Just like there are mutual funds which invest in stocks, there are also mutual funds and ETFs that invest in TIPS. A TIPS mutual fund is especially a great way to invest in TIPS. It offers convenience and diversification at a low cost.
Buying TIPS through a mutual fund (or an ETF) is a good idea. The advantages of buying TIPS through a mutual fund include:
1. Buy at any time without a transaction fee. Although there is no charge to buy individual TIPS bonds at auctions through certain places (Fidelity, Schwab or TreasuryDirect), the auctions only come up a few times a year. If you want to buy individual TIPS bonds when there’s no auction, you must use a brokerage account and buy on the secondary market.
Some brokerage firms charge a commission for bond orders. Vanguard charges minimum $40. You also pay a higher price (“markup”) than the wholesale price when you buy on the secondary market. Or you will just have to wait until the next auction, but the prices will have changed by then. You can buy shares in a TIPS mutual fund at any time without a transaction fee.
2. Instant diversification. A TIPS mutual fund holds about 20 bonds with different maturities. You get all of them with one purchase. If you are buying individual TIPS bonds, they don’t come on auction at the same time. You must wait for the auctions or pay commissions to establish your positions.
3. Sell at any time without a transaction fee. If you have individual TIPS bonds, there is no fee if you wait until they mature. If you want to sell before they mature, you may have to pay a commission. TreasuryDirect doesn’t sell for you any more. Vanguard charges at least $40. You also receive a lower price (“markdown”) than the wholesale price when you sell on the secondary market. If you sell shares in a TIPS mutual fund, you receive the Net Asset Value for each share, without having to pay a transaction fee.
4. Buy or sell for any random amount. Minimum additional investment in the Vanguard TIPS fund VIPSX is $100. Want to buy $456.78? No problem. The individual TIPS bonds are in $100 increments at TreasuryDirect or in $1,000 increments in a brokerage account.
5. Reinvest interest payments immediately without charge. If you have individual TIPS bonds, you must hold the interest payments elsewhere. Reinvesting in another TIPS bond is also subject to the auction cycles and $100 increments at TreasuryDirect or $1,000 increments in a brokerage account. The most convenient way to reinvest the interest payments from an individual TIPS bond is putting it into a TIPS mutual fund. TIPS mutual funds typically offer automatic dividend reinvestment for free.
6. Easy tax handling (for taxable accounts only). Individual TIPS bonds in a taxable account have a unique phantom income issue. Both the interest payments and the inflation adjustment are taxable, although the latter is not paid out until the bond matures. A TIPS mutual fund shields that issue away from the investor. You receive regular dividends from the fund and you get a Form 1099-INT at the end of the year, just like you do when you invest in any other mutual fund.
All these convenience come at a cost of 0.20% a year for the Vanguard Inflation-Protected Securities Fund (VIPSX). That’s $20 a year for each $10,000 invested. If you invest $50,000 or more in TIPS, Vanguard’s fund offers Admiral shares which cut down the expense ratio to 0.10%, or $10 a year per $10,000 invested. The cost is very reasonable.
Why bother buying individual bonds then? Because …
1. Low expenses. If you buy at auctions and hold to maturity, there is no extra expense. If you buy a large amount of TIPS, you can save money by building your own fund with individual bonds. Fidelity, Schwab and TreasuryDirect charge no fee or commission if you buy at auctions and hold to maturity.
Even if you buy on the secondary market, as long as you buy long-term bonds in large quantities and you hold the bonds to maturity, a one-time commission and markup spread over many years can be less expensive than having to pay an ongoing expense year after year.
2. Be your own fund manager. You get to decide what maturity you buy. When you buy fund shares you buy a basket. The fund’s (experienced) managers decide what to buy and when to buy. With individual bonds, now you become the (amateur) manager for your own fund. Want short maturities? Buy 5-year notes. Want long ones? Buy 20-year bonds.
Buying at auctions and holding to maturity is not that hard. Please read more in the TIPS Auctions section. But buying TIPS through a mutual fund is more convenient and very cost-effective.