Wall Street Journal Article “Why Stocks Are Riskier Than You Think” Features iBonds and An Error

The Wall Street Journal today had an article titled “Why Stocks are Riskier Than You Think“. The article discussed a strategy using iBonds & TIPS as a partial alternative to stocks along with the use of options to limit risks of a large downswing in your stock portfolio value.

While I am not here to recommend a particular investment strategy I do discuss iBonds and they have a little infographic called “Creating a Safety Net” with iBonds and TIPS and it describes the key features of each. Here is a link to the infographic. They talk about how the bonds move with inflation, interest, maturity, fees, taxes, and price fluctuations.

But on the key measure of “purchase limits”, which has fluctuated over the years from as high as $30,000 per SSN (with the option to also buy equivalent “paper” iBonds which are no longer offered) to as low as $5000, the article says that the limit is now:

Each Social Security number is entitled to a maximum of $5000 a year in electronic bonds.

However – this is incorrect. If you go to the site http://www.treasurydirect.gov, which is now the only place where you can purchase iBonds (you can no longer buy paper ones at banks) – here is what the US Government web site says:

Buying I Bonds through TreasuryDirect:

Sold at face value; you pay $50 for a $50 bond.
Purchased in amounts of $25 or more, to the penny.
$10,000 maximum purchase in one calendar year.
Issued electronically to your designated account.

This price limit changed a few months ago and whomever wrote this article didn’t bother to check this basic fact. That is unfortunate.

In looking at as many of the comments as I could (they are filled mostly with rants and one-sided arguments) no one there knew about this limit either. So Wall Street Journal – could you please fix your infographic? It supports your argument (by allowing for larger purchases) and that little infographic is pretty good other than this key error.

iBonds Update December 2011

This site has been a big fan of iBonds for several years now. Here is a link to a post I wrote in early 2010 that basically sums up the key elements of iBonds including:
– very low risk
– able to defer taxes indefinitely until redemption (up to 30 years). They are also exempt from state and local taxes
– very competitive interest rate of a “base” low amount plus inflation adjusted every six months
– able to buy $10,000 / year worth of bonds (that is the limit if you buy “jointly” between you and your spouse, but you can buy $10,000 in your name and $10,000 in your spouse’s name if you are not worried about will or trust issues)
– because they are very simple (deferring taxes) you don’t have to do much of anything as far as work to maintain these securities. You won’t get a 1099 form for interest if you select the “base” method which is deferring taxes until maturity or until you redeem them

The downsides are
– you can’t get at the money for 12 months (your latest purchase; if you have been buying iBonds annually for years it is only your most recent purchase that is held for 12 months)
– if you redeem within 5 years, you lose 3 months of accrued interest
– the interest rate, while WAY better than money markets or savings accounts, isn’t that great. The “base” interest rate offered by the US government now is 0.0%, so essentially you only receive the inflation component. Even with a “0.0%” base interest rate, inflation paid about 3.75% in 2011 which is a great rate considering the alternatives

Here is a link to the Treasury Direct site discussing iBonds. Starting 1/1/12 the US Government will no longer issue paper iBonds anymore. Thus you must buy them through the US government if you want them.

iBonds Update December 2011

The Wall Street Journal recently had an article about iBonds. The article summarized their advantages and noted that beginning 1/1/12 they no longer were going to allow for “paper” issued iBonds which limits the number of bonds individuals can purchase. This article says that iBond limits were going to be $5000 per person; the treasury recently updated their rules and now you can buy up to $10,000 per person.

If you haven’t bought iBonds before now would be a good time to start. You can purchase bonds by year end 2011 (the next few days) and then buy some in early 2012. This starts the “clock” on the 12 months where you can access your money. After that the money is available for short-term cash needs (you do lose 3 months of interest in the next 5 years).

Interest Rates and Returns

When I was young in the 1970’s I heard a discussion between my grandfather and my father. My grandfather was literally “grandfathered in” as a CPA; he was a practicing CPA prior to the test being a requirement to practice as a CPA so he was able to continue his work without ever taking the exam.

