TIPS

TIPS - Treasury Inflation-Protected Securities, generate income tax each year based on the additions to principal. The potential problem is that that income is taxed but not paid to you until the end of the term when the bond matures.

TIPS bond funds have no maturity date.

TIPS should be held in a tax-free ROTH IRA or a tax-deferred retirement account.

Bonds and a Negative Annual Return

There is much talk these days about the future of bond funds because interest rates will likely rise resulting in potential losses in bond funds.

Craig L. Israelsen in a Financial-Planning.com magazine article entitled The Rebalance Premium (June 2011) reminds us that "...bond funds seldom have had negative annual returns, while stock funds lost money in a calendar year nearly 30% of the time..."

Do not lose sight of the importance of cash and bonds to stabilize a portfolio.

"...over the 85-year period from 1926 to 2010...bonds had a negative annual return on eight occasions, about 9% of the time..."

More importantly, using Ibbotson U.S. Intermediate-Term Government Bond Index, "...the losses were relatively small, never exceeding 3%. Over the same period, stocks were in the red 24 times, or 28% of the time. Six of the annual losses exceeded 20%...."

He further drives home the point, looking at 3-year returns over this 85-year period, "...the worst three-year slide for the S&P 500 was a 61% free fall, but for bonds the worst cumulative return over any three-year period was 1.6%..." (yes, less than 2%).

As the article reminds us, this illustrates "...the pragmatic difference between stocks and bonds..."

 

Bond Investing Comparisons

Alternative I: Bond ETF's

Many larger, more popular funds can be tax efficient, easy to trade during the day (marketable) and inexpensive but the value you "buy at" may be more expensive (premium) than its underlying value and when you sell the value may be less (discount) than its underlying value. It is difficult for ETF companies to create a sampling strategy that matches the broader bond indices, therefore, the investor must scrutinize how diverisifed they are within size, sectors, etc.

Alternative II: Bond Mutual Funds (indexed or actively managed)

Diversified for the investor though you must pay attention to this (size, quality, sector) as well as to duration and cost when selecting funds.

Alternative III: Individual Bonds

Difficult to adequately diversify and manage on your own (professional management is important). This method can be tax efficient and you can trade bonds during the day, unlike bond mutual funds.

Managing duration and having enough bonds to create an allocated portfolio requires more funds than many investors are willing to allocate to this strategy.

Interest Rates and History

The Wall Street Journal's September 28, 2010 article by Andy Kessler noted an interesting reminder about interest rates:

"...we are at the bitter end of a 30-year interest rate cycle. Declining interest rates are the ideal environment for economic growth. In January 1981, short-term interest rates were 19.08% - now they are 0.14%. Thirty-year mortgages in October 1981 were 18.45% - now they are 4.28%..."

When interest rates go down, bond prices go up. From 1985 through 2009, bond returns dipped negative only three times (in 1994, -4.7%; in 1999, -1.2%; and in 2008, -7.8%).

When interest rates go up, bond prices go down.

Bonds Are Not Always Safe

In the April 2010 issue of Financial Planning magazine, author Jim Grote, CFP(r) quotes another respected financial planner, Ross Levin. Mr. Levin, like me, does not consider bonds "...an automatic safe haven for retirement portfolios..."

"...People who bought 10-year Treasuries at 5% [10 years ago, for example] may have avoided a gut-wrenching crash in the market, but now they must reinvest in Treasuries paying only 3.5% [or even less, as this was written in April 2010]..."

The point he makes though is that this is a 30% drop in income from these bonds and, indeed, that is a point well taken.

Municipal Bond Investing

There is much discussion of whether investing in tax-free municipal bonds (especially if from the state you reside) is a good idea. It, of-course, depends on your income need, your tax situation and other issues. Municipal is just another name for bonds offered by states, counties and cities instead of the Federal Government or from Corporations.

