here are the three share classes, with identical investing philosophies but differing fee structures:

  • Short-Term Inflation-Protected Securities Fund Investor Shares (VTIPX), a traditional mutual fund with a 0.25% purchase fee and an expense ratio of 0.20%. Minimum investment: $3,000.
  • Short-Term Inflation-Protected Securities Index Fund Admiral Shares (VTAPX), a traditional mutual fund with a 0.25% purchase fee and an expense ratio of 0.10%. Minimum investment: $10,000.
  • Short-Term Inflation-Protected Securities ETF (VTIP), an ETF with no purchase fee and an expense ratio of 0.10%. No minimum investment, but brokerage fees might apply.

The purchase fee on the two mutual funds doesn’t apply to reinvested dividends and capital gains. While this fee benefits current shareholders, and is designed to discourage short-term trading, I think the ETF should be the way to go with this investment, especially in a brokerage (like Vanguard) with no commissions and automatic reinvestment of dividends.

However … as Vanguard notes: “The market price of Vanguard ETF Shares may be more or less than net asset value.” This is the case as of Friday, with the market price of the ETF closing at $49.88, and the NAV ending at $49.75. For this reason, the Admiral shares also have appeal, with dividends reinvested.

This is going to be a moderately-traded ETF, with average volume likely to be about 30,000 shares a day, compared to 900,000+ a day for the TIP ETF. Therefore, buyers and sellers should set limit orders, not market orders. Here is how the ETF performed versus Admiral shares in the last five days:

Short-term TIPS

While the ETF and the Admiral shares should have identical performance, the ETF has outperformed in recent days, putting its price above net-asset-value. For this reason, some investors might prefer the more-accurate Admiral shares, despite the 0.25% purchase fee.

Goals of these funds. Vanguard lays out three simple investing goals:

  1. Invests primarily in U.S. Treasury Inflation-Protected Securities with remaining maturities of less than five years.
  2. Seeks inflation protection and income consistent with short-term U.S. Treasury Inflation-Protected Securities.
  3. Principal and interest adjusted for inflation.

Consider N0. 2, income consistent with short-term U.S. Treasury Inflation-Protected Securities. Because TIPS yields have plummeted since mid 2011, short-term TIPS provide income well below the rate of inflation. There are only 14 TIPS with maturities of less than six years, and these have a typical yield of -1.35%. So if inflation averages 2.5% in the next few years, these issues will provide a yield of about 1.15%, which is less than you can get on a 5-year bank CD.

Consider No. 3, principal and interest adjusted for inflation. Well, not quite. Keep in mind that because of No. 2, principal and interest will currently lag inflation by about 1.35%.

Short-term TIPS versus cash. Cash in a money market account or bank savings account, earning maybe 0.04% today (I”m being generous), is going to lag inflation by an even wider margin. That is why I think these short-term TIPS funds could work as slightly more risky substitute for cash.

These TIPS funds aren’t money market accounts and their net asset value will vary. Although there is zero credit risk, there is interest-rate risk and you could lose money.

There are two other ETFs that track short-term TIPS — iShares Barclays 0-5 Year TIPS Bond (STIP) and PIMCO 1-5 Year US TIPS Index ETF (STPZ) — and here is how they performed over the last year:

Short-term TIPS funds

Although the price fluctuations aren’t Halloween scary, short-term TIPS funds will see a rise and fall in net asset value.

At this point, Vanguard isn’t listing duration or yield for these brand-new funds, but from the Pimco and iShares funds you can predict a duration of about 2.5%, meaning that net asset value will fall about 2.5% for every 1% rise in yield. If short-term TIPS returned to a more ‘normal’ yield of 0.5% above inflation, investors could see a 4.5% drop in net asset value. So the risk is not extreme, but it is there.

On yield, buyers can expect about 1% in the near term. That’s not great, but it is better than cash.

Other alternatives. If you haven’t invested in US Savings I Bonds this year, you can still buy $10,000 per person before Oct. 31 and get a six-month interest rate of 2.2% and then 1.76% for the next six months, resulting in a combined annual yield of 1.98% in the next year. That’s definitely better than cash, and you avoid any current tax liability.

Another strategy, as I noted above, would be to buy and hold to maturity every new issue and reissue of 5-year TIPS on Treasury Direct. This produces zero cost and zero risk. The next 5-year offering is a reissue on Thursday, Dec. 20, 2012.

Conclusion. I view the Vanguard short-term TIPS funds as a low-risk and low-return investment. Because of the built-in protection against unexpected inflation, these funds are a good alternative to cash, if you can tolerate the small additional risk.

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6 Responses to Vanguard’s new short-term TIPS funds: Better than cash?

  1. John S says:

    At the beginning of your post, I think your intention was to reference the Investor VTIPX version of the Vanguard TIPS fund with its $3,000 minimum rather than the Institutional VTSPX version with its $5,000,000 minimum.

  2. tipswatch says:

    John, you are correct! Thanks for the alert and I made the correction. (Don’t we wish we could be investing in VTSPX?)

  3. Royce says:

    I was looking at ask prices for TIPS on Vanguard and Schwab and was only presented with four available for purchase. If in fact this is all there is in the market, where will Vanguard get the TIPS necessary for the new fund?

  4. tipswatch says:

    Royce, I am sure there more TIPS available that you would see posted on brokerage accounts. But it is a great question. An index fund would need to own a lot of TIPS, and one just starting up would need to dip into some sort of market. Just how liquid are these?

  5. thom says:

    A high-yield saving account, say at Ally will get you a 0.90% interest rate. That’s probably the best place to park short-term cash.

  6. Pingback: How have short-term TIPS funds performed? | Treasury Inflation-Protected Securities

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