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|Subject: Bond and F-I FAQs: Part 3A||Date: 2/14/2007 2:23 PM|
|Author: Lokicious||Number: 19768 of 36086|
So, in General, How Are Tradable Bonds Different from Savings Bonds, CDs, and so on?
• The basic difference between Tradable Bonds and the “fixed income” options we have talked about so far is that they are bought and sold on the bond market, instead of cashed in with the issuer.
• This means you have the opportunity to make a profit by buying a bond trading at a lower value than when you sell.
---Inversely, you may end up selling for a loss.
• You don't have to sell tradable bonds—you may chose to hold to maturity (unless “called”).
• If you choose to hold to maturity, the main reason for buying tradable bond is to get a higher yield than what is available from any of the “cash in” options.
---Also, if you are buying U.S. Treasury Securities, you are protected by the credit worthiness of the government well above the limits of FDIC/NCUA insurance.
United States Treasury Bills, Notes, Bonds (“Treasuries”) and TIPS
What Are Treasuries?
• To finance the national debt, the United States Treasury issues debt obligations of various maturities, collectively called simply Treasuries.
• As debt guaranteed by the United States Government, Treasuries are considered, around the world, the safest debt obligations available (the scope of the national debt and deficit notwithstanding).
---U.S. Savings Bonds, also issued by the government, along with FDIC or NCUA insured savings accounts, money markets, and CDs would be considered to have the same, or nearly the same, very low risk.
• The maturities (excluding TIPS) currently being issued by the U.S. Treasury are:
---28 day, 91 day (3 month) and 182 day (6 month) Treasury Bills, T-Bills for short,
---2, 3, 5, and 10-year Treasury Notes,
---and, the 30-year Treasury Bond.
---30-year Treasuries were discontinued in 2002, but reintroduced in February 2006.
• Treasury Notes and Bonds pay dividends semi-annually at a fixed coupon (interest rate) multiplied by the face value.
• T-Bills are issued at a discount to face value then you receive the face value at maturity (how much of a discount determines the yield).
• The coupon is set near the time the Treasuries are auctioned by the government and that is the interest that will be paid no matter how often the bond gets traded or for what price.
• The Treasury Department sometimes “reopens” a note, bond, or TIPS for auction (e.g., 3 months after the initial auction).
---When this happens, the maturity date, coupon, and Cusip number remain the same, but the price at which the security is auctioned will change, so the yield (coupon divided by price) reflects prevailing rates.
• Usually, longer maturities have higher coupons (because the government doesn't have to pay back the loan for a long time).
---Sometimes, however, there is “an inverted yield curve,” during which shorter maturities have higher yields than longer ones.
• You can find information on the original coupon rate, but daily and historical data for interest rates on bonds are posted as current yields, the coupon multiplied by the premium or discount at which the bond is trading (e.g., a 4% coupon that is trading for $1010 for $1000 face value has a yield of 3.96%).
---Yields provide a more accurate picture of where interest rates are at a given moment, although they refer to the bonds sold at the most recent auction of that maturity, which will actually have a shorter time until they mature than their listed maturity (usually just a little shorter, unless the issue has been discontinued).
• One place to see daily yields on Treasuries and TIPS is http://www.bloomberg.com/markets/rates/index.html
---Historical data on yields for different maturities and for TIPS can be found on this link to the Federal Reserve (look at the various maturities for US Government Securities—Treasury Constant Securities and Inflation Indexed Securities) http://www.federalreserve.gov/releases/h15/data.htm
---Information on recent auction results can be found at
http://wwws.publicdebt.treas.gov/AI/OFNtebnd (Notes, Bonds, and TIPS) and at http://www.treasurydirect.gov/RI/OFBills (T-Bills).
---For information on Treasuries from the Treasury Department, see
http://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm (T-bills), http://www.treasurydirect.gov/indiv/products/prod_tnotes_glance.htm (Notes), and http://www.treasurydirect.gov/indiv/products/prod_tbonds_glance.htm (Bonds).
What Are TIPS?
• TIPS are a kind of Treasury security that pays interest in two ways.
• Like regular Treasuries, there is a coupon (fixed rate) set at the time of the original auction that is paid semi-annually to the bondholder.
• In addition, the Treasury pays an inflation adjustment, based on the Consumer Price Index (CPI-U).
---This inflation adjustment is not paid to the bondholder until the bond matures.
---Instead, the adjustment is added to the face value (principal) of the bond, and the next dividend payment is the coupon rate multiplied by the new face value.
---The net effect is that your principal has the same buying power (as measured by CPI-U) as when you invested it, plus you have gotten compounded coupon payments.
• The “reference CPI-U” for the “dated date” of the TIPS (the official date from which time to maturity is set) is the actual CPI-U two months prior to the “dated date,” and the CPI-U on which dividends are based will always be two months ahead.