In the 1970’s inflation was endemic and interest rates were high; the Federal funds rate peaked at 19% in 1982. At the time my grandfather made the prediction that “interest rates would never go below 10%”. This seemed like a reasonable statement at the time…

Living in a “normal” interest rate environment, here would be some basic assumptions:

– bonds would give you a reasonable interest rate, maybe 5% to 10% depending on conditions
– stocks would give you price appreciation, plus a dividend yield (overall) of maybe 2% – 4%
– these items would barely keep you up with inflation

In today’s interest rate environment, the US government is keeping interest rates effectively near zero. They are doing this to help the economy and it also helps the US government since we are issuing a lot of debt (running a deficit) and keeping a low interest rate allows them to raise money at a low debt rate (for as long as someone on the other side will keep buying it; the largest buyer of US debt is the US government under QE2 but that is a different question).

Regardless of governmental policy, here is the practical impact on my portfolio:

Bonds – here is my current “CD ladder” that I use in lieu of bonds:

CD’s Rate Duration (Years)
CD 3.9% Monthly due 12/19/11 3.9% 0.5
CD 2% Monthly due 1/19/12 2.0% 0.6
CD 4.1% Monthly due 12/17/12 4.1% 1.5
CD 2.2% Semi due 3/28/13 2.3% 1.8
CD 2.8% Monthly due 1/8/14 2.8% 2.5
CD 2.45% Monthly due 3/31/14 2.5% 2.8
CD 1.35% Semi due 6/24/14 1.4% 3.0
CD 2.9% Semi due 4/1/15 2.9% 3.8
CD 2.05% Semi due 6/29/16 2.1% 5.0

Average interest rate (assuming all CD’s are equal value) 2.6%
Portfolio “duration” in years 2.4

For those with advanced skills in this area I am not calculating my duration exactly right because I am not taking into account the effect of re-invested interest but frankly in this era of low interest rates it doesn’t throw my calculation off too much.

This CD ladder reflects a few things – I bought the highest yielding CD’s (online) and a lot of banks failed and were taken over, particularly in Puerto Rico. Although there was no principal loss (because the US government insures up to $250,000 and my individual bank exposures were lower than that) I had to re-invest the proceeds and by that time interest rates drifted even lower. In any case interest rates now are brutal; 5 years gets you 2%, and 3 years gets you 1.4%, and frankly less than 3 years and you might as well leave your money in the bank account (which will get you less than 0.2%, but is immediately liquid, and gives you more re-investment opportunities).

iBonds – the US government used to let you buy up to $30,000 / year in iBonds. Recently they dropped this to only $5000 / year (yes I know for those advanced people that this is per person, and if you wanted to not buy jointly which could cause some other problems later you could buy $5000 each and then $5000 in paper which also requires a trip to a bank and is a pain).

Why did they do this? Probably because today, due to inflation and the fact that I bought my iBonds when they had a “real” interest rate of more than 1% (it is ZERO today), my iBonds yield 5.78%. People would KILL for that risk free return today if they could get it; as you can see above 3 and 5 year interest rates are between 1.4% – 2%. Of course, if inflation dives or deflation comes, the return on iBonds plummets as well; at one point in 2008-9 the iBonds paid ZERO return on principal AND the adjusted inflation component. But for now these are doing great, if you were able to buy them before the limits tightened up.

Stocks

The crazy thing now is that STOCKS offer a similar yield in the form of dividends than BONDS do in the form of interest (for non “junk” debt). Here are some of the dividend yields that I am receiving today (ignoring price appreciation or losses):

Fund or ETF Ticker Yield

Vanguard Value Index Fund VFINX 1.64%
Vanguard Selected Value Fund VASVX 1.42%
Ishares Dow Jones Select Dividend Index Fund DVY 3.24%
Vanguard Emerging Markets ETF VWO 1.66%
Vanguard European ETF VGK 4.24%
Vanguard Total Stock Market ETF VTI 1.71%

Average dividend yield 2.3% (assuming all funds / ETF’s equally weighted)

Thus the dividend yield I am getting on this basket of funds and ETF’s is roughly equivalent to my return on CD’s, which approximates the Federal interest rate curve; this is not what we were taught to expect, at all.

Another element is that dividends are (currently) taxed at 15% while interest is taxed as ordinary income, which is 28% and above. Thus even if they are both roughly the same, dividends come out higher on tax efficiency, although there is a significant risk of capital loss (while the CD’s are far less risky).

In all financial situations you should do your own research and come to your own conclusions; I really didn’t see the total yield vs. interest rate situation brought home until I ran it with my own numbers.

