By David Enna, Tipswatch.com

This article is the third in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering off bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

In 2015, something actually happened!

After two years of hinting and signaling, in 2015 the Federal Reserve finally raised short-term interest rates. But that 25-basis-point increase in the federal funds rate came very late in the year, on Dec. 16, 2015. It was the first of nine rate increase that would come over the next three years.

In reaction — and without the ballast of any Fed bond-buying program — real and nominal interest rates increased in 2015 across the board. The move higher was less drastic than we saw in 2013, but TIPS yields surged a bit higher than yields of nominal Treasurys. Here are the 2015 statistics:

Note that inflation for the year 2015 ran at only 0.7% year over year. When TIPS yields increase faster than nominals, and inflation runs lower than expected, the result is that TIPS funds under-perform the overall bond market. The lack of Federal Reserve bond-buying in 2015 is a significant factor, too. Inflation in 2015 was running at 0.7%, but a 10-year nominal Treasury was yielding 2.27% and TIPS real yields were well above zero. Compare that to today, with annual inflation currently running at 5.0% and the 10-year Treasury yielding 1.33% and real yields for all TIPS of all maturities well below zero.

Here is how these funds performed in 2014, with the chart showing changes in net asset value and not reflecting distributions:

In a year of rising interest rates, VTIP was the apparent “safe harbor” because of its low duration, meaning it was less sensitive to rising rates.

But the chart is a bit misleading, because it does not include distributions. When you look at total return, BND (the total bond market) outperformed both VTIP and SCHP because inflation adjustments couldn’t match the higher nominal yields of the total bond market.

The TIPS market in December 2015 was actually very attractive for new purchases. A five-year TIPS reopening auctioned on Dec. 17, 2015 with a real yield of 0.472%, the highest in five years. This TIPS had original auctioned in April 2015 with a yield to maturity of -0.335%. So from April to December, the 5-year real yield surged 80 basis points higher. Great for investors, but bad for holders of TIPS funds.

Conclusion

In reality, 2015 was not a disastrous year for TIPS or the bond market, even with the late-in-year increase in short-term interest rates. The Federal Reserve had done an excellent — and lengthy — job of signaling the increase, and the bond market handled it without any sort of “tantrum.” For most bond investors, it was a flat year, as reflected by the 0.56% total return of the total bond market.

A key (and rather obvious) lesson is that in times when inflation runs at very low levels, nominal bond funds like BND are highly likely to out-perform inflation-linked funds.

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.