---When TIPS mature, the principal will be adjusted according to the CPI-U two months before the maturity date.
---CPI-U adjustments for existing TIPS may be seen at
---CPI-U numbers can be found at this Bureau of Labor Statistics link: http://www.bls.gov/cpi/
• In the event of deflation, there is a deflation adjustment on the principal lowering the face value by which the coupon is multiplied to determine dividend payments.
---However, you are guaranteed to get back the original face value, so the worst you can do is receive the interest from the fixed coupon multiplied by the deflated face value.
• Because TIPS have the inflation adjustment, the fixed coupon will be lower than that of regular Treasuries of the same maturity (except, maybe, in some extreme deflation expectation situation).
• From 1962 through 2005, the “real yield” above CPI-U on 10-year Treasuries (the equivalent of the fixed coupon on TIPS) has averaged about 2.8%, both mean and median, although the range has been from negative to over 8%: http://boards.fool.com/Message.asp?mid=23212071
---For an up-to-date chart with “real yield” for short and long term Treasuries, see: http://www.martincapital.com/chart-pgs/CH_mmnry.HTM
• The difference in yields between TIPS and Treasuries of the same maturity is more or less what bond traders are guessing inflation will be for the remaining life of the TIPS. (Change in TIPS face value is also factored in, which makes more of a difference with listings for TIPS issued further back in time.)
---Inflation expectations change daily, so the differential in fixed yield between TIPS and Treasuries varies—from January '03 through July '05, inflation expectations for 10-year Treasuries and TIPS ranged from a high of 2.71% to a low of 1.61%. http://www.federalreserve.gov/releases/h15/data.htm
• Treasury Inflation Protected Securities (TIPS) are available in 5, 10, and 20-year maturities, with some legacy 30-year TIPS, which were discontinued in 2002, available on the open market.
• Taxes on TIPS are paid each year on both the fixed coupon payment and the inflation adjustment (in a taxable account).
---You will receive a 1099-INT for the coupon payment and a 1099-OID for the inflation adjustment, both of which you enter on Schedule B.
---Paying taxes on “phantom income” seems to upset some people, but it really isn't any different than paying taxes on money compounding in a CD until it matures or on money earning interest in a savings account you aren't using.
---There may be, however, a cash flow problem for those living off savings paying taxes on money they don't have.
• See this link for the Treasury Department's FAQs on TIPS
How Do I Buy Treasuries and TIPS?
• Treasury Notes, Bonds, and TIPS are purchased in $1000 denominations, whether bought at auction or on the open market.
---T-bills are bought in $1000 face-value denominations, but the actual price per bill with be something below that, since they are bought at a discount.
---Unlike US Savings Bonds, there are no limits as to how much you can buy.
• Treasuries and TIPS of different maturities are auctioned by the Treasury Department (to raise funds for the government) on a regular basis.
---Some maturities are auctioned more often than others, notably T-bills and 2-year Notes.
---If you want to buy longer maturities, you may have to wait or buy (for a commission) on the open market.
• Here are some auction dates from 2006:
---5-year TIPS were auction in April and re-opened in October;
---10-year TIPS were auctioned in January (re-opened in April) and in July (re-opened in October);
---30-year Bonds were auctioned in February and re-opened in August;
---2-year Notes were auctioned monthly;
---10-year Notes were auctioned 6 times, including re-openings, but not at 2-month intervals;
---T-bills of all sorts are auctioned weekly;
• If you are interested in participating in an auction, check the tentative schedule, then keep your eyes open for the official announcement as the time nears.
---Note that the announcement date precedes the actual auction date, usually by a few days.
---For scheduled auctions, see http://www.treasurydirect.gov/RI/OFAnnce
---For tentative auction dates, see http://www.treas.gov/offices/domestic-finance/debt-management/auctions/
• Anyone can buy Treasuries and TIPS at auction, either through the Treasury Department's Treasury Direct or through a brokerage that accommodates auction bids.
---To use T-Direct, you must have established an account with enough cash in it to cover your purchase or have enough cash in a linked bank account.
---T-Direct works purely electronically, and you must have your “bid” submitted by noon of the auction day, although most people prefer to submit in advance to avoid making mistakes.
---Treasury Direct charges no commission for auctions.
----Some brokerages have commission free auction bids, at least for preferred customers, but not all do.
• There are now two versions of Treasury Direct:
---Treasury Direct (print your own statements) allows you to buy both tradable Treasuries/TIPS and US Savings Bond (EE- I-). http://www.treasurydirect.gov/indiv/indiv.htm (T-Direct)
---Legacy Treasury Direct allows only purchases of tradable Treasuries and TIPS but will send paper bonds: http://www.treasurydirect.gov/indiv/myaccount/myaccount_legacytd.htm (Legacy T-Direct).