Finally, in any era of super low interest rates, like today, retirement is almost impossible, because you can’t earn anything on your money. At 3% (let’s round up), that becomes about 2% when taxes are taken out, which means that if you have $1M saved up and earning income you are left with $30,000 before taxes. That is more than enough to live on if your needs are extremely modest but 1) the average American probably has less than $1M in income earning assets at retirement 2) $30,000 won’t do squat in any major metropolitan area. Thus retirement, unless you have a solid pension (generally from a government job, there are few other ones nowadays) or income producing assets like ownership in a business, is really just a time when you are drawing down assets rapidly towards zero, because at these low rates you are earning virtually nothing.

iBonds Revisited

I have written about iBonds on this site in the past and wanted to re-visit them.

IBonds are US government bonds and thus they are the “benchmark” for low risk debt instruments. IBonds have the following characteristics (which are well-summarized at the US Government web site here):

– a “fixed” interest payment that is set when you buy the bond. This component is set at the time that you make the original purchase and is constant throughout the 30 year life of the bond (or until you redeem it). This component has ranged from a high of 3.6% back in 2000 (before the government basically went with a zero-rate policy to prop up the markets) down to ZERO in the middle of 2008. It currently has a rate of 0.3%
– every 6 months you get a return equal to the inflation rate. This rate (for comparison purposes I am multiplying it by two to get an annual rate, although it is a tiny bit more if you are into statistical details due to compounding) has ranged from 5.7% (2.85% * 2) back in 2005 to NEGATIVE 5.56% in mid 2009 (which meant that EVERYONE who owned an existing iBond was getting NO interest for 6 months, because even if you bought one of those “golden” 3.6% ibonds back in 2000 that annual rate was less than this negative inflation component
– If you buy an iBond now, you get an annual rate for the next 6 months of 3.36%, which is basically the 0.3% “fixed” rate plus a bit more than 2 times the current inflation rate of 1.53%
– Your existing iBonds take the “fixed” rate from the year that you bought them plus 2 times 1.53% to determine the current yield; so if your rate was 1.55% (mid 2006 vintage) then you are currently earning about 4.6% / year
– There are also some tax advantages. You don’t need to pay state or local taxes on the iBond interest that you earn until you redeem the bond (you have the OPTION of reporting interest annually, which could be a good idea if you are buying them for a child and they are in a low interest rate bracket, but this is beyond the pale for the current discussion)
– One disadvantage is that you can’t get access to your funds for 12 months after you buy a bond issue. If you redeem them within 5 years, you lose the last 3 months of interest. After 5 years, there are no penalties

I wrote about iBonds most recently when their interest rate paid on ALL iBonds regardless of fixed rate component went to ZERO. I was interested in following up with them to see the current fixed rate being offered as well as the interest component.

Basically, iBonds are a GREAT deal right now. They provide inflation protection for when interest rates increase (which will drive inflation), they are the lowest risk class bond available (when the Federal government can’t float debt any longer we are all in big trouble), and they provide deferral opportunities for taxes.

In reviewing other debt alternatives (something I will come back to in additional posts), right now a 2-3 year CD is yielding 1.5% to 2% / year. This is less than the iBond is yielding now (although it is guaranteed, while the iBond can fluctuate and go down if there is deflation, although not below zero). Other government securities are in the 2% range (or less) and then you need to go up the risk ladder a bit to get even 3% or 4%.

The Federal government knows this and they want to keep the iBond program relatively small, I guess, because they are limiting the purchase of iBonds to $5000 / year. You can go online to treasurydirect.gov to purchase them (it is very easy to do) and they will sweep the $ out of your bank account. If you really put your thinking cap on you can buy some for you and some for your spouse but in general for most the $5000 cap will apply unless you have a comprehensive estate plan in place. For a while you used to be able to buy $30,000 / year of iBonds which in hindsight was a great purchase plan but they cut it back accordingly.

All in, iBonds should be considered by anyone looking for an effectively zero risk component of their savings. Right now banks and CD’s are offering almost nothing so this is a very viable alternative. You can’t get at your money for 12 months but since your purchases are only limited to $5000 / year this likely isn’t a significant deterrent.

