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August 13, 2005

The Basics of Treasury Inflation Protection Securities (TIPS)

Treasury Inflation Protection Securities (TIPS), issued by the U.S. Treasury, are similar to other Treasury bonds in a number of respects:

  • They are backed by the full faith and credit of the U.S. government, so they have no credit risk. Credit risk is the risk that the issuer's credit rating will be downgraded, which could decrease the bond's value, while default risk is the risk that the issuer will not be able to pay interest and/or principal. Keep in mind that the government guarantee relates only to the prompt payment of principal and interest and does not remove market risks.

  • They are sold at Treasury auctions twice per year.

  • Interest is paid semiannually.

  • There is a very liquid secondary market.

The main difference between TIPS and other government bonds is that the bond’s face value is adjusted periodically for inflation based on the increase in the Consumer Price Index for All Urban Consumers (CPI-U). The designated interest rate is determined at auction and does not change during the bond’s life, but the principal is adjusted every six months. Thus, subsequent interest payments are based on the increased principal amount.

From a tax standpoint, interest income is subject to federal income taxes, but not state or local income taxes. Also, any increases in the bond’s principal value is subject to federal income taxes in the year the adjustment is made, even though the funds aren’t received until the bond matures. However, if the TIPS are held in a tax-advantaged account, such as a 401(k) plan or Individual Retirement Account, income taxes are not paid until the funds are withdrawn.

To decide whether TIPS are a better alternative than other Treasury securities, calculate the difference between the yield on a 10-year TIPS and a 10-year Treasury security. If inflation is higher than the difference, the TIPS will have a higher yield than the other Treasury security. However, if inflation is lower than the difference, the other Treasury security will have a higher yield than the TIPS.

What happens if we enter a period of deflation? Then your principal will decrease so that your interest payments will also decrease over time. However, when the bond matures, you will still receive the full principal value.

Assessing a Bond's Credit Risk

Credit risk is the risk that the issuer’s credit rating will be downgraded, which could decrease the bond’s value. Lower credit ratings also are an indicator that a bond may be subject to default risk, or the risk that the issuer will not be able to pay interest and/or principal. When investing in bonds, be sure to assess these risks.

Keep in mind that not all bonds are subject to credit or default risk. U.S. Treasury securities, because they are backed by the full faith and credit of the U.S. government, have no credit or default risk. Agency bonds, which are issued by government-sponsored entities, have a low level of credit and default risk. Municipal and corporate bonds, however, have varying levels of credit and default risk.

One way to assess a bond’s credit or default risk is by reviewing its bond rating. Rating agencies assign ratings to bonds to give investors an indication of the bond’s investment quality and relative risk of default. Major rating agencies include Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch IBCA. Before assigning a rating, these services thoroughly review a bond issue.

The agencies assign letter ratings, with the first four categories considered investment-grade bonds and the lower categories are considered speculative. Not sure that credit ratings are useful in assessing credit risk? S&P calculated the average cumulate default rates 15 years from the initial bond rating by grade. The default rates were 0.67% for AAA, 1.3% for AA, 2.88% for A, 9.77% for BBB, 24.51% for BB and B, 41.09% for CCC, CC, and C, and 60.7% for D. (Source: 2004)

After a bond is issued, the rating agencies continue to monitor it, changing the rating if warranted. The agencies also give advance warning of possible changes. Lowered ratings can mean a decline in market value of the downgraded debt for investors and higher future financial costs for the issuer. Price changes are typically minor if the rating changes by only one notch. The following downgrades are more significant and should cause you to review whether to continue holding the bond:

  • A downgrade that moves a bond from an investment-grade rating to a speculative rating.

  • A downgrade of more than one notch.

  • A series of downgrades over a short time period.

A rating is a general guide of a bond’s investment quality and risk of default, not a recommendation to purchase the bond. Other factors should be considered before investing in a particular bond.

Keeping an Eye on the Economy

Watching key economic indicators over time should help you understand the signals the economy is sending. While you may not make financial decisions with certainty, understanding the economy should help you make decisions, such as which investments to purchase and sell, when to lock in mortgage rates, and when to purchase major durable goods, with more confidence. Some of the more important statistics to track include:

Interest rates. At a minimum, follow the prime rate, Treasury bill rates, and Treasury bond rates.

  • The prime rate is the rate banks charge their best business customers. Since many consumer loans are tied to the prime rate, following this rate will indicate whether your personal borrowing costs are likely to increase or decrease.

