The following is the fourth of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered municipal bonds. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
When it comes to investing, there are no guarantees. However, with U.S. Treasury securities you come close. No other investment carries their probability that interest and principal will be paid on time. If you’re looking for predictability, U.S. Treasuries are one way to go.
Another appealing feature of Treasuries is that they typically don’t have "call" provisions like their fixed income brethren – municipal and corporate bonds, which gives issuers the go-ahead to pay off the bond before its maturity date. If you have the pleasure of owning Treasuries with no call provision, you don’t have to sweat, you know how long your income will flow.
There’s flexibility too. You can get Treasuries with varying maturities and you can ladder them, so as they mature you can invest the money elsewhere. Treasury interest payments escape state and local taxes, but Uncle Sam gets his.
Although Treasuries are considered to have very low free credit risk, they are affected by other types of risk, mainly interest-rate risk and inflation risk. The Securities Industry and Financial Markets Association (SIFMA) points out that while investors are effectively guaranteed to receive interest and principal payments as promised, the underlying value of the bond itself may change, depending on the direction of interest rates.
As with all fixed-income securities, if interest rates in general rise after a Treasury security is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market. Similarly, as SIFMA points out on its website, www.investinginbonds.com, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues.
What’s good can also be bad. Because many consider Treasuries the safest investments around, Treasuries pay lower interest rates than other taxable fixed-income investments. This may not be an issue though, if safety is a priority for your portfolio.
What You Need to Know
There are different types of government/agency bonds. You can still get those U.S. Savings Bonds your grandparents may have given you as gifts back in the day. But there are STRIPS (Separate Trading of Registered Interest and Principal Securities) and TIPS (Treasury Inflation-Protected Securities). If you’re not familiar with these, there’s good information on The Securities Industry and Financial Markets Association’s website, www.investinginbonds.com. You’ll find a primer of sorts. You don’t get a certificate when you buy a U.S. Treasury bill, note or bond. SIFMA explains that your investment is tracked in a book-entry system of accounts that generates a receipt and periodic statements.
If you’re looking for short-term investments, go for T-bills. They work like zero-coupon bonds, which don’t pay periodic payments. You buy them at a discount from the face value and receive the full amount when the bill matures. On the other hand, Treasury Notes come due in two, three, five, seven and 10 years. Treasury bonds are for 20-30 years and interest is paid semi-annually. You can get U.S. Treasury securities from a bank, broker, or www.TreasuryDirect.gov. You can also invest in a mutual fund where the bulk of the holdings are Treasuries or those that include Treasuries.
Typically there is no commission for buying or selling U.S. Treasury securities. Dealers benefit by buying bonds at one price and selling them to you for a higher price.
Tips about TIPS
TIPS are relatively new, they came on the investing scene in 1997 and were designed to protect investors from the impact of inflation. They have some advantages.
"They are indexed to inflation, which makes their par value rise in step with inflation, while their interest rate is fixed. That means that folks can feel comfortable knowing that if inflation, one of the biggest enemies of long-term investors, hits hard, the value of their bonds should rise,’ says Douglas Goldstein, a certified financial planner and author of Rich As a King: How the Wisdom of Chess Can Make You a Grandmaster of Investing.
TIPS, like other government-backed instruments have a low risk of default. Interest is paid semi-annually, providing predictable cash flow. They trade actively, so they can be bought and sold quickly and easily.
"They are good for people seeking diversification in their fixed-income portfolios," says Goldstein.
But like all investments there are risks. "Interest rate risk is a huge problem. If interest rates go up in the marketplace, the lower-yielding bonds that you’re holding can go down in value. These days, with rates at historic lows, it’s reasonable to assume we might see them move up in the relatively near future. That would likely erode the price of TIPS and TIPS funds that people are holding," says Goldstein.
Then too, the semi-annual inflation adjustment is taxable. So if inflation is high, the high payment against gets taxed. "If there’s no inflation, or if the market anticipate deflation, the value of the bonds could drop and investors could lose money," warns Goldstein.
Know too, that if you have TIPS in a mutual fund and ETFs (exchange-traded funds), the value of the funds can go up and down, and when you sell, you might get back less money than you paid, he adds.
Paul Jacobs, chief investment officer of Palisades Hudson Financial Group used to invest in TIPS for several years, but he no longer does. "Many investors purchase TIPS with the goal of protecting against inflation, but end up surprised when their investment fluctuates wildly in value, despite no real changes in actual inflation," he says.
Returns are heavily influenced by traditional Treasury bonds. Investors who are concerned about the rising interest rates should be very wary about investing in TIPS. He says that in 2013, the Barclays U.S. Treasury Inflation Protected Securities Index dropped over 8% due to rising interest rates.
Jacobs says there are other ways to protect yourself more directly against rising inflation. He likes mutual funds that invest in inflation swap contracts, such as the JP Morgan Tax Aware Real Return Fund or the DFA Short-Duration Real Return Fund. "They take on less interest rate risk and will provide returns that are more similar to actual inflation than TIPS. You can also protect yourself against inflation by investing in hard assets, such as real estate or energy investments."
The bottom line, before you go gung-ho into U.S. Treasuries, says Braden Perry, a partner in the law firm of KennyHertz Perry, "The more research and preparation that is done on them, the better. Proper due diligence requires creativity coupled with common sense for any unnecessary surprises to be avoided, especially with Treasury securities during a time of relative cheap money and potential risks for inflation."
Editor's Note: For information on savings bonds, please refer to the article Treasury Lowers Rates for I and EE Savings Bonds.