Cross posted at Chicago Boyz and LITGM

iBonds… You’ll Get Nothing, and Like it (or not)

From time to time I have posted about iBonds as an investments. iBonds are interest securities backed by the US Government that you can purchase online or at a bank (I guess, although I have never tried that). The general attraction to iBonds is that their interest rate goes up as inflation goes up – which provides protection in times of rising prices (hence the “i” in the name – I originally thought it was tied to the “dot com” era). Here is an in-depth analysis that I wrote about iBonds in December, 2008, noting that the government had reduced the total amount that you could buy each year from $30,000 / person to $5000 / person. Note that you can’t LOSE money on iBonds unless the US government defaults, in which case we all have some big problems.

In short – there are 2 components to your iBond return. The FIRST part is the “fixed” interest rate that the US Government offers you. I bonds have been issued for about 10 years, and the “fixed” rate used to be as high as 3.4% / year which dropped as low as 0.0% (yes, that’s zero) but recently were bumped up to a negligible 0.1% rate. What this means is that if you bought an iBond years ago and kept it, that is a better iBond than one that you are buying today since the rate today is near zero. I think that the iBonds that I purchased over a couple year period have a rate near 1%, give or take.

The SECOND part of your iBond return is the variable component. This component takes into account inflation. Thus if prices are going up (you have inflation), then the interest rate that you receive will go up, as well. For the decade or so the iBonds have been in existence, this rate has been positive (meaning rising prices), providing an interest rate of between 1% and 6% or so.

Thus since iBonds have been created, the return that you could have gotten (depending on when you purchased the underlying bond) your return would vary from a fixed component of between 0% and 3% and a variable component of between 1% and 6% meaning that the “real” range of interest is between 1% and 9% overall.

TODAY, however, the new iBond rate has been unveiled… and since we are in a deflationary period (prices are going DOWN), for the first time, the rate of return on iBonds is ZERO (the interest rate can never go negative). The decline in real prices is -2.78% for six months per the government calculations, which means that it annualizes to -5.56%, so no matter when you purchased your iBond your return is ZERO, because even the highest iBond rates were about 3% or so they are all dwarfed by the -5.56% annual rate.

OUCH. It is never good to have an investment with a return of zero, especially when you purchased it explicitly for interest income (and to ensure you didn’t LOSE any money). However, the inflation rate will be adjusted in six months, and if prices are going up then, the interest rate will reset upwards.

I wouldn’t invest in iBonds now if you haven’t already bought some, especially because you are just getting this anemic 0.1% return as a base level. Check again when they announce interest rates for the next six months, which will be on November 1, 2009. I wouldn’t sell what you have, however, because you’d just have to re-invest the money in something else, and savings and checking accounts are generally yielding almost nothing now, as well, along with money markets.

Note – for those of you that don’t get the reference (probably those younger than 21 or so… of course it is from Caddyshack).

iBonds

Recently I have been writing about investing in secure securities (i.e. where you can’t lose money, except in extremely unlikely scenarios). I focused on purchasing CD’s that are insured by the FDIC and constructing a “ladder” of varying maturities through your brokerage account. The return on these CD’s is much higher than is currently being offered by US Treasury securities and has other advantages such as convenience and simplification of statements.

There is another form of safe investing that is easy to do and risk-free (assuming the US Government does not collapse). This is called an “I Savings Bond” or “iBond”.

ABOUT IBONDS AND CALCULATING THE INTEREST RATE:

iBonds are issued by the US Government. iBonds can be purchased at www.treasurydirect.gov after you set up an account and provide appropriate information, at zero charge. The iBonds are issued electronically and the money moves electronically which makes them very convenient, as well.

Unlike virtually all other types of bonds, the iBond interest or “coupon” rate is tied to the inflation rate as measured by the US Government. Virtually all other bond instruments either adjust their coupon rate according to how interest rates move (short term rates mainly determined by the Federal Reserve, long term rates a combination of short term rates and market sentiment) or the price adjusts (i.e. if you have a bond paying 6% interest and the market price moves to 5%, you could sell that bond for a gain in the market and it would be priced “above par”), depending on the type of bond.

The iBond has 2 components; a “fixed” interest rate that has varied between 0% (low) to 3.4% (high) over the last several years and a semi-annual interest rate component tied to the rate of inflation that changes every six months. ONCE YOU BUY AN IBOND THE FIXED RATE NEVER CHANGES, but the semi-annual component tied to inflation adjusts every six months (thanks to an alert reader for catching this error in a previous post). iBonds have a thirty year maturity.

The “fixed” interest rate component has had different base rates since the iBond program was started in 1998. The “fixed” component was 3.4% in 1998 and then dipped as low as 0% for bonds purchased between May 1, 2008 and October 31, 2008. The current fixed rate component on iBonds is 0.7% for bonds purchased between November 1, 2008 and April 30, 2009. If you buy iBonds today that “fixed” component will stay the same until you cash them in or they mature, 30 years from now.

The “variable” interest rate component is determined by the inflation rate, divided by 2 (the semi-annual inflation rate). The current semi-annual inflation rate is 2.46%, or 4.92% for the year. Thus iBonds purchased between November1, 2008 and April 30, 2009 pay about 5.64% (it is slightly higher than 0.7% + (2.46% * 2) because of compounding interest).

Note that if you buy different issues (i.e. $5,000 / year) of iBonds, your fixed rate may vary by year, but the “variable” component will be the same for each issue over every six month period. I realize this is confusing (it confused me, for what that is worth) and here is a link to the government site where they try to explain it.

IBOND LIMITS AND REDEMPTIONS:

An individual can purchase up to $5,000 / year in iBonds. If you are married and want to go into details 2 individuals can purchase $10,000 / year in iBonds under 2 SSN’s, electronically. You can also go physically to a bank and buy “paper” iBonds up to that same limit (this can be done at a bank). You can also purchase iBonds for kids (i.e. for college or a trust account) under their SSN up to the same limits.

UPDATE – THE LIMITS HAVE BEEN REDUCED TO $5000 / YEAR AS OF 1/1/08.

You can’t sell back your iBonds in the first year after purchase (unless there is a natural disaster or some other unique circumstance in your area); thus they are not “cash and cash equivalents”.

If you sell back your iBond within 5 years of purchase, you lose one quarter of one years’ interest. After 5 years you can redeem your iBond with no penalty.

IBONDS AND TAXES:

The advantage of iBonds is that you can defer Federal taxes on iBonds until they are redeemed, and they are immune from state and local taxes. Deferring taxes in this manner is useful because the interest that would have been taxable grows at a compound rate for the life of the bonds. In some circumstances (using them for education), the interest isn’t taxed at all when the bonds are redeemed (you should read about these at the government site, I am not an expert on the various criteria, but they seem pretty generous). Overall, iBonds receive very favorable tax treatment. IBonds might be considered as part of your college savings solution; they essentially have the same treatment as 529 accounts (you aren’t taxed on your earnings, assuming they are used for qualified education purposes). If you wanted a guaranteed portion for college you could use IBonds and get a guaranteed (albiet low, if the markets are booming) return.

IBONDS AND INFLATION:

iBonds provide protection against future inflation. If you own a bond with a fixed coupon at, say 6%, and inflation moves from 3% (current rate) to 5%, it will significantly erode the value of your bond (the price in the market will be lower if you want to sell it prior to maturity; you will receive your same coupon payments in the meantime). For iBonds, however, they automatically adjust to the inflation rate, and thus they provide a “hedge” against changes in inflation. For this reason it may be good to have them in your portfolio, because they are not correlated with your other investments (this is a good thing in “portfolio theory” terms).

Note that inflation as computed by the Treasury may not match actual inflation; they measure a basket of goods and don’t count services like college costs nor do they count real estate (an asset). Thus YOUR rate of inflation could be much higher (or potentially lower) than the rate quoted for your iBond.

SUMMARY:

You may want to look into iBonds, especially if you are in a high tax bracket or the AMT. iBonds have very favorable tax treatment, more so if your state has a high tax rate. iBonds are also attractive if you are saving for college for yourself or your children; the interest may be non-taxable if used for certain purposes.

iBonds don’t come with any expenses and are easy to buy and sell. You don’t have to deal with a broker, you can just do it all online at the Federal government site.

IBonds are currently paying VERY competitive rates – 5% – 6% depending on when you made your initial purchase – but this could easily go down if inflation slows with the cooling economy. CD’s are paying 4% or so for a couple year maturity. The brokerage CD’s have an advantage in that they can be sold in the open market while the iBonds are “stuck” for one year. Money market (which is paying below 2%) is immediately available (but less well protected, in extreme cases).

The 1 year “lock up” and 5 year “interest penalty” of one quarter means that you shouldn’t use this for your emergency fund. They might be a good component of a balanced investment program, especially if inflation rises which will erode your other bond and fixed rate investments.

Cross posted at LITGM