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A caution about comparing TIPS and Treasuries

It’s best to use caution when comparing Treasury inflation-protected securities (TIPS) and conventional U.S. Treasury securities. Because of differences in the way the bonds work, there are differences in both their current yields and estimates of their duration, or sensitivity to interest rates.

The Vanguard® Inflation-Protected Securities Fund invests in TIPS (also called Treasury inflation-indexed securities) and inflation-indexed securities issued by other U.S. government agencies. TIPS are designed to provide a "real" rate of return over inflation, which is one of the primary risks to fixed income investors. Unlike conventional bonds, the principal value of TIPS is adjusted for changes in inflation, as measured by the Consumer Price Index. The coupon, or interest rate, on an inflation-protected bond is then applied to the adjusted principal value. If the Consumer Price Index rises, the principal value of the inflation-protected bond will rise, and the income provided by the coupon rate will rise too.

Because TIPS yields are quoted in real yield terms, their yields at any point in time will appear to be lower than conventional Treasury securities. With conventional Treasuries, real yield and expected inflation are combined in the quoted yield to maturity. The size of this gap fluctuates, depending on investor expectations of future inflation. As of December 31, 2002, for example, the yield of a TIPS bond maturing in July 2012 was 2.24%, while the yield of a conventional Treasury bond maturing at about the same time (August 2012) was 3.76%. The difference of 1.52% is the market’s estimate of how much of the inflation adjustment will be paid to TIPS holders.
Duration—Not a reliable guide to TIPS risk

When choosing a bond fund, investors often rely on the fund’s estimated duration to gauge how sensitive the fund's share price will be to interest rate changes. The longer a fund's duration, the more its price will fluctuate when interest rates rise or fall.

Duration is an excellent way to evaluate interest rate risk for conventional bond funds, but it is less useful when evaluating a TIPS fund. For a fund holding conventional Treasuries, duration provides a good estimate of the percentage change in the fund’s share price you can expect in response to a change in nominal (non-inflation-adjusted) interest rates. A fund with an average duration of five years will see its share price move up or down 5% in response to a 1% change in market interest rates.

But TIPS do not respond to interest rate changes in the same way as conventional bonds. Price fluctuations for TIPS are determined by changes in real interest rates (the current interest rate minus the market’s expectations of future inflation rates). By contrast, price fluctuations for conventional Treasury securities are determined by changes in real interest rates and inflation expectations, as well as in changes of the risk premium for future inflation. The result is that relationship of real rate changes to nominal rate changes varies over time and is difficult to predict.

The duration estimate of Vanguard Inflation-Protected Securities Fund is based on the recent patterns of relative changes in real and nominal interest rates. Because of the variability of the relationship of real and nominal interest rates, this estimate is much less precise than the duration estimates of Vanguard’s conventional bond funds.

The upshot is that a TIPS fund and a fund invested in conventional Treasuries with similar duration estimates may see very different price movements when interest rates change. Although TIPS prices have generally been less volatile than those of conventional Treasuries with similar maturities, estimates of average duration won’t necessarily reflect differences in the interest rate sensitivity for TIPS and conventional Treasuries.

Posted: January 9, 2003.