Demystifying Government Bonds
Reader Question: “Should I own government bonds in my investment portfolio? Which kinds would be best? Are Treasuries really safe? Do I need to diversify bonds like stocks?”
Bonds issued by the United States Federal Government are just one of several types of bonds available to investors. Some non-governmental bond categories include: international bonds, corporate bonds and junk (high-yield) bonds. Within each of the major categories of bonds, there are also many variations. Each has its own merits and shortcomings. While some bonds may be more appropriate for you than others, it is usually a good idea to have a mix of bonds and bond types. Bond funds can be a good way to achieve this diversification.
Within the category of government debt, here are some common variations:
1. Treasuries issued by the United States Federal Government include Treasury bills (one year maturity or less), Treasury notes (three, five, seven and ten years in length) and Treasury bonds (twenty or thirty years in length). Because they are backed by the “full faith and credit” of the United States, Treasuries are considered one of the safest and most liquid securities on the planet. In particular, the “price” and “yield” on ten-year treasuries (referred to as “tens”) are closely watched by professional investors and money managers. Treasuries of various maturities are widely held by a variety of institutions, including insurance companies, pension plans, foreign investors, foreign governments and mutual funds. With very low risk, also comes a low fixed rate of interest that is set when this debt is issued. Remember, return usually travels with risk. Generally, the longer the maturity, the higher the interest. Interest earned on these investments usually isn’t taxable at the state or local level, but it is included as income for your federal tax return.
2. Treasury Inflation-Protected Securities (TIPS) are also issued by the U.S. Government and carry with them the same perceived safety and general tax treatment. According to TreasuryDirect.gov, TIPS are available in maturities of five, ten and thirty years. Like regular Treasuries, the interest rate percentage on TIPS is set when issued. However, the big distinction with TIPS is that the principal value will vary according to the Consumer Price Index (CPI is a commonly used measure of inflation). The value of these marketable securities will increase when inflation increases, hence the “Inflation-Protected” feature and label. The semi-annual interest paid on TIPS is also affected by inflation. The fixed interest rate percentage is multiplied against the TIPS’ inflation-adjusted value. If inflation occurs, the TIPS’ value and interest will go up. Conversely, if deflation occurs, the TIPS’ value and interest will go down. At maturity, the investor will receive the greater of the TIPS’ adjusted value or the original principal.
3. Municipal Bonds are bonds issued by a state, city or local government (they are often referred to as “Munis”). Cities, counties, school districts and other forms of local governmental agencies may issue bonds that are “general obligations” or “revenue” bonds to be repaid through the collection of specific government tax revenue. Under current tax law, interest earned on municipal bonds is generally not taxed at the federal, state or local level. This special tax treatment allows municipalities to borrow at a lower interest rate. It also makes munis an attractive alternative for higher income taxpayers. However, this is an individual decision for investors; some taxpayers would realize a higher, after-tax return by buying a taxable bond that carries a higher interest rate than if they had purchased the tax-free muni.
4. Agency Bonds are bonds issued by a U.S. government-sponsored agency, such as Sallie Mae, Fannie Mae and Freddie Mac. Some of these bonds get the “full faith and credit” label while others do not. Bonds without the “full faith” label typically will pay a higher interest rate. However, most bonds in this category are considered on the “safe side” of investing. Income tax treatment of these bonds varies.
5. Savings Bonds are available in Series EE/E and Series I for individual investors and are fully-backed by the federal government. Interest is taxable at the federal level (exceptions apply if the funds are used for education), but is usually exempt from state and local taxes. Interest can be reported each year or deferred until maturity. Series EE bonds earn a fixed rate of return for the life of the bond, which can be up to thirty years. Series I bonds have a fixed and a variable component, which is tied to inflation like TIPS. According to the U.S. Treasury, Series H/HH bonds were discontinued in 2004; however, they may still earn interest for up to twenty years. Check out treasurydirect.gov for more information.
While certainly less risky than corporate and high yield bonds, loading up your portfolio with government bonds could limit your returns; it also might make you a tad nervous when our political leaders squabble over deficits, debt ceiling, taxes and the printing of more money. As with investing in general, it is wise to take a balanced and diversified approach with bonds. You can purchase a variety of bonds through an investment adviser, a broker, mutual funds and online.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.