Bonds: Safety in the Bargain Bin
November 18, 2008 – by Richard Band
In the 2008 financial hurricane, there have been few places to hide (other than cold, hard cash). It’s a sign of the epidemic fear around us that prices of even many high-grade bonds have tanked—corporates, municipals and, yes, some Treasuries!
For investors who can accept anything less than a promise from Uncle Sam, I continue to believe that corporate paper offers