On Wednesday, my friend Dan Wiener of The Independent Adviser for Vanguard Investors alerted me to an item he had just put out on his website. It noted that Vanguard’s Inflation-Protected Securities Fund (VIPS) had disclosed that the fund would not pay out a quarterly distribution (dividend) in December. The reason: the Consumer Price Index had declined in the August-October period, lowering the value of its bond holdings enough to offset the regular bond income. As Dan headlined, it was a case of “Deflation for TIPS (Treasury Inflation-Protected Securities) Investors.”

For the same reason, approximately 5% of the fund’s $0.426 in distributions so far this year ($0.853 on the Admiral shares) will have to be re-characterized as a “return of capital.” That's mostly an accounting change, which will result in a slightly lower capital gain for those who sell the fund this year.

Unlike other bond funds, the yield on TIPS funds increases as inflation goes up. But what can also happen--as this incident shows--is that TIPS bonds and funds can also be hurt when inflation declines.

A call to Vanguard’s PR office confirmed all of the above. But the giant fund family didn’t seem particularly concerned. Spokesperson Rebecca Cohen told me this was “a fairly ho-hum event for our shareholders.” Why? As she put it, “TIPS funds are designed for use as an inflation hedge and for total returns. Their dividends are typically volatile, so these funds are generally not used by investors looking for steady, monthly income.”

Cohen also noted that the risks associated with the Inflation-Protected Bond Fund are fully disclosed in the fund’s prospectus. But I’m not so sure that gets Vanguard off the hook.

Why? Well, just about every investor is taught that inflation is one of the big risks for bond/bond fund holders, because it eats away at real returns over time. (Just take a look at our home video, “The NBR Guide to Buying Bonds”). So I suspect that when looking for a conservative bond fund to invest in, many people on fixed incomes may think of an “inflation-protected” fund as safer than an “unprotected” bond fund.

The problem is that no matter how clear the language in a prospectus is, or how well the
potential for losing money is stated, many investors are going to make their buying decision on the basis of one thing alone—the fund’s name. That being the case, I would argue that perhaps Vanguard should consider renaming this fund, “The Inflation-Protected But At-Risk for Deflation Bond Fund.” Not very catchy, perhaps, but at least it would give a clearer indication of the fact that a TIPS fund can be a two-way street.