You’re sold on the idea of adding cost-of-living protection to some or all of your bond portfolio. You’re going to invest in Treasury Inflation-Protected Securities. You know that now is a particularly good time to buy, since the yield on TIPS due in 2056 is 2.7%, close to as high as it has ever been. Now the details.
Which will be better for you, individual bonds or bond funds? Which of either of these is the best buy? If you put the investment in a taxable brokerage account, how will the taxes be computed? Do you really need one of those bond ladders that financial planners talk about? Are I bonds, the inflation-protected version of U.S. Savings Bonds, a good deal?
This article will answer those questions, beginning with the fundamental choice of fixed-income investing: bonds versus bond funds.
First rule of bonds: individual securities make sense only if you can hold at least 100 bonds ($100,000 of initial par value) in each position. For smaller stakes, the better choice is a low-cost fund. Remember that you need liquidity, whether you are a retiree planning to spend down the portfolio or a younger saver who might need cash unexpectedly.
Above the 100-bond threshold, individual Treasury securities are likely to minimize investment costs. In yield terms, typical bid-ask spreads on a 100-bond trade of TIPS maturing five or more years out are in the neighborhood of 1 basis point, or 0.01% of principal annually. That compares with the 3-basis-point annual cost 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 due in ten years or thereabouts and 100 bonds due in 20 years. Put the balance of the $300,000 into a blend of funds with an average maturity of 5 years.
For the next ten years, spend down the funds. When the first individual bond matures, invest the proceeds in a replacement mix of funds, and spend those down for decade. In 2046, repeat the process.
What funds? From the scores of TIPS funds on the market, this table displays the 15 with annual expense burdens no higher than 0.2%. Within this list, it makes sense to aim for the cheapest funds you can find that match your investing horizon.
If you are buying individual TIPS, you have these. Omitted from the list: a few issues that are either hard to trade or are very short-term and have negative yields.
The arithmetic is a bit perplexing at first. Here are the details Charles Schwab & Co. was quoting in early June for one issue, the one due in February 2042. This TIPS was issued in halcyon days when the government could get away with a 0.75% coupon. Now, amid higher real rates, the bond is worth less than its principal. Schwab was letting clients have it at a price of just over 77.1 cents on the principal dollar.
For the 0.75s of ’42 your yield to maturity, reflecting both the coupon and the repayment at 100 cents on the dollar, would have been approximately 2.5%. That’s a real yield. In nominal terms, you wind up with the sum of 2.5% and the average inflation rate 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 particular issue the factor is a bit more than 1.46, making the principal amount just over $146,000. That 46% add-on reflects what has happened to the Consumer Price Index since the bond came out. The broker’s computer multiplies 1.46 by 0.771 to get the price of the bond. Then it adds the interest that has accrued since the last coupon date (February 15). Final price tag: $113,000 and change.
Five rules for TIPS fans:
1. Don’t obsess over ladders.
A ladder of bonds is a portfolio of different maturities, one for each year of your retirement. Financial advisors fuss over these things. Good grief.
A ladder would be great for someone who wants to put $3 million into TIPS. Then each position would clear the $100,000 minimum I recommend. Non-plutocrats should settle for an approximate ladder. Bunch your TIPS buy orders into a few maturities falling between 5 and 30 years. That compromise will roughly match your interest-rate risk to your future spending. It will spare you the agony of trying to time the market.
The table highlights four bonds with an average maturity of 16 years. That 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 over taxes.
They are arithmetically messy, but the broker’s computer will do the arithmetic.
The semiannual coupon payments on an individual bond are taxable on your federal return. For a full year of ownership of that 0.75% bond mentioned above, they would come to 0.75% times the inflation-adjusted principal. Also currently taxable: that year’s paper gain from inflation adjustments. If inflation is 2.5% you’d have $3,650 of taxable income on $146,000 of starting principal.
When the bond matures, the discount you got, roughly $33,000 in our example ($146,000 minus $113,000), becomes taxable as ordinary income.
It is often said that TIPS taxes are so horrible that you should own these bonds only in a tax-sheltered IRA. I disagree. Their taxable income is no higher than it would have been on a conventional bond paying 5%.
Commentators are anguished that the $3,650 inflation increment, not paid out until the end, is immediately taxable. My answer to the timing mismatch: Get over it. Scare up some cash elsewhere in your portfolio to pay the IRS.
TIPS work fine inside an IRA, as do conventional Treasuries. But note that outside, they enjoy an exemption from state income tax. If space in your IRA is limited, it should be given first to state-taxable high-income investments like junk bonds, CDs and shares of business development companies. TIPS should be second in line.
3. Ignore the SEC yield on a fund.
Schwab’s TIPS exchange-traded fund discloses, per a government regulation, that its yield is 13.4%. This number is garbage. Why do we have it? Whoever at the Securities & Exchange Commission wrote the regulation didn’t understand the basic concepts.
To get the real yield on a fund, look at its average maturity. Find where that sits on the yield curve. The curve can be found here.
Then subtract the fund’s expense ratio. For the Schwab fund, the number was 1.7% at the end of May.
4. Consider auctions.
You can avoid the pain of bid-ask spreads by submitting a “non-competitive tender” for bonds at a Treasury auction. You can do this inside a brokerage account. You agree to pay a price equal to the average of whatever the big boys end up paying at that auction.
It will take several months to assemble a portfolio of diverse maturities this way. Here’s the current auction schedule:
5. Skip I Bonds.
These U.S. savings bonds pay real (inflation-adjusted) interest. They have their fans. I think they’re a waste of time.
The bonds come with two advantages. One is that they can be cashed in without penalty at any point between 5 and 30 years out. That’s like having a free put option. The other is that federal tax on the return can be postponed until redemption. (As with other Treasury securities, the interest is exempt from state income tax.)
I Bonds come with two disadvantages. One is that they are inconvenient. There’s a purchase limit of $10,000 per year, and they can’t be put in a brokerage account. The other is that the real yield is a crummy 0.9%.
If you want to park money away for 30 years, get a 2056 TIPS paying 2.7% real. If you need liquidity, get a TIPS ETF.