---Some people prefer to use a brokerage, if it has no-commission auction bids, because it provides a better paper trail than (new) Treasury Direct, plus for convenience if you use the brokerage for other purposes.
• The Treasury Department sets the coupon when it announces the auction, in intervals of 1/8%, based on prevailing interest rates for that maturity security.
---At the auction, bids are made slightly above or slightly below par, so the yield from the auction will be somewhat different from the coupon. Also, the issue date may precede the auction date, so you might have to pay a little for accumulated interest.
---This means you will probably not be paying exactly $1000 for $1000 face value, so you must be sure to have a little extra money available in case the auction price is at a premium. See this about TIPS, as an example: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm
---A recent change now makes it that small investors don't have the option to make their own “competitive” bids, but must settle for the average yield of auction bids by institutional traders.
• When you buy re-opened TIPS or Treasuries, expect the premium or discount to be significant.
---This is because the prevailing interest rates that affect yields have changed and, for TIPS, because the face value will have been adjusted to the CPI-U (2 months' previous).
---In addition, (coupon) interest may have accumulated that could factor into the price.
• You will be able to find the price paid at auction by following the “recent auction results” link at the end of the day of the auction:
---You should have a day or two before the “issue date,” when the money is transferred from your linked bank account to T-Direct, to make sure you have enough to cover the withdrawal.
---You won't be able to confirm your purchase through T-Direct (i.e., see the purchase in your account assets list) until the “issue date.”
---If you use a brokerage, the money for the auction is taken on the day of the auction, and you can see your purchase.
• For more about auctions, see: http://www.treasurydirect.gov/indiv/research/indepth/res_auctions_indepth.htm
Can Treasuries and TIPS Be Bought on the Open Market?
• Existing Treasuries and TIPS (ones that have been previously auctioned) may be purchased or sold on the open market.
• The Treasury lets you sell through “Sell Direct,” for a $45 commission: http://www.publicdebt.treas.gov/sec/secselld.htm
• If you hold Treasuries in a brokerage account, you can sell through that, as well as purchase Treasuries others are selling.
---Vanguard, for example, charges a $40 commission per order for its preferred (Voyageur) customers (up to $54,000 purchase, $.75 per $1000, above that).
• When you buy or sell existing Treasuries or TIPS, you normally will not be buying or selling at face value, but at a premium or discount determined by the variation of the coupon rate from prevailing interest rates on bonds with the same time remaining until maturity.
---In other words, to buy a bond with a face value of $1000 (the amount you will get back when the bond matures), you will pay the current owner more or less than $1000 (e.g., $1005.64, $973.17), depending on how the bond's coupon rate compares with current interest rates and the amount of time left until the bond matures.
---For corporate bonds, other factors beside current interest rates come into play to determine the price of a bond.
• The way this works conceptually is this:
---When a bond matures, you get back its face value (e.g. a $1000 Treasury).
---Between now and when it matures you get periodic payments (typically semi-annually) based on the bond's coupon rate times the face value. So, the total amount you receive from the bond between now and maturity is the face value plus the dividends.
---There is also compounding to consider, which is guesswork to estimate, since you would be reinvesting the dividends at whatever the prevailing interest rate is at the time, not the original coupon rate.
---In sum, the sales value on the bond has to match what someone would get as a grand total, face value plus dividends and compounding, at the same maturity date for a bond with a different coupon.
---This is why tradable bonds use Yield-to-Maturity as the standard way of measuring yield.
---If you are thinking of buying a Treasury on the open market, you will want to use YTM, which should be listed, as the basis for comparison with other options. (See more in the discussion of corporate bonds.)
---If you are buying at an auction re-opening where the coupon and yield are considerably different, you should try to calculate YTM.
---For example, in February 2006, the 30-year bond was auctioned for a price of $99.51 for $100 face value, with a coupon of 4.5%. When the bond was re-opened in August, the price was $91.18. The difference in yield (coupon divided by price) was 4.53% versus 5.08%. The YTM for the original issue, using 4.5% for compounding, was around [$1000 face value + $1350 coupon payments + $70 compounding - $995.10 purchase price] divided by $995.10 divided again by 30 years = 4.773%. The YTM for the reissue, using 5% for compounding, was around [$1000 + $1327.50 for 29.5 years + $75 - $911.80]/$911.80/29.5 = 5.542%.
• Bonds with different maturities sell at different premiums or discounts for the same change in interest rates, because the dividends (plus compounding) extend for different times.
