Inflation Investing TIP – Vanguard Readies Inflation-Indexed Fund

Principal and interest payments will be adjusted to reflect changes in inflation shown by such indicators as the Consumer Price Index for Urban Consumers, which governs adjustments to Treasury Inflation-Indexed Securities (or “TIPS”).
 
If you believe inflation will go up, such fixed income instruments can be a good call within this asset class, although at present it might not appear so.  The current yield on a 10-year Treasury Inflation-Indexed Security is 4.12%; by comparison, the yield on a conventional 10-year Treasury bond is 6.12%. 
 
The 200 basis point difference is the “implied inflation rate;” the expected inflation rate over the life of the bond.  Looking at the twelve months ended April 30, 2000, the Consumer Price Index (CPI) increased at an annual rate of 3.0%, 100 basis points higher than the implied inflation rate.  With few exceptions, prices have risen over the past five decades; the question going forward is, how much? 
 
Inflation-indexed bonds have greater income risk than traditional bonds.  However, they offer a greater level of protection against interest rate risk, since they mostly bear the risk of changes in real rates, which historically have been stable over time.  The more volatile component of interest rate changes-the current inflation rate and expectation of future inflation-is addressed by these securities.
 
The Vanguard Inflation-Protected Securities Fund will be offered at an expense ratio of 0.25% by Vanguard’s Fixed Income Group.  This group within the $560 billion company oversees $140 billion in assets spread through 45 taxable and tax-free bond and money market portfolios.