My retirement portfolio comes more or less straight from the Vanguard playbook. It’s mostly indexed. My mix of broadly diversified stock and bond funds is consistent with what you’d find in a Vanguard Target Retirement Fund designed for someone two decades or so from retirement. A source of excitement it’s not.

It does contain one curio, however: a modest allocation to inflation-protected securities.

Warning: Vanguard bloggers are writing a series of posts about why they hold particular investments. It would be unwise to use the posts as a source of guidance for your own portfolio. These holdings reflect the bloggers’ unique situations, perhaps even their missteps. If you need help with an investment portfolio, stop reading this blog and explore the useful tools on vanguard.com.

TIPS: A primer

When you buy a conventional, or “nominal,” bond, you receive regular fixed interest payments. When the bond matures, you receive its face value. When you buy a Treasury Inflation-Protected Security, by contrast, neither the bond’s face value nor the interest payments are fixed. Both are adjusted upward (or downward) to reflect changes in the general price level for goods and services. I think of TIPS as a conventional U.S. Treasury bond attached to an insurance policy against unexpected spikes in inflation.

(You can learn more about the technical details of TIPS at TreasuryDirect.gov.)

As a child of the 1970s, I may have an excessive affinity for this insurance. I first learned about inflation as prices were leaping skyward at double-digit annual rates. Today, as interest and inflation rates hover near generational lows, my memories from that period—my parents’ relief that they were able to get a mortgage loan at an annual rate of just 14%—seem surreal.

(Vanguard economists see limited risk of a return to high inflation, in part because wage growth remains subdued.)

Satisfactory returns, modest prospects

Even if my decision-making was as much emotional as rational, the results have been satisfactory. Since 2003, when I first invested in TIPS, the Barclays U.S. Treasury Inflation Protected Index has produced an average annual return of 4.85%; over the same period, the Barclays U.S. Aggregate Bond Index has returned a bit less, 4.55%. Combined, my allocation to TIPS and nominal bonds has helped diversify my stock-heavy portfolio.

These days, the prospects for TIPS—and bonds in general—are far more modest. Yields, and thus future returns, have tumbled. In fact, shorter-term TIPS offer negative yields, a mind-bending data point. (Investors’ expectation is that once the TIPS are adjusted for future inflation, returns will be positive.)

Andy Clarke_Tips yields have tumbled_8.29.14Source: Federal Reserve

 

It’s uncomfortable to hold a security with a negative yield, but TIPS remain in my retirement portfolio. I consider them a reasonable complement to the modest bond allocation that’s part of my long-term investment plan. And if inflation spikes unexpectedly, a small portion of my portfolio will be protected.