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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: New (Improved) FAQ on Treasuries and TIPS Date: 1/19/2006 5:04 PM
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Changes in caps (2Old, look around the caps a bit to see if I erased something in addition to the additions). I didn't put in a CPI-U link, since still hoping for a daily one.

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United States Treasury Bills, Notes, Bonds (“Treasuries”) and TIPS
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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, as safe debt obligations as are available (the scope of the national debt and deficit notwithstanding). US 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 very low risk.
-----The currently available maturities are 13 Week (3 month) and 26 week (6 month) Treasury Bills, T-Bills for short, 2, 3, and 5-year Treasury Notes, and 10-year Treasury Bonds. 30-year bonds, once a staple of the bond market, were discontinued in 2002, but will be reintroduced in February 2006.
-----Regular Treasuries (excluding TIPS) pay dividends at a fixed coupon (interest rate) multiplied by the face value; dividends are paid semi-annually for Treasury Notes and Bonds.
-----The coupon is set at 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 SOMETIMES OFFERS A BOND OR NOTE FOR AUCTION MORE THAN ONCE. WHEN THIS HAPPENS, THE MATURITY DATE, COUPON, AND CUSIP NUMBER REMAIN THE SAME, BUT THE PRICE AT WHICH THE SECURITY IS SOLD AT AUCTION WILL CHANGE, S0 THE ACTUAL 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 matures than their designated maturity (usually just a little shorter, unless the issue has been discontinued).
----One place to see daily yields on Treasuries and TIPS is Bloomberg
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 AUCTIONS CAN BE FOUND AT
http://wwws.publicdebt.treas.gov/AI/OFNtebnd
----FOR INFORMATION ON TREASURIES FROM THE TREASURY DEPARTMENT, SEE
http://www.publicdebt.treas.gov/sec/sec.htm

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 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 does not get paid to the bondholder until the bond matures. Instead, it 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 the 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 THREE MONTHS PRIOR TO THE “DATED DATE.” AND THE CPI-U ON WHICH DIVIDENDS ARE BASED WILL ALWAYS LAG THREE MONTHS BEHIND. WHEN THE TIPS MATURES, THE PRINCIPAL WILL BE ADJUSTED ACCORDING TO THE CPI-U THREE MONTHS BEFORE THE MATURITY DATE.
----CPI-U ADJUSTMENTS FOR EXISTING TIPS MAY BE SEEN AT
http://www.publicdebt.treas.gov/of/ofcpi022006pr.htm
-----In the event of deflation, there is a deflation adjustment on the principal lowering the face value BY WHICH THE COUPON IS MULTIPLED 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.
-----Because TIPS have the inflation adjustment, the fixed coupon will be lower than that of regular Treasuries of the same maturity. The difference IN YIELD (COUPON DIVIDED BY PRICE) is what bond traders are guessing inflation will be for the remaining life of the TIPS (so the totals for TIPS and Treasuries would come out even in the end). Inflation expectations change daily, so the differential in fixed yield for 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%. (See previous link on historical data.)
----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). What happens to compensate for previously paid taxes on inflation adjustments if there is deflation, only Alan Greenspan knows for sure, and he ain't telling. (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.)
----Treasury FAQs on TIPS
http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm

How Do I Buy Treasuries and TIPS?

----Treasuries and TIPS are purchased in $1000 increments, whether bought at auction or on the open market. Unlike US Savings Bonds, there are no limits as to how much you can buy.
----Treasuries are auctioned by the Treasury Department (to raise funds for the government) on a regular basis, with auctions for different maturities (and TIPS) occurring on different dates.
----Scheduled auction dates are listed on the Treasury Direct website, which also links you to a PDF file with a tentative schedule ANNOUNCEMENT DATES for future AUCTIONS.
http://www.publicdebt.treas.gov/sec/sec.htm
----IF YOU ARE INTERESTED IN PARTICIPATING IN AN AUCTION, CHECK THE TENTATIVE SCHEDULE THEN KEEP YOUR EYE OPEN FOR THE OFFICIAL ANNOUNCEMENT AS THE TIME NEARS.
----Anyone can buy Treasuries and TIPS at auction, either through the Treasury Department's Treasury Direct (you must have established an account with enough cash in it or enough cash in a linked bank account to cover your purchase) or through a brokerage account that offers auction purchases.
----Some brokerages (including Vanguard and Fidelity) don't charge a commission for Treasuries and TIPS purchased at auction, at least if you are a preferred customer.
----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 THAT WILL LIKELY BE SLIGHTLY ABOVE OR BELOW PAR, SO THE YIELD FROM THE AUCTION WILL BE A LITTLE DIFFERENT FROM THE COUPON.
----A recent change now makes it that small investors don't have the opportunity to bid at auction, but must settle for the average yield for bids by the big traders on the auction day. THAT MEANS YOU WILL PROBABLY NOT BE PAYING EXACTLY $1000 FOR $1000 FACE-VALUE, SO YOU NEED TO BE SURE TO HAVE A LITTLE EXTRA MONEY AVAILABLE IN CASE THE AUCTION PRICE IS AT A PREMIUM.
----SEE AN EXAMPLE FROM THIS LINK
http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm
----WHEN YOU BUY A RE-AUCTIONED TIPS, EXPECT THE PREMIUM OR DISCOUNT TO BE SIGNIFICANT, BECAUSE BOTH PREVAILING INTEREST RATES THAT AFFECT YIELDS HAVE CHANGED AND BECAUSE THE TIPS' FACE-VALUE WILL HAVE BEEN ADJUSTED TO THE CPI-U (3 MONTHS' PREVIOUS).

Can Treasuries and TIPS Be Bought on the Open Market?

----Existing Treasuries and TIPS (ones that have been previously auctioned and are now being resold) 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 $40 per order for its preferred (Flagship) customers and a minimum of $40 (for $1000) to a maximum of $75 to others. https://flagship5.vanguard.com/VGApp/hnw/content/AccountServ/Brokerage/ATSIntegrityValueContent.jsp
----Obviously, if you are buying on the open market in small increments, the commissions will substantially reduce your actual yield ($12,500 for $40 commission would be about the expense ratio of a Vanguard bond fund), so you need a pressing reason for making small market purchases, instead of waiting for the next auction.
----When you buy or sell existing Treasuries of TIPS, you normally will not be selling for the face value of the bond, but at a premium of 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.
----The way this works conceptually is: 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 get from the bond from now through maturity is the face value plus the dividends. There is also compounding to consider, which is a crap shoot to estimate, since you would be reinvesting the dividends at whatever the prevailing interest rate is at the time, not the original coupon rate. Anyway, 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.
---Bonds with different maturities (remaining time until they mature) sell at different premiums or discounts for the same change in interest rates because the dividends (plus compounding) extend for different times. Here's 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 gets added OR SUBTRACTED.

What Are The Advantages and Disadvantages of Treasures and TIPS

----Dividends paid by Treasuries and TIPS are exempt from state and local taxes, in taxable accounts, so comparisons with other fixed-income options, such as CDs, need to look at the after-tax yields. (As usually, in tax deferred accounts, all interest, dividends, and capital gains are treated as ordinary income and taxed to the max when you take your distributions.)
----Treasuries and TIPS are secured by the US Government, which is generally considered to make them the lowest risk category investment, along with federally insured bank and credit union accounts and US Savings bonds.
----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 extra cost; bought on the open market, they may be cost prohibitive, especially in small amounts.
----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 are convinced you have a better crystal ball than the traders and that 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. However, remember the inflation adjustment for TIPS is the CPI, which does not necessarily correspond to inflation, as you personally will experience it.
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