  • Following Treasury bills and bonds will help you determine trends in short- and long-term interest rates. Check these rates at least monthly.

  • Study the yield curve, which is a graph plotting interest rates for the same type of bond for a series of maturities, usually ranging from three months to 20 or more years. Changes in the yield curve’s shape can signal a change in the economy’s direction. In general, a normal upward sloping curve indicates a healthy economy, a steep upward sloping curve often occurs at the beginning of an economic expansion, a flat curve may indicate an economic slowdown, and an inverted curve typically precedes a recession.

Inflation. The most common measure of inflation is the consumer price index (CPI), which is announced the fourth week of every month for the preceding month. The CPI is a measure of the average change in prices paid by urban consumers for a fixed basket of goods and services. An annual inflation rate below 2% is considered low, 2% to 4% is moderate, and above 4% is high. Look at the annual rate and whether inflation is increasing or decreasing over time. This is a closely watched statistic since the Federal Reserve is committed to keeping inflation under control.

Gross domestic product (GDP). GDP is a measure of the goods and services produced by the nation and includes consumer spending, business investment, government spending, and net exports. Approximately three weeks after the end of a quarter, the government announces the annual GDP growth rate. Under 2% is considered low growth, 2% to 5% is considered moderate growth, and over 5% is a boom considered difficult to sustain.

Unemployment. Statistics regarding unemployment are some of the most timely statistics generated by the government. These figures are typically released within a week of month end. Unemployment statistics are closely watched since they quickly signal broad-based changes in the economy. While low unemployment rates generally indicate a strong economy, rates that are too low can also cause inflationary pressure. A low supply of workers makes it necessary for companies to increase wages to attract employees. Increasing unemployment rates, on the other hand, can signal that we are headed toward recession.

Corporate profits. How well businesses are performing is an important indicator of the economy’s overall health. A common measure of corporate profits is earnings per share for the Standard & Poor’s 500. Comparing this figure to the prior year’s numbers indicates whether profits are increasing or decreasing.

While you may not be able to predict where the economy is headed with certainty, following the above key indicators will provide you with some direction.

Are Municipal Bonds Appropriate for You?

No investment, including municipal bonds, is appropriate for every investor. Before purchasing, consider their advantages and disadvantages to see if they are appropriate for your portfolio.

Some of the advantages of muni bonds include:

  • Municipal bond interest income is generally exempt from federal, and sometimes state and local, income taxes. Your marginal tax bracket is a major factor when deciding whether to invest in municipal bonds. Thus, you should compare a municipal bond’s yield to the after-tax yield of a comparable taxable bond. To do that, calculate the municipal bond’s taxable equivalent yield. If you’re not investing in a municipal bond issued in your resident state, the calculation is: the taxable equivalent yield equals the tax-exempt interest rate divided by one minus your marginal tax bracket. For instance, if you are considering a municipal bond with a yield of 4.5% and you’re in the 25% tax bracket, the taxable equivalent yield is 6.0% (4.5% divided by 1 – 25%).

  • A wide variety of bond choices exist. With over 1.5 million municipal bond issues outstanding, you can find bonds with all kinds of different characteristics.

  • Muni bonds typically have high credit ratings. Municipal bond defaults are rare, but they do occur. Make sure to review the credit quality carefully before investing. You may want to stick with investment grade ratings, which is an indication that the issuer is considered financially stable and unlikely to default.

  • Many municipal bonds are insured. About half of all muni bonds are insured. The bond issuer purchases the insurance when the bonds are brought to market, with the insurance company committing to make timely payment of principal and interest in the event of the bond issuer’s default. When the bonds are insured, the bond issue receives the same rating as the insurance company’s rating, typically AAA. In the event of default, the investors can look to the insurance company for the payment of principal and interest. Thus, investors should review the financial soundness of both the issuer and the insurance company. Keep in mind that insurance relates only to the timely payment of principal and interest and does not remove other market risks, such as interest rate fluctuations or early principal repayment.

Some disadvantages of muni bonds include:

  • Muni bonds are not appropriate for all types of portfolios. Municipal Bonds should not be considered for Individual Retirement Accounts (IRAs), 401(k) plans, or other tax-advantaged plans. Since municipal bond interest is already exempt from federal income taxes, you gain no further benefit from placing the bond inside a tax-advantaged vehicle. In fact, the interest income will ultimately be subject to ordinary income taxes when withdrawn.

