TIPS

Buying TIPS through a mutual fund (or ETF) is a good idea, because it gives you a lot of convenience for a small price. Pros for investing in a 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. 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.

2. Instant diversification. A 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 charges $45. Vanguard charges at least $40. You also receive a lower price ("markdown") than the wholesale price when you sell on the secondary market.

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.

6. Easy tax handling (for taxable accounts only). TIPS bonds in a taxable account have a unique phantom income issue. I won't go into the details here. The fund shields that issue away from you. You receive regular dividends from the fund and you get a 1099 at the end of the year, just like any other mutual fund.

All of these convenience come at a cost of 0.20% a year for the Vanguard TIPS fund VIPSX. That's $20 a year for each $10,000 invested. If you have $100,000 or more for TIPS, Vanguard's fund offers Admiral shares which cut down the expense ratio to 0.11%, or $11 a year per $10,000 invested. It seems very reasonable to me. 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 chunks and hold the bonds to maturity, a one-time commission and markup 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.

I've bought all of these before, the Vanguard TIPS fund VIPSX, the iShares ETF TIP, and the individual bonds. They all worked the way they're supposed to. Right now I'm buying individual bonds and holding them to maturity because I want to save the ongoing expenses.

Buying at auctions and holding to maturity is not that hard. I have a step-by-step guide for doing so. If you buy long-term bonds at least $10,000 at a time, the secondary market can also be cost effective. If the the yield becomes attractive between auctions, I will not hesitate to buy on the secondary market. After all, for a 20-year bond, paying a one-time 1% commission plus markup beats paying a 0.2% expense every year for 20 years.