Using short-term bonds to preserve buying power

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Using short-term bonds to preserve buying power

Postby matthewjheaney » Tue Jan 29, 2013 5:00 am

Hello,

I have some money set aside, earmarked for use as the deposit for the purchase of a home. The money is currently invested in a money market fund, in a taxable account (at Vanguard).

I won't be buying a home for another year or two, and so I'd like to invest (some of) it in a manner such that its buying power is preserved (because inflation is slowly eroding its value). Given my time horizon, the investment must be relatively conservative.

I've been looking at short-term bond funds, since those funds have a shorter duration and hence are less sensitive to changes in interest rates. I noticed that Vanguard has a new short-term TIPS fund, VTAPX. In answer to the question about who should invest in this fund, Vanguard states that:

  • Investors seeking a bond fund that provides inflation protection.
  • Investors willing to accept some volatility in income distributions and modest fluctuations in share price.


This seems to fit the bill. Does use of this fund make sense, for preserving the purchasing power of money I'll need in, say, a couple of years?

There is a nominal fund, VBIRX, that is also indexed (the same as for VTAPX). That fund seems to be intended for generating income. About who should buy this fund, Vanguard says:

  • Investors seeking a high level of interest income.
  • Investors willing to accept modest fluctuations in share price.


Would (nominal) VBIRX better then (real) VTAPX for this purpose? Or should I hedge, perhaps, by buying an equal amount of each fund? I don't need this money to generate income -- I wish only for its purchasing power to be preserved, over a 1- or 2-year time horizon.

I'm trying to wrap my head around short-term bond funds, and to determine whether they are the intended mechanism for the investment problem I'm having. Any advice you have about such things would be much appreciated.

Regards,
Matt
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Re: Using short-term bonds to preserve buying power

Postby Occupier » Tue Jan 29, 2013 12:01 pm

The conventional wisdom is that if your saving for an event, you want to use bonds that have a duration no longer than the time till the event happens. In the current low interest rate environment that means your savings are not going to grow much. The short term TIPS fund per the Vanguard website has a purchase fee of .25%. But that might get paid back by the time you need the money. If you went to the older intermediate Vanguard TIPS fund you get a slightly higher yield, but take a risk that if interest rates go up the NAV will fall. The fund has a duration of 8.5. So if interest rates go up 1% the NAV or price of the fund will fall 8.5%. That sort of illustrates the conventional wisdom. Dave
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Re: Using short-term bonds to preserve buying power

Postby matthewjheaney » Tue Jan 29, 2013 5:59 pm

Thanks Dave, for your response to my post.

This is the aspect of (short-term) bond funds that I don't quite understand. I think it's true that if I buy an individual bond, and then hold it for at least at long as its duration, then I'm free and clear, with respect to changes in its value because of changes in interest rates. However, how does this work for a bond fund? A fund comprises a rolling series of individual bonds, so it's not as if my effective duration changes the longer I wait -- the duration of the bond fund doesn't change. Or am I misunderstanding this?
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Re: Using short-term bonds to preserve buying power

Postby john94549 » Tue Jan 29, 2013 7:56 pm

It's tough to find any fixed-income product approaching a real rate of return these days unless you are willing to go out on the curve. Which would not appear to be your case. Short duration bond funds won't be hit as hard in a rising-rate environment, but you won't do much better than a garden-variety savings account, and maybe worse. Beware the lure of current distribution yields in bond funds. Look at the SEC yield (a better snapshot of where yields are going) and the trajectory of distributions (try Morningstar).
Last edited by john94549 on Tue Jan 29, 2013 8:00 pm, edited 1 time in total.
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Re: Using short-term bonds to preserve buying power

Postby Call_Me_Op » Tue Jan 29, 2013 7:59 pm

matthewjheaney wrote:Hello,
I won't be buying a home for another year or two, and so I'd like to invest (some of) it in a manner such that its buying power is preserved (because inflation is slowly eroding its value).


Can't be done with a 2 year horizon and guaranteed return of principal. You will need to accept a small real loss.
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Re: Using short-term bonds to preserve buying power

Postby matthewjheaney » Tue Jan 29, 2013 9:22 pm

Thanks, John and Call_Me_Op.

Call_Me_Op said,

You will need to accept a small real loss.


OK, but is this real loss less than the loss that would occur if I leave the money in a money market fund, instead of investing it in a short-term bond fund?

For a (short-term) bond fund, is there some minimum holding time, in order to guarantee return of principal? Or do bond funds simply have no such guarantee?
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Re: Using short-term bonds to preserve buying power

Postby nisiprius » Tue Jan 29, 2013 9:27 pm

1) As others have noted, for a two-year period, there just isn't anything terribly clever you can do. Hopefully, inflation won't be too bad over that short a period of time.

2) Vanguard puts VTIPX at "risk potential 1" and says that funds in that category "Such funds may be appropriate... for investors with short-term investment horizons (three years or less)." So VTIPX wouldn't be a crazy or wildly unsuitable choice (and by the way I'm pretty sure you can get checkwriting on this fund).

3) But it will fluctuate.

Alas, VTIPX is too new to have much history to look at, but PIMCO's STPZ ETF is a fairly similar fund, and VTIPX's degree of fluctuation should be pretty similar to STPZ's. Here is what your account balance would look like if you put $10,000 each in a money market fund (blue) and a short-term TIPS fund (orange). You can use this live link and drag your mouse along the line and watch the totals go up and down.

As you see, it's bouncing up and down by $50, $100, and there is definitely a possibility of losing money if you buy and sell at the wrong times. If you expand the scale to 3 years it doesn't look so bad. But it is still a bond fund and bond funds do fluctuate.

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Re: Using short-term bonds to preserve buying power

Postby matthewjheaney » Tue Jan 29, 2013 9:58 pm

Thanks nisiprius for the response. Very instructive.

nisiprius wrote:As you see, it's bouncing up and down by $50, $100, and there is definitely a possibility of losing money if you buy and sell at the wrong times. If you expand the scale to 3 years it doesn't look so bad. But it is still a bond fund and bond funds do fluctuate.


So is there some optimal time to buy or sell? I assume that the optimal time to sell is any time you've had a real gain. But what is the optimal time to buy? When interest rates have ticked up, or down? (Sorry to be so dense, but I have never invested in a short-term bond, and it's all still very confusing to me.)

I see from the interactive graph that if you wait 3 years, you will have had a real gain. But is this because the waiting period was greater than the fund's duration? Or because of some favorable market environment?

Suppose I contribute $10K to a fund, and then would like to contribute another $10K (say, 6 months later). Is there some optimal time to make the additional contribution to the fund? Or does it not matter? What is the relationship between the duration of the fund, and the fact that there two separate deposits, spread out in time?

Thanks again,
Matt
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