  • Municipal bonds are callable. Most muni bond issues have call provisions, which allows the issuer to redeem the bonds before maturity. The exact provisions, however, can differ significantly between bonds, so carefully review these provisions before purchasing a bond. While you can’t prevent an issuer from exercising a call provision, you can purchase bonds with call provisions most favorable to you. Early redemptions generally occur when market interest rates are lower than the bond’s interest rate. Even though you receive the principal and possibly a premium, the money must then be reinvested at a time when interest rates are lower than that paid on the original bonds.

  • Muni bonds are still subject to some taxes. While interest income is typically exempt from federal income taxes, selling a bond before maturity for a profit will result in a taxable gain. Also, some bonds pay interest income subject to the alternative minimum tax (AMT). State and local taxes must also be considered if the bond is not issued in your resident state.

Bond Strategies for Various Financial Goals

The strategies used for bond investing will depend on the financial objectives you are pursuing. Consider these financial objectives and bond strategies:

  • Earning interest while preserving principal. This is the most typical role for bonds and is usually accomplished with a buy-and-hold strategy. With this strategy, you purchase a bond and hold it to maturity, looking for the highest return potential for a given time frame within a comfortable risk level. By holding the bond to maturity, you don’t have to worry about interest rate changes impacting your bond’s price.

  • Maximizing income. Since bonds with longer maturities typically have higher interest rates, this strategy typically involves investing in longer-term bonds. Interest rate changes will typically affect a longer-term bond’s price more because long-term bonds have a longer stream of interest payments that don’t match current interest rates. Someone looking to maximize income will also be more likely to sell a bond before maturity to lock in capital gains. Another strategy to help achieve this objective is to invest in high-yield bonds, which are bonds with lower credit ratings. Due to the lower credit rating, these bonds often have to offer higher interest rates to obtain investor interest.

  • Managing interest rate risk. One of the most significant bond risks is interest rate risk, or the risk that increases in interest rates will cause a decrease in your bond’s price. Bond ladders can help manage this risk. A bond ladder is a portfolio of bonds of similar amounts maturing in several different years. When one of the bonds matures, the principal is reinvested in another bond at the bond ladder’s longest maturity. By spreading out maturity dates, you lessen the impact of interest rate changes. Holding the bond to maturity prevents interest rate changes from resulting in a loss when you sell the bond. Since your bonds mature every year or so, your principal is reinvested over a period of time instead of in one lump sum. If interest rates rise, you have principal maturing every year or so to reinvest at higher rates. In a declining interest rate environment, you have some funds in longer-term bonds with higher interest rates. But the main advantage is you won’t continue to hold only short-term bonds while you wait for interest rates to peak, an event that is difficult to predict.

  • Helping reduce the volatility of stock investments. The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully help offset this decline. For instance, in 2002, the S&P 500 returned –22.1%, while long-term government bonds returned 17.8% and intermediate-term bonds returned 12.9%.* One way to assess the percentage of bonds to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.

  • Investing for a specific future goal. Because bonds have a definite maturity date, you can select maturity dates to coincide with when you need your principal. You might want to consider zero-coupon bonds for this purpose. Zero-coupon bonds are issued with a deep discount from face value and do not pay interest during the bond’s life. The return results from the bond’s price increasing gradually from the discounted value to face value, which is reached at maturity. The longer a zero-coupon bond has until maturity, the greater its price discount will be. Like other fixed-income investments, a zero-coupon bond’s price moves up when interest rates fall and down when rates rise. However, since zeros lock in a fixed reinvestment rate of interest, they are affected more drastically by interest rate changes. One important factor to consider is taxation. Even though you do not receive any interest income until the zero-coupon bond matures, you are taxed on the yearly growth in the zero’s value (called accretion).

  • To recognize a loss for tax purposes. A bond swap, which is simply the sale of one bond and the purchase of another, can help achieve this objective without changing the basic composition of your bond portfolio. In essence, you sell a bond with a current market value less than your purchase price to realize a loss and deduct it on your tax return. You then use the proceeds to purchase similar bonds. The end result is that you still own a comparable bond, but you also have a tax loss. Review the cost of the swap before executing the transactions to ensure costs don’t offset most of your expected tax savings. Make sure to comply with the wash sale rules or your loss won’t be deductible. A wash sale occurs when an investor sells a security and 30 days before or after the sale purchases a substantially similar security. Bonds purchased within the 30-day window must differ from the bonds sold in a material way, which includes different issuers, coupon rates, or maturity dates.

  • To reduce income taxes. One strategy would be to invest in municipal securities.

    * Source: Stocks, Bonds, Bills, and Inflation 2005 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. Stock Market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

 

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