As part of an email interview with John Hollyer, co-manager of the Vanguard Inflation-Protected Securities Fund, I asked, "What factors do you look at to determine what individual TIPS are added to the Vanguard TIPS fund?"
What factors do you look at to determine what individual TIPS are added to the Vanguard TIPS fund?
When buying TIPS for the fund (Vanguard Inflation-Protected Securities Fund), we start with the benchmark we seek to track, which is the Barclays Inflation Notes Index. That tells us the composition of the TIPS market. Our performance and risk measurement standard is this index.
What we'll do is evaluate TIPS in a variety of different contexts, such as their relative value versus other TIPS. For example, we may evaluate a TIPS bond that has a particularly high yield relative to nearby TIPS. We might be tempted to underweight a TIPS bond that has a lower yield, for example, because it's so-called "on the run."
Balance Risk and Reward When Buying TIPS Bonds
We'll also try to balance that risk factor I discussed earlier about TIPS bonds that have very low accrual levels (inflation adjustments). These TIPS with low accrual levels tend to be more resilient to deflation scares, but they also have lower yields. So, we don't really want to overweight those bonds excessively because they have lower yields, but we also don't want to excessively underweight them, which could hurt us in the event of a deflation scare.
That's a risk management framework for putting around the fund to ensure that we don't get unbalanced on the deflation risk factor. We may have a view, for example, that the yield curve may steepen or flatten in response to things like Fed policy and the course of the economy and so we may over or underweight longer or shorter TIPS (and vice versa) in anticipation of potential changes in the yield curve.
For the entire interview with John Hollyer: An In-Depth Look at TIPS with Vanguard's John Hollyer