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  • Home>Research & Insights>Investment Insights>A Low-Cost Inflation-Protected Bond ETF

    A Low-Cost Inflation-Protected Bond ETF

    This Vanguard exchange-traded fund is a good option for protecting your portfolio from Consumer Price Index fluctuations.

    Phillip Yoo, 10/11/2017

    Vanguard Short-Term Inflation-Protected Securities ETF VTIP is one of the cheapest funds providing exposure to the short-end of the Treasury Inflation-Protected Securities market, earning it a Morningstar Analyst Rating of Gold. The exchange-traded fund's short duration reduces interest-rate risk and provides a high correlation to immediate inflation changes, but it also leads VTIP to a lower yield and return than its peers.

    This fund provides protection against inflation, credit, and interest-rate risk because it only invests in TIPS shorter than five years and is backed by the full faith and credit of the U.S. government. The fund's duration of 2.7 years as of September 2017 was shorter than the average duration of 5.7 years for the inflation-protected bond Morningstar Category that encompasses the broad TIPS market. To illustrate, if the rate curve shifts by 1 percentage point, this fund would lose approximately 2.7% of its value, while the average TIPS fund would decline by 5.7%.

    The fund's returns are directly correlated to short-term inflation, as its principal and distributions evolve with changes in the Consumer Price Index. Gains and losses from the price volatility are mitigated thanks to the fund's short duration. As a result, this fund more closely tracks the realized inflation fluctuations over the short run than its longer-duration counterparts do.

    However, the fund's low volatility and high correlation with the inflation rate come at the cost of low returns. Although this fund is cheaper than 95% of its peers, it gained 0.5% annually over the three years through September 2017. Its category peers delivered a 0.9% annual return during the same period.

    Fundamental View 
    TIPS are issued with a fixed interest rate but with a variable principal, which is adjusted based on the two-month-delayed CPI figure. The CPI measures the level of prices for a market basket of goods and services that urban consumers buy. The major categories of the goods and services include food, housing, apparel, transportation, medical care, recreation, education, and communication. TIPS apply the fixed rate to the CPI-indexed principal, which changes the semiannual coupon that investors receive.

    TIPS aren't always a better bet than non-inflation-protected Treasuries. The current U.S. Treasury yield reflects the market's expectation for the future inflation. If realized inflation is less than the expectation, Treasuries would offer better real returns than TIPS. But TIPS come out ahead when the opposite is true. The break-even inflation rate refers to the rate that would equal the real return from regular Treasuries and TIPS with the same maturity. As of September 2017, the break-even inflation rate was 1.8%--0.2% lower than the 10-year rolling break-even rate average of 2.0%. Any actual inflation exceeding 1.8% would reward TIPS investors while the opposite would reward U.S. Treasury holders. Per the Bureau of Labor Statistics, the inflation rate was 1.9% in August 2017, and the trailing 10-year average was 1.7%. Federal Reserve chairwoman Janet Yellen's medium-term target inflation rate is 2.0%.

    The fund's duration risk is limited even though the fund follows the market-cap-weighted Bloomberg Barclays U.S. Treasury Inflation-Protected Securities 0-5 Year Index. Since the index weights its holdings by market capitalization, its duration can change over time. For example, if the U.S. government issues large quantities of five-year TIPS, the duration of the fund will lengthen and vice versa. However, even if the fund invests 100% of its capital in the five-year TIPS, the duration would be less than five years.

    Given the reduced interest-rate risk, this fund would continue to exhibit a direct relationship with the CPI and inflation changes. The primary source of the fund's return is the inflation-indexed coupon payments because the short duration minimizes the price volatility. This fund could be a good option for an investor looking for an instrument that closely reflects immediate shifts in CPI and inflation.

    Phillip Yoo is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.