---Here is a simple example: Suppose I buy a $1000 4% 10-year Treasury today and sell it a year from now when 10-year Treasuries are yielding 5%. Over the following 9 years, my 4% Treasury would provide $360 in dividends plus about another $20 in compounding, then pay back $1000 in principal for a total of $1380. The new Treasury would provide $450 in dividends over 9 years, plus about $25 in compounding, for a total of $1475 (including the face value). This means I would have to sell my $1000 Treasury for $1380/1.475=$936 or a 6.4% loss.
---For the same situation and yields with a 5-year Treasury, we have $160 in dividends over the 4 remaining years plus about $7 in compounding, while the new 5-year Treasury would provide $200 in dividends over 4 years plus about $11 in compounding, so I would have to sell for $1167/1.211=$964 or a 3.6% loss.
---We can do the calculations the other way to look at selling a bond at a premium. For a $1000 10-year Treasury with 5% coupon sold 1 year later with 4% prevailing interest rates, after 9 years, my Treasury would have grossed about $1475 while a new 4% Treasury would gross $1380. Therefore, I could sell my Treasury for $1475/1.380=$1068.84. For a 5-year Treasury, the result would be $1211/1.167=$1037.70.
• With TIPS, the tradable value depends on how the fixed-coupon rate relates to current fixed yields.
---However, this gets complicated because the face values of TIPS change over time, as the inflation adjustment is added or subtracted.
• Commissions (and mark-ups) reduce the actual yield, especially when buying in smaller amounts, so you need a pressing reason for making small market purchases, instead of waiting for the next auction.
---However, don't let commissions scare you. If yields are attractive between auctions, the after-commission yield may still be attractive.
---To calculate the effect of a commission on simple yield (coupon divided by price), just multiply the price per bond times the number of bonds, add on the commission, divide by the price per bond times the number of bonds, then use this as the denominator by which to divide the coupon.
---For example, if a 30-year Treasury with a coupon of 4.5% sells for .975 ($975 for $1000 face value), the simple yield would be 4.615%. If you pay a $40 commission on $5000 face value, the cost is $4875 plus $40, or $4915. Divide $4915 by $5000 to get .983 (instead of the original .975). Divide into 4.5% and your simple yield after commission is 4.578%, a reduction of 3.7 basis points. The same calculation for $20,000 face value with $40 commission reduces the yield to 4.606%, less than 1 basis point below a no-commission purchase.
What Are the Advantages Treasuries and TIPS?
• Dividends paid by Treasuries and TIPS, and TIPS' inflation adjustment, are exempt from state and local taxes in taxable accounts.
• Treasuries and TIPS are secured by the US Government.
• Treasuries and TIPS can either be held until maturity or traded, so you have some flexibility.
---However, if you have to trade into rising interest rates, you will sell for a loss (with falling interest rates you would have a gain).
• Treasuries and TIPS can be bought at different maturities and used to build ladders.
---With longer maturities available than typically can be found on CDs, this allows for longer ladders, though to build a complete instant ladder requires buying on the open market.
• Longer maturities on Treasuries and TIPS allow you to lock in higher interest rates, when these are available, for a longer time than with CDs.
---Deciding what is a high interest rate, that is the chance that the rate you are getting will be higher over the long term than rolling over shorter maturities at a new rate, is at best an educated guess.
---Looking at historical yields, as well as analyzing the macroeconomic situation, is what allows for the guess to be educated.
• If bought at auction, Treasuries and TIPS can be had for no commission.
• TIPS are difficult to assess, because the inflation adjustment is not predictable, so there is a lot of guesswork involved as to whether TIPS are a better or worse choice compared to Treasuries of the same maturity or CDs.
---If you believe your crystal ball is clearer than those of the traders, and the inflation component they are factoring in is too low, TIPS would be a good choice.
• TIPS may also be a good choice, if your long term planning requires a certain return above inflation on “fixed-income” investments and TIPS are providing that return as their fixed yield.
---In other words, you can use TIPS to cover the risk of unexpectedly high inflation.
--- Remember, however, the inflation adjustment for TIPS is the CPI-U, which does not necessarily correspond to inflation, as you personally will experience it.
What Are the Disadvantages of Treasuries and TIPS?
• The yield on Treasuries (and implicitly, TIPS) is usually lower, even with the state tax exemption, than the yields on some CDs or on high rated corporate or mortgage bonds of similar maturities.
• Treasuries and TIPS must be bought for face values in multiples of $1000.
---This makes them impossible for people who can't afford that much at a time, although it may be possible to accumulate funds in anticipation of an auction.
• Bought and sold on the open market, commissions may be cost prohibitive in small amounts.
• If you need to sell before maturity, you are at risk of selling for less than face value if interest rates have gone up.
• TIPS, with the lower fixed-rate component, are not a good choice for locking in high rates, if your intent is to sell for a gain.
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