New Fund Invests in Inflation-Indexed Bonds
On June 5, 2000, The Vanguard Group added a new fund to
its lineup, Vanguard© Inflation-Protected Securities Fund,
which will invest primarily in inflation-indexed bonds issued by
the U.S. Treasury and other U.S. government agencies, as
well as those issued by corporations.
Investment advisory services to the new no-load fund will be
provided at cost by Vanguard Fixed Income Group, which
oversees nearly $140 billion in assets invested in 45 taxable
and tax-free bond and money market portfolios. The fund seeks to provide investors with
inflation protection and income consistent with investment in inflation-indexed securities.
Vanguard.com? writer Karen Dawson recently interviewed the
comanagers of the fund?John W. Hollyer?principal, portfolio
manager, Vanguard Fixed Income Group and Kenneth E.
Volpert?principal, portfolio manager, Vanguard Fixed Income
Group?about the fund's objectives and the differences between
inflation-protected securities and other funds.
What are inflation-indexed securities?
What is the fund's investment objective and strategy?
How do inflation-indexed securities differ from conventional
bonds?
How will inflation-indexed bonds react to changes in
inflation?
What are the tax implications of the inflation adjustment for
a shareholder?
Why is Vanguard offering an inflation-protected securities
fund at this time?
How will the schedule and level of income distributions
differ from this fund relative to other fixed income
portfolios?
For whom is the fund appropriate?
What is the anticipated expense ratio of the fund?
What are inflation-indexed securities?
Mr. Hollyer: Inflation-indexed securities are after-inflation investments. By adjusting their
value for inflation, they give investors a dependable, or real, rate of return.
Inflation erodes the purchasing power of money over time, and investing only in common
stocks or conventional bonds doesn't necessarily fix the problem. Common stocks have
historically generated returns well in excess of inflation over the long term, but investors
must accept substantial short-term volatility to achieve this. Conventional bonds, on the
other hand, offer less price volatility than stocks, but they do not offer explicit protection
against inflation.
Inflation-indexed securities give investors the opportunity to combine explicit protection
against inflation with low to medium principal risk. They are designed to provide a "real rate
of return"?a return after adjusting for the impact of inflation. For example, if an investment
provides a nominal total return of 7% in a given year, and inflation is 3% during that time, the
inflation-adjusted, or real, return is 4%.
What is the fund's investment objective and strategy?
Mr. Volpert: The fund seeks to provide investors with inflation protection and income
consistent with investments in inflation-indexed securities. It will do this through investing
primarily with inflation-indexed bonds issued by the U.S. government and its agencies; it can
also hold inflation-indexed bonds issued by high-quality corporations.
How do inflation-indexed securities differ from conventional bonds?
Mr. Hollyer: Conventional bonds make regular fixed income interest payments and repay
the face value of the bonds at maturity. With inflation-indexed bonds, however, the principal
and interest payments are adjusted over time to reflect inflation. This is significant, given
that the Consumer Price Index (CPI) has risen in 49 of the past 50 years. And even in the
event of deflation?a drop in prices?the U.S. Treasury guarantees the repayment of at
least the original face value of its inflation-indexed securities.
How will inflation-indexed bonds react to changes in inflation?
Mr. Volpert: Interest rates on conventional bonds have two primary components: a "real"
yield, plus an increment that reflects investor expectations of future inflation. By contrast,
rates on inflation-indexed securities are adjusted for inflation and they aren't affected
meaningfully by inflation expectations.
This, then, means that only real rates influence the prices of inflation-indexed securities. A
rise in rates will cause the prices of these securities to fall, while a decline in real rates will
boost the prices. Real interest yields have been relatively stable, so the prices of
inflation-indexed securities have generally fluctuated less than those of conventional bonds
with comparable maturity and credit-quality characteristics.
What are the tax implications of the inflation adjustment for a shareholder?
Mr. Hollyer: The IRS considers any increase in principal resulting from inflation adjustments
as taxable income in the year that it occurs. This means that taxes must be paid on income
that is not received until the bond matures. By contrast, a mutual fund holding these
securities pays out both interest income and the income attributable to inflation adjustments
each quarter in the form of cash or reinvested shares.
Investors in inflation-indexed bond funds who do not reinvest at least the portion of the
income attributable to inflation adjustments will not maintain the purchasing power of the
investment over the long term. This is because income, which is earned on the level of
investment, will not grow with inflation if the principal adjustment is spent.
Why is Vanguard offering an inflation-protected securities fund at this time?
Mr. Volpert: The market has developed substantially since the first inflation-indexed
securities were introduced in 1997. There are a number of issues that create yield curves
from short to long. Liquidity has increased a lot, as has the depth and breadth of the market.
We feel we can offer value and have a market that is sufficiently liquid to support a mutual
fund.
How will the schedule and level of income distributions differ from this fund
relative to other fixed income portfolios?
Mr. Hollyer: Income distributions from the fund will reflect both coupon interest and an
inflation adjustment applied to the securities as determined by monthly changes in the CPI.
Positive changes (inflation) in the CPI will increase the income distributed, while negative
changes (deflation) will reduce the income distribution.
These monthly adjustments are likely to result in substantial volatility in the level of income
distributions relative to conventional bond funds if the CPI changes rapidly over a given
period. The fund will distribute quarterly dividends in March, June, September, and
December.
For whom is the fund appropriate?
Mr. Volpert: The Vanguard Inflation-Protected Securities Fund is appropriate for investors
who are:
Seeking inflation protection.
Willing to accept some volatility in income distributions.
Willing to tolerate some modest fluctuation in share price.
Seeking diversification benefits within an investment portfolio.
What is the anticipated expense ratio of the fund?
Mr. Hollyer: The fund is expected to maintain an expense ratio of 0.25%. The minimum
initial investment is $3,000 (or $1,000 if investing in an IRA or custodial account for minors).
Thank you, gentlemen.
Posted: June 5, 2000.
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