You probably have a chunk of savings in Treasurys. Here’s how to size up conventional bonds, the inflation-protected ones and other ways to guard against a weak dollar.
By William Baldwin, Senior Contributor
The Federal Reserve will quickly get the inflation rate down to 2%.
Do you believe that? If you do, then the usual variety of Treasury bonds is right for you. They pay 4%, more or less.
If, however, you are skeptical about the Fed’s efforts to tame the cost of living, then it isn’t such a good idea to let the government repay you in cheapened dollars. You’d be happier with Treasury Inflation Protected Securities, a.k.a. TIPS. They pay 1.7%, more or less, plus whatever the inflation rate turns out to be. The inflation rate may turn out to be, between now and when the bond matures, something a lot worse than 2%.
Here, we’ll look at the pros and cons of conventional (or “nominal”) bonds lacking inflation protection, at TIPS and at some cost-of-living hedges outside the bond market.
To start: Treasury bonds are not the safe things some savers assume them to be. The ones that come due in the distant future are extremely hazardous. Yes, they deliver par value at maturity, but in the meantime, if you dare to look at your account statements, you discover that you are on a rollercoaster.
Treasurys of the nominal sort, which account for most of Treasury debt outstanding, have two risks. One is that inflation turns out to be higher than expected. The other is that the real rate—the inflation-adjusted rate, that is—turns out to be higher than expected. If either of these events occurs, nominal bond yields go up and the prices of bonds, especially long-term bonds, go down. That happened last year. Long Treasurys got killed.
TIPS eliminate just one of these two risks, the one relating to inflation. They still have the risk that real rates could go up. That happened last year, too, when the real rate on ten-year paper zoomed from -1% to +1.6%. TIPS got killed.
Which kind of bond is better for your retirement account? That depends. If inflation turns out to be surprisingly low, you’ll wish you had put all your money in nominal bonds. If inflation turns out to be surprisingly high, you’ll wish you had bought TIPS.
Given life’s uncertainties, it makes sense to diversify your bets. That explains the portfolios at Wealth Enhancement Group, a Minneapolis-headquartered firm overseeing $67 billion of assets. “It is likely that inflation is coming down,” says Jim Cahn, chief investment officer. This guarded optimist explains that while he does not shun nominal-rate bonds, he wants clients to be prepared for the risk that the Fed’s inflation-fighting disappoints.
“Very few people own fixed income in a vacuum. With equities you get some hedge against inflation,” Cahn says. Beyond that, his clients have the additional protection afforded by allocations to TIPS, to commodities and to a Lord Abbett institutional fund that uses derivatives linked to the Consumer Price Index.
A blend of inflation-protected and unprotected bonds gets you one kind of diversification. The other kind of diversification has to do with duration.
Duration, closely related to the years to maturity, measures the sensitivity of bond prices to the ups and downs of interest rates. Durations of a medium-term portfolio, such as Schwab’s index fund tracking the whole investment-grade bond market, is in the neighborhood of 7 years, meaning that a percentage-point spike in rates chops a bond’s value by 7%. You’ll get a duration about double that on a long-term bond.
If you knew that rates were headed up, you’d own only short-duration bonds. If you knew they were headed down, you’d have only long-duration ones. Since you don’t know, spread your bets around. That’s the idea in the table of suggestions for your fixed-income investing.
Spread Your Bet
Diversify your investments across maturity dates and inflation protection—and maybe add small doses of commodity plays. The bonds are priced to deliver yields of roughly 4% (unprotected) or 1.7% (protected). All of these objects are liquid and easy to buy and sell. The ETFs have low annual expense ratios—0.04% or less per year for the first three and 0.1% to 0.25% for the Pimco, SPDR and GraniteShares products. Bonds bought directly are an even better deal for stakes of $100,000 or more, with bid/ask spreads indicating that you lose no more than 0.02% a year to the middleman.
Costs matter. All of the recommended funds have expense ratios at the low end of what’s available in their categories. Committed cheapskates can squeeze a few more pennies out of the cost ledger. If you have enough money in play, you can undercut the first four funds by owning U.S. Treasury paper rather than a fund. You’ll find a lot of choices in the secondary market. Or you could get Treasurys directly from the government in an auction by submitting a “noncompetitive tender” through your broker, but the auctions don’t give you much choice in maturities.
Treasurys are very liquid, which means that bid/ask spreads are tight. Comparing ask prices shown on the Fidelity Investments website to the midpoint of the bid/ask, I see frictional losses to the buyer of 1 to 2 basis points (0.01% to 0.02% per year if the bond is held to maturity) for trades in the $100,000 to $250,000 range. If that’s outside your pay grade, be content with low-expense funds.
A bond fund discloses the average yield to maturity of its holdings in its so-called “SEC yield.” For a fund holding nominal bonds (such as the first two in the table), the Securities & Exchange Commission yield is a trustworthy number. Alas, if the fund holds TIPS, the government-mandated formula produces a garbage number.
If you want to know what you’re earning on a TIPS portfolio, take advantage of data produced by a more intelligently run arm of government, the U.S. Treasury. Look for the “real yield” curve published here and subtract the fund’s expense ratio. You can find most of what you want to know about a mutual fund or ETF by typing its ticker into a Morningstar.com search box.
One last matter is income tax. If you put bonds and bond funds in an IRA or 401(k), which is usually the rational place to put them, you have nothing to worry about. Outside a tax-sheltered account, things get complicated.
In a taxable brokerage account you have to think about the choice between taxable and municipal bonds and about the oddball treatment of TIPS and bonds bought at a discount to par value. Also note: “K-1 free” commodity funds, such as the one shown in the table, can be a disaster in a taxable account. It’s best to avoid these complications. Do your fixed-income investing inside a tax shelter.