Remember that bond issue for a new school or whatever that you saw on your last ballot when you voted in the last election? You could be a buyer of those municipal bonds.

Though many state budgets are under duress during this 2007-2011 period, the default rates are really quite low. Really low like .03 percent for the 30-year period ending in 2009. And in 2010, those default rates still remain well under 1%. Many states have regulations that require paying their bond debt before other expenditures (usually education gets a first seat at the table, then bond payments).

For those in high-income tax brackets, the 3.8% additional tax (in 2013) on investment income will not apply to municipal bond interest. So, this may be another enticing factor to consider municipal bonds within a diversified strategy.

This is not a recommendation to buy but rather a thought to consider if they may be appropriate for you. Discuss this with your independent Fee-Only financial planner. You have one, right?

Bubbles

A bubble means that the price of an asset—and in the most recent case, that of housing—is significantly higher than its fundamental value.

Watch out because it seems like ever since the March 2009 stock market lows (which may be re-tested someday, who knows?), investors have created another bubble - Treasury Bonds.

Yes, the safety of bonds may have been true (especially over the past 10+ years) but may not be so going forward. The interest rates on 10-year bonds have increased 1% in this year alone and, based on the duration of holdings you may own of 4-5 years, that means that a 1% change in interest rates results in a 4-5% change in the opposite direction of your bond values.

Past performance is no guarantee of future returns. Be diversified.

TIPS - Treasury Inflation-Protected Securities

Several fund families (like Fidelity, Vanguard, T. Rowe Price) and ETF's (like iShares) have an easy way to invest in Treasury Inflation-Protected Securities (TIPS). If you have gone through the exercise to determine your risk tolerance and your time horizon and know that these are right for you then next is understanding the rates.

Short-term investment asset class returns are based on a historical risk premium added to an inflation rate, which is calculated by subtracting the TIPS (Treasury Inflation Protected Securities) yield from the 10-year Treasury yield. This method results in an appropriate estimate of the market inflation rate for the next 10 years.

10-year Treasury Yield: Answer:______ (go to www.bankrate.com to get the rate)

Then subtract, TIPS Yield: Answer: ______ (go to wwwbankrate.com to get this rate, too)

Your answer, which is ever-changing, is the suggested Inflation Rate. If this rate comes out to be higher than what you believe inflation will be for you (yes, your personal inflation rate is more important anyway), then buying TIPS will keep you a little ahead of inflation. See my "Portfolio-Allocation" label for more thoughts on allocations.

Municipal Bond Rates

Basically, muni's historically yield about 80% of treasuries but of late (Sept. 2007) they have been yielding 90% making them a little more appealing to lower tax brackets (25% maybe).

Maturity Yield as of Aug. 30 and Feb 28th for a 35% tax-rate equivalent Yield:

Term-----Muni 8/30---T/E--Muni 2/28
2-year 3.74% 5.75% 3.66%
5-year 3.87 5.95 3.71
7-year 4.00 6.15 3.78
10-year 4.29 6.60 3.94
15-year 4.65 7.15 4.19
20-year 4.82 7.41 4.34
30-year 4.85 7.46 4.42

I-Bonds and interest rates

Yesterday, the Treasury Department reset the rate on its inflation-adjusted savings bonds, or I Bonds, to 4.52%. Although the rate is an improvement over the previous rate of 2.41% for I Bonds bought after April 30, it is still well below last fall's rate of 6.73%, which was buoyed by a spike in energy prices in the wake of Hurricane Katrina.

Two parts. The current 4.52% rate includes a fixed-rate of 1.4% that lasts for the 30-year life of the bond. It also includes 3.1% annualized rate of inflation as measured by the percentage change in the consumer-price index for all urban consumers, or CPI-U, from March through September. The Treasury Department says it comes to 4.52% after rounding.
The inflation-adjusted rate is reset every six months, on May 1 and Nov. 1. But it's the fixed rate of 1.4% that will matter most to investors over the long term. Based on yesterday's rate change, investors who buy I Bonds between now and next April can essentially expect a 1.4% return after inflation.

For investors looking for a hedge against inflation, high-yielding certificates of deposit or TIPS may be better alternatives than I Bonds. Five-year TIPS, for example, are yielding about 2.5% after inflation -- which is the rate that investors need to compare to the I Bond's fixed 1.4% rate, says Greg McBride, senior financial analyst at Bankrate.com. And with five-year CDs paying yields as high as 5.75%, investors can still reap a real return of 2.75% even if inflation runs at a 3% annually for the next five years, he says. "The CD still comes out way ahead of the I Bond, even if you have to pay state and local taxes."


But I Bonds are still appealing to many investors, particularly conservative, older investors in higher tax brackets who want to defer interest income to minimize their taxes, says Daniel Pederson, author of "Savings Bonds: When to Hold, When to Fold, and Everything in Between." That is because investors can defer paying federal taxes until they cash in their bonds; interest is also exempt from state and local income taxes.

EE Bond Catches - Be Careful

Question: I have some EE savings bonds that qualify for college tuition payments without being taxed. Are they tax-free for graduate school, too?

Maybe, but only in very specific circumstances. Interest earnings on savings bonds usually are subject to federal income tax. However, interest on Series EE and I bonds issued after 1989 can be tax-free when used to pay for qualified education expenses if you meet certain requirements.
Your modified adjusted gross income (2006) must be below $124,700 if married; $78,100 if single in 2006. Married couples earning more than $94,700 and singles earning more than $63,100 can exclude only part of the interest. Your modified adjusted gross income is generally your adjusted gross income without taking into account any savings bond interest exclusion and a few other deductions. See IRS Publication 970, Tax Benefits for Education, for the full definition.
To get this break, you also have to be at least 24 years old when the bond was first issued. And the money must be used for tuition and fees (room and board don't count).
Graduate school tuition is considered a qualified educational expense, but there could be a catch: The bond must be used for the bond owner, spouse or a dependent whom you claim as an exemption on your return. If the bond is in your name and your child is no longer considered your dependent for tax purposes, then you can't get the savings bond tax break to help pay his or her grad school tuition. You can use bonds you own for your own tuition, however, or you could even buy a new bond after age 24 and use it tax-free for your own grad school costs in the future.

TIPS

The principal value of inflation-indexed Treasurys is stepped up along with the consumer-price index. You also earn a small amount of additional interest. This "real" yield reflects your gain above inflation -- and right now the rate is pretty attractive.
For instance, if you buy 10-year inflation-indexed Treasurys today, you can lock in a yield above inflation of just under 2.4 percentage points a year. That's some 2.6 percentage points less than the 5% yield on conventional 10-year Treasury notes.
In other words, if annual inflation turns out to be higher than 2.6% over the next 10 years, inflation-indexed Treasurys will outperform conventional Treasury notes. That strikes me as a distinct possibility.
But even without a pickup in inflation, the yield on inflation bonds looks pretty appealing. The average historical, after-inflation return on conventional intermediate and longer-term bonds is roughly 2.3%, notes investment adviser Larry Swedroe, co-author of "The Only Guide to a Winning Bond Strategy You'll Ever Need."
With inflation-indexed Treasurys, "you should be willing to accept a lower return, because you're getting insurance against unexpected inflation," he argues. Indeed, when 10-year TIPS hit 2.15% late last year, Mr. Swedroe started buying individual inflation-indexed Treasury bonds, and he has continued to buy as rates have climbed.
If you prefer mutual funds, check out offerings like Fidelity Inflation-Protected Bond or Vanguard Inflation-Protected Securities. One warning: Like other taxable bonds, inflation-indexed Treasurys can generate big tax bills. To postpone those bills, hold your inflation-indexed bonds or funds inside a tax-sheltered retirement account.