Bond Investments

The Appel companies may allocate a portion of client assets into bond funds that invest in corporate or high yield bonds, Treasury notes, mortgage-backed securities, TIPS, or other types of income-producing securities.  There are pros and cons for investing in each type of bond instrument.

TIPS
The return on Treasury Inflation-Protected Securities (TIPS) arises from two components, a fixed, real rate of return that is determined at the time you buy the bond and does not change afterwards, and a variable return to balance out losses of purchasing power from inflation. Inflation is measured by the Consumer Price Index for urban consumers, called CPI-U. The inflation-adjustment is paid to you as a monthly increase in principal (or decrease, if the cost of living falls), but the real return is paid as interest once every six months. The total return is the sum of both yields. The yield quoted on TIPS is only the real part.

So, for example, suppose you buy an inflation-protected Treasury Note for $10,000 that yields 3.0% and that the cost of living rises by 2% during the next six months. Then after six months (half a year), you would receive an interest payment of $150 (half a year’s interest at 3% per year=1.5% of principal at each payment), and your principal would rise to $10,200 (2%, equal to the rise in the CPI-U). Six months after that, you would receive interest of $153 (1.5% of $10,200) and your principal would be further adjusted to reflect inflation during the next six months. Monthly principal adjustments and twice-yearly dividend payments would continue until the bond matures, at which point you would receive the original $10,000 principal multiplied by the increase in the consumer price index.

Tax Consequences

Both the principal adjustments and the dividend payment count as taxable interest income, even though you do not receive any cash in hand from increases in principal until you sell the bonds. There are no tax advantages of TIPS compared to regular Treasury Notes. Theoretically, during periods of high inflation, the tax liability from TIPS could exceed the disposable income produced for investors in high enough tax brackets. (Of course, TIPS held in IRA or qualified pension plans owe no taxes until assets distributions from the retirement account are made.)

Where do you buy Treasuries?

You can set up an account with the U.S. Treasury to buy new issues directly through its website, www.publicdebt.treas.gov/bpd/bpdhome.htm. There are no costs to buy bonds this way, although you may pay a fee if you want to sell them before they mature. Otherwise, most stock brokers can sell them to you just like you would buy any other bond. Generally, it should not cost you very much to buy and sell a TIPS through a broker, but before you make any final decisions make sure you understand how much you are being charged.

When you buy bonds from a bond dealer, you often do not pay a separate commission. Instead, the price you pay for the bonds includes a mark-up over what the bond dealer paid. The price of a bond may be negotiable, especially for a good customer, so ask to get your bonds at the minimum commission the broker’s firm allows.

Just as a merchant will be reluctant to tell you how much profit he is making on a sale, it is sometimes hard to get brokers to reveal their profit margin on your bond purchases. One way to get an idea of the size of the broker’s mark-up is to get a price quote from your broker just for information (late in the business day), and then compare it to the quote in the next day’s newspaper. Your broker’s quote will not be as favorable as the newspaper quote, which applies to large institutional traders. But if the difference is too large for your tastes, you can look for a different broker or buy from the Treasury department.

The government also offers individual savers tax-deferred savings bonds called I-Bonds. (Do not confuse these with the other type of savings bonds called series EE, which are not inflation-indexed.) There are two outstanding features of I-bonds. First, interest compounds tax-deferred. Second, you get to choose how long to hold the bonds, anywhere from five to thirty years without penalty. (After thirty years, no more interest is paid. Prior to five years, you forfeit three months’ interest to redeem the bonds. I-bonds cannot be redeemed for the first six months.)

The high inflation of the 1970’s changed the landscape of the bond market. During the past fifteen years, the fixed yields on long term government bond yields ended up being, for most of the time, from 3.4% to 5% per year more than inflation.