Hello all, I'm brand new to fixed income investments after finding myself tiring of pi$$ing my money away in the equities market. I'm interested (I think) in purchasing some I bonds after listening to Brinker on Money Talk the other day. I went to Treasury Direct and see that they are offering a 6.73% rate of return as of 11/1/05. That sounds nice, but all of the posts here are talking of "down from 1.2% to 1%". What happened to 6.73%? What is the 1% and how is that transformed into 6.73%? Where does the additional 5.73% come from?Also, Brinker said that I bonds should be held in a personal (non tax exempt) account because there is no advantage to holding them in a tax sheltered account - I can sort of understand that. But, when referring to TIPS he was clear in stating that they should be held in a tax sheltered account. My question - why?I don't even know if I'm asking the right questions.Any clarification regarding these issues would be greatly appreciated.Trying to stop the bleeding.Thanks,Joe Bass
Hello all, I'm brand new to fixed income investments after finding myself tiring of pi$$ing my money away in the equities market. I'm interested (I think) in purchasing some I bonds after listening to Brinker on Money Talk the other day. I went to Treasury Direct and see that they are offering a 6.73% rate of return as of 11/1/05. That sounds nice, but all of the posts here are talking of "down from 1.2% to 1%". What happened to 6.73%?I bonds have a "fixed" rate and an "inflation: rate that are added together (doubtlessly using some sort of complex formula, this is government after all) to get the nominal rate that is paid on those bonds. The fixed rate remains the same over the life of the bond while the inflation portion changes. Today that rate is 1 + 5.73 or 6.73%.What is the 1% and how is that transformed into 6.73%? Where does the additional 5.73% come from?See above.Also, Brinker said that I bonds should be held in a personal (non tax exempt) account because there is no advantage to holding them in a tax sheltered account - I can sort of understand that. But, when referring to TIPS he was clear in stating that they should be held in a tax sheltered account. My question - why?Because I bonds have no tax due until you dispose of them (redeem them) in almost all cases, while TIPS have "phantom" income every year that is taxable. The real income is only rceived later.You can get just about everything you need to know about I bonds here -http://www.publicdebt.treas.gov/sav/sbiinvst.htmAlso read through some of the earlier posts - KenAtPcs and Lokicious appear to be the experts here.
We do have some FAQs in process: lots of work, since we are the only board at TMF covering fixed-income/bonds, which would be something like having one board covering "investing in stocks."Anyway, the first thing you need to understand about I-bonds is that they have two components: a fixed-rate, which remains the same until you cash in, and an inflation adjustment rate, which changes every 6-months, based on the previous 6-months' Consumer Price Index (CPI).Every 6 months (May 1, Novemeber 1), the Treasury announces a new fixed-rate for I-bonds to be issued over the following 6 month period. This is done at the same time they announce the inflation adjustment that will cover both new I-bonds and previously issued I-bonds for the next 6 month period. (You get the inflation adjustment for 6 months, regardless of whether you bought the I-bond on the first or last day of the period, then the next adjustment goes for 6 months, etc.) Unfortunately, the Treasury is now announcing the new combined rate, fixed plus inflation component, as if it were a single rate, which is confusing and, someone of a cynical nature, might suggest, deliberately misleading.If you had bought I-bonds on October 28 (like some, here, did, to make sure they didn't get caught in transition on October 31), you would have received a fixed rate, for the life of the I-bond, of 1.2%. You would also have received an inflation adjustment for the first 6 months of 3.6% (the previous inflation adjustment), then for the following 6 months, you would receive the 5.7% inflation adjustment. After that, we have no idea (so far it looks like the next adjustment will be low, since gas prices are way down).If you bought an I-bond today, you would get the new fixed-rate of 1% (some previous I-bonds have fixed rates over over 3%). You would now get a 5.7% inflation adjustment for the next 6 months, and after that we don't know.A 1%, or even a 1.2%, fixed rate, which is the real return you will get after inflation (as measured by the CPI), is very low as a fixed income real return (though probably better than a money market). Currently 5-year TIPS, the Treasury's tradable inflation adjusted bond, are at a fixed-rate of 1.8%, 10-year TIPS at 2%, and historically intermediate and long term Treasury bonds (TIPS are pretty new) have averaged over 2.5% above inflation, although the average covers up considerable volatility. When Bush was pumping his private Social Security accounts, he used a default for returns on Treasuries of 3% above inflation; not that any of us took that seriously, but it does give you some sense of just how low a 1% real return, locked in for up to 30 years, really is.Most of those buying I-bonds are doing so for one of two reasons:1) they need some liquidity, usually as a contingency fund against hard times (a.k.a., an emergency fund), and I-bonds are a reasonable compromise, where you can cash in after 1-year if necessary with a 3 month interest penalty, or no penalty after 5 years, and at least beat inflation by a little; 2) because you can delay paying taxes until you cash in the I-bond, if you are going to be in a much lower tax bracket when you cash in than while you are saving, you may get a better after-tax return than something paying a higher interest rate being taxed as you go (some folks, looking at retirement in the next 10-15 years, are figuring on going from 25% or 28% tax bracket down to 15%). You can also buy I-bonds in small amounts, whereas TIPS require $1000 a shot. (Because the short term combined rate is so high, if you bought TIPS just before the new rate was announced, they made a good place for keeping money for the next year, even if you lost 3 months interest cashing them in.)The advice to hold TIPS in a retirement account is simplistic. In general, any fixed-income investment (TIPS, Treasuries, Corporate bonds, CDs, bond funds) that gets taxed at your marginal rate is better held in a tax-advantaged account—even if you are in the same tax bracket after retirement, at least you get compounding before paying taxes. In the real world, however, many of us end up with plenty of fixed-income money in taxable accounts, and the hype about TIPS being worse from a tax point of view is just the usual spouting off of nonsense by media loud mouths. I pay taxes on "phantom income" on CDs and, if the traders guessed right about inflation adjustments, you would pay the same annual taxes on 10-year Treasuries as 10-year TIPS.Paying taxes on "phantom income" on TIPS is problem in one specific situation—if you need cash flow from interest on bonds to pay for the taxes on the interest. With regular Treasuries, you get a full interest payment every 6-months from which to pay the taxes. With TIPS, you only get the fixed component paid out, while the inflation adjustment gets added to the principal, but you get taxed on the whole thing. If you are in a tight cash flow situation, this is a problem. If not, who cares? If you are laddering, you won't have a cash flow problem.
Loki wrote:(Because the short term combined rate is so high, if you boughtreplace the word "I-bonds" herejust before the new rate was announced, they made a good place for keeping money for the next year, even if you lost 3 months interest cashing them in.)The main factor in this was that it was known within a few bips what the interest rate would be for the whole year. One of the previous posts in this board has the calculation. It was a rate much higher than can be earned on any short-term CD or bond. So a lot of us bought I-bonds fully expecting to cash them in in a year or so.
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