Yyou are sold about the idea of adding cost of living protection to some or all of your bond portfolio. You will invest in Treasury inflation-protected securities. You know now is a particularly good time to buy, as the TIPS yield expected in 2056 is 2.7%, almost as high as it’s ever been. Now the details.
Which will be better for you, individual bonds or bond funds? Which of the two is the better purchase? If you place the investment in a taxable brokerage account, how will taxes be calculated? Do you really need one of those bonds that financial planners talk about? Are I-bonds, the inflation-protected version of US savings bonds, a good deal?
This article will answer those questions, starting with the fundamental choice of fixed income investing: bonds vs. bond funds.
First rule of bonds: individual securities only make sense if you can hold at least 100 bonds ($100,000 initial face value) in each position. For smaller stakes, the best option is a low-cost fund. Remember that you need liquidity, whether you’re a retiree planning to spend down the portfolio or a younger saver who may need unexpected cash.
Above the 100-bond limit, individual Treasuries are likely to minimize investment costs. In yield terms, typical bid-ask spreads on a trade of 100 TIPS bonds maturing five years or more are close to 1 basis point, or 0.01% of principal per year. This compares to the annual cost of 3 basis points of the cheapest TIPS funds.
Here’s an investment plan for a new retiree who has $300,000 to invest and wants to spend it over the next 30 years. Buy 100 bonds maturing in ten years or so and 100 bonds maturing in 20 years. Put the remaining $300,000 in a mix of funds with an average duration of 5 years.
For the next ten years, spend the funds. When the first individual bond matures, invest the proceeds in a mix of replacement funds and spend them down over a decade. In 2046, repeat the process.
What funds? Of the TIPS fund ratings in the market, this table shows the 15 with an annual expense charge of no more than 0.2%. Within this list, it makes sense to target the cheapest funds you can find that match your investment horizon.
If you buy individual TIPS, you have these. Omitted from the list: some issues that are either difficult to negotiate or are too short-term and have negative returns.
The arithmetic is a bit complicated at first. Here are the details provided by Charles Schwab & Co. in early June for one issue, the one maturing in February 2042. This TIPS was issued in days when the government could get away with a 0.75% coupon. Now, amid higher real interest rates, the bond is worth less than its principal. Schwab was letting customers have it for just over 77.1 cents on the principal dollar.
For ’42’s 0.75 your yield to maturity, reflecting both the coupon and repayment at 100 cents on the dollar, would be about 2.5%. This is a real performance. In nominal terms, you end up with the sum of 2.5% and the average rate of inflation over the next 16 years.
The principal value of 100 TIPS bonds is not $100,000 but rather $100,000 times an inflation factor. For this issue the factor is just over 1.46, bringing the starting amount to over $146,000. This additional 46% reflects what has happened to the Consumer Price Index since the bond was issued. The broker’s calculator multiplies 1.46 by 0.771 to get the bond price. It then adds the interest that has accrued since the last coupon date (February 15). Final price: $113,000 and change.
Five rules for TIPS fans:
1. Don’t obsess over the stairs.
A bond ladder is a portfolio of different maturities, one for each year of your retirement. Financial advisors shake these things up. Good grief.
A ladder would be great for someone looking to put $3 million into TIPS. Each position will then clear the minimum amount of $100,000 that I recommend. Non-plutocrats will have to settle for an approximate ladder. Concentrate your TIPS buy orders in a few maturities between 5 and 30 years. This trade-off will roughly match your interest rate risk to your future spending. It will save you the agony of trying to time the market.
The table highlights four bonds with an average duration of 16 years. This would be a starting point for a medium sized TIPS account. The portfolio could be rounded out with a few funds.
2. Don’t panic about taxes.
It’s numerically messy, but the broker’s computer will do the math.
Semiannual coupon payments on an individual bond are taxable on your federal return. For a full year of owning that 0.75% bond mentioned above, that would come to 0.75% on the inflation-adjusted principal. Also currently taxed: that year’s paper profit from inflation adjustments. If inflation is 2.5%, you’ll have $3,650 of taxable income on $146,000 of principal.
When the bond matures, the discount you received, about $33,000 in our example ($146,000 minus $113,000), is taxable as ordinary income.
It’s often said that TIPS taxes are so horrendous that you should only hold these bonds in a tax-sheltered IRA. disagree. Their taxable income is no higher than it would be with a conventional bond paying 5%.
Commentators are concerned that the inflation increase of $3,650, which was not paid until the end, is immediately taxable. My answer to the time mismatch: Get over it. Fear some cash elsewhere in your wallet to pay the IRS.
ADVISORS work well inside an IRA, just like conventional Treasurys. But note that apart, they enjoy exemption from state income tax. If space in your IRA is limited, it should be given first to state-taxed high-income investments, such as junk bonds, CDs and stocks of business development companies. TIPS should be second in line.
3. Ignore the SEC performance on a mutual fund.
Schwab’s TIPS exchange-traded fund discloses, according to government regulation, that its yield is 13.4%. That number is garbage. Why do we have it? Whoever at the Securities and Exchange Commission wrote the regulation did not understand the basic concepts.
To get a mutual fund’s true performance, look at its average maturity. Find where it is on the yield curve. The curve can be found here.
Then remove the fund’s expense indicator. For the Schwab fund, the number was 1.7% at the end of May.
4. Review the auctions.
You can avoid the pain of bid-ask spreads by making a “non-competitive bid” for bonds at a Treasury auction. You can do this within a brokerage account. You agree to pay a price equal to the average of what the big boys are paying in this auction.
It will take several months to assemble a portfolio of different maturities in this way. Here is the current auction schedule:
5. Skip I Bonds.
These US savings bonds pay real interest (adjusted for inflation). They have their fans. I think it’s a waste of time.
Bonds have two advantages. One is that they can be redeemed without penalty at any time between 5 and 30 years. This is like having a free placement option. The other is that the federal tax on the return can be deferred until the redemption. (As with other Treasury securities, the interest is exempt from state income tax.)
I Bonds have two disadvantages. One is that they are uncomfortable. There is a $10,000 per year purchase limit and they cannot be placed in a brokerage account. The other is that the real return is 0.9%.
If you want to park money for 30 years, get a TIPS 2056 at 2.7% real. If you need liquidity, get a TIPS ETF.
