VTIP: As Yields Sink, Consider Adding Inflation Protection

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About: Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), Includes: AGG, STIP, STPZ, TIP, VGSH, VMRXX, VUSXX
by: Tipswatch
Summary

The Federal Reserve looks likely to begin cutting short-term rates in 2019, possibly as much as 75 basis points over the next year.

Yields for money market funds and short-term Treasurys will track lower with those rate cuts.

Inflation-protected investments could perform well in a time of falling rates and steady moderate inflation.

The "glorious" days of getting a 2% return on a very safe, very liquid investment are drawing to a close. Why? The Federal Reserve is on the brink of beginning a series of cuts to its Federal Funds rate, the nation's key short-term interest rate.

After essentially keeping this rate at zero from 2009 to late 2015, the Federal Reserve began ticking its funds rate up, step by step, until reaching today's range of 2.25-2.50% in December 2018. This correlates to a current yield of 2.33% on Vanguard's Treasury Money Market Fund (VUSXX) and 2.44% on Vanguard's Prime Money Market Fund Admiral Shares (VMRXX).

Barron's reported this week that federal funds futures markets are pricing in a half-point cut this year and another 40 basis points in 2020. What would that mean? From the Barron's report:

If the markets are right, rates could fall by three-quarters of a point over the next year, taking federal funds to a range of 1.5% to 1.75% from their current 2.25 to 2.5%. That would have wide-ranging consequences for stocks, bonds, and savings vehicles like money-market funds.

In fact, yields on money market funds, short-term Treasurys and bank savings accounts will fall very quickly with each move by the Federal Reserve. Here is how the 4-week Treasury bill has reacted to moves in the Federal Funds rate over the past 15 years (the grey area indicates the 2008-09 recession, which pushed short-term interest rates to near zero for six years):

Federal Funds Rate

(Source: St. Louis Fed)

Looking for alternatives? Consider inflation protection

Over the last two years, financial markets have been fretting over a dire "bond bubble" that would send bond prices plummeting as yields rose. Actually, bonds have had a pretty good year in 2019. The total bond market (represented by the AGG ETF) has had a total return of 5.06% so far this year. Not bad for half a year in a plain-vanilla bond fund.

Because the Federal Reserve has broadly indicated that it is willing to see U.S. inflation rise above 2.0% in the short term, I think shorter-term ETFs that invest in Treasury Inflation-Protected Securities could be attractive in this upcoming period of declining short-term rates. As short-term rates decline, these funds will benefit with higher bond prices. And if inflation holds at 2.0% or above, they will benefit from a moderate rate of inflation.

What about longer-term bonds funds? I'm not so sure, because yields on 10+ year maturities have already plummeted. Is a lot of the gain already priced in? And as shorter-term rates fall, longer-term rates could rise with expectations of better economic conditions.

My picks for short-term TIPS ETFs are:

  • VTIP from Vanguard, with an expense ratio of 0.06% and daily volume of 186,000.
  • STIP from iShares, with an expense ratio of 0.06% and a daily volume of 36,000.

Both of these ETFs are widely traded and have ultra-low expense ratios of 0.06%. With this sort of ETF, a very low expense ratio is crucial. Another ETF in this area is STPZ from PIMCO, but its expense ratio is 0.20%, 14 basis points higher. And because VTIP trades at about 5 times the volume of STIP, I'd favor it overall, especially if your broker allows no-commission trading of this ETF.

Here's a comparison of how these funds have performed in recent years:

VTIP comparison

A few things to note in this chart:

  • Vanguard's Treasury Money Market Fund (VUSXX) has gained about 1% in less than half a year, and so it will end up returning 2%+ for the full year, most likely, but rate cuts could lower that yield later this year.
  • The full maturity-range bond ETFs have been the best performers year to date because of the larger drop in longer-term rates, giving them an advantage over the shorter-term funds. Plus, their higher durations give them a boost as yields fall.
  • Vanguard's Short-Term Treasury ETF (VGSH) has the best 3-year annual return of this group (3.78%). This is a low-risk fund that could serve as a decent replacement for money market funds in the short term.
  • The short-term TIPS funds have benefited from some declines in yields, plus inflation running at 2.0% over the last 12 months. The principal balances of TIPS rise (and sometimes fall) with monthly U.S. inflation.
  • Inflation at 2.0% means that the short-term TIPS funds are now outperforming both money market funds and short-term Treasurys. This trend will continue if the Federal Reserve begins lowering rates, while inflation remains near 2.0%.

A final point: With oil prices falling dramatically in recent weeks, U.S. inflation could see a short-term phase of deflation in coming months. That would put a damper on the returns of all TIPS investments. The May inflation report will be released Wednesday; the consensus estimate is for monthly inflation of 0.1% and 12-month inflation of 1.9%, down from the April numbers.

How risky are TIPS funds?

I have pointed out in the past that the broad-based TIP ETF can be fairly volatile, with a duration of 7.34 and a limited number of holdings. In the second quarter of 2013, the TIP ETF lost 7.1% of its value. That is a shocking figure for a theoretically "rock-solid safe" investment. In that same quarter, AGG lost 2.4%.

Vanguard's short-term TIP fund, VTIP, also lost 2.4% of its value that quarter, despite having a lower duration than AGG. So that's the lesson: even the short-term TIPS funds are not totally safe from declines in value. Investors in these ETFs should keep that in mind.

Here's a comparison of VTIP's share price performance versus that of VGSH (short-term Treasurys) over the last two years:

VTIP vs VGSH

(Source: Yahoo Finance)

Overall, VTIP is a more "risky" investment than a straight short-term Treasury ETF like VGSH. But it remains, in my opinion, solidly in the "safe" zone of bond investments. I like it as a shorter-term investment, but I'd favor a plain-vanilla Treasury money market fund for money I might need in the next six months.

I Bonds: A solid alternative in 2019

U.S. Series I Savings Bonds currently offer a fixed real return (meaning above inflation) of 0.50%, meaning they will outperform U.S. inflation by 0.50% for as long as you hold them, with earnings growing tax-deferred. Because I Bonds can be redeemed after 5 years with no penalty, they are a reasonable substitute for a short-term TIPS fund for money you will hold that long.

There are about 16 TIPS currently trading on the secondary market with yields of 5 years or less, and the great majority of those have real yields well below 0.50%. As of Friday, the Treasury estimated a full-term 5-year TIPS would have a real yield of 0.31%.

I am a big fan of I Bonds in 2019 for purchases before November 1, when the Treasury will reset the fixed rate. A permanent real yield of 0.50% is better than a real yield of 0.31%. Simple math.

However, for money you want to set aside for future needs, especially money you will need in a year or two, a short-term TIPS funds looks like a solid investment as we head into a time of declining yields.

Disclosure: My portfolio includes small holdings in VGSH and VTIP.

Disclosure: I am/we are long VTIP, VGSH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges.