How Does One Determine Yield To Maturity On TIPS?

I look at TIPS as basically a 6 month T-bill with inflation adjustment that just keeps getting rolled over at the original interest rate at the time of purchase.

My thinking on this issue is that TIPS pricing should therefore generally be affected by short term interest rates. Long term interest rates are largely a reflection of inflation uncertainty, a factor already addressed in TIPS.

I'm not sure what affect an inverted yield curve would happen on this type of instrument. I think the reason that the yield is currently rising is in the anticipation of future FED hikes in short term interest rates.

[charlie]

Wab,

You said that TIPS are "simply less risky". That may
be true for those who buy individual bonds and
hold to maturity. But what about those who invest
in a TIPS fund? This is a pure off-the-wall impression,
but it seems to me that Vanguard's TIPS fund is
more volatile than most of their other bond funds.
If you equate volatility to risk, then the TIPS fund
seems more rather than less risky. ??

Charlie ZZZZZZZzzzzzz

[wabmester]

Charlie, I believe the same logic applies to a TIPS fund, but you need to compare apples to apples. Here's a comparison of Vanguard's TIPS fund and their long-term bond index fund (similar avg maturity) over the last couple of years:

http://finance.yahoo.com/q/bc?t=2y&s...=m&q=l&c=vipsx

The TIPS fund looks less volatile to me. However, if you look back to the start of TIPS (1997, I think), TIPS were a bit more volatile. I think this was due to the novelty of TIPS when they were first introduced, but now they're pretty well understood (and popular, and liquid, etc).

One thing to watch out for is that TIPS supply may greatly increase in the coming years, which could cause the yield to go up if demand doesn't match. (The treasury wants to move away from conventional debt and ramp up TIPS.)

[charlie]

Wab,

Thanks!! From the look of the chart I think you are
right. The shape of the curve is very similar but the
amplitudes of the individual wiggles seems a bit
smaller.

However, would it be more fair to compare the TIPS fund to an intermediate term fund like VBIIX? I noticed that the long term bond index has an average
maturity of 20.1 years while the TIPS fund is 11 years.
The intermediate term bond index is 7.5 years. When
I compared TIPS to the intermediate fund I noticed
that the individual wiggle amplitudes seem a bit larger.
I would provide a link here but don't know how to
do it. I used your link above to look at VBIIX vs. VIPSX.

It still seems to me that TIPS may be a bit more
volatile than bonds of similar duration due to the
X factor of real yield changes. As you pointed out,
a larger supply in the future might drive the price
down.

One final question however. If Bob can get 2.5%
real yield to maturity on a long term TIPS, then why
do TIPS fund investors only get 1.25% currently?
Is the difference basically because of the difference
in maturity?

Thanks for all your help. I think I am finally beginning
to understand TIPS a little bit.

Cheers,

Charlie

[wabmester]

I noticed that the long term bond index has an average maturity of 20.1 years while the TIPS fund is 11 years. The intermediate term bond index is 7.5 years.

Oops, mea culpa. *I was looking at the avg maturity for the category. * But the point is the same, TIPS volatility is similar to that of conventional bonds -- both in magnitude and in covariance of the peaks and troughs. (At least when inflation is relatively constant; they should be less volatile as inflation changes.)

One final question however. *If Bob can get 2.5% real yield to maturity on a long term TIPS, then why do TIPS fund investors only get 1.25% currently?

When a fund quotes yield, it quotes the SEC Yield, which is basically the trailing 30-day average yield. * We all know what has happened to yields the last 30 days (up up up), so the SEC Yield will be lower than the instantaneous yield calculation you see for bonds on the secondary market.

I'd bet that the instantaneous yield for VIPSX is much closer to 1.9% or so (current yield for 10-year is 2.1% - fees of around 0.2%).

BTW, the SEC Yield is supposed to prevent confusion in the market by making it easier to compare funds side-by-side with everybody using the same definition of "yield." *Unfortunately, it doesn't help prevent confusion with comparisons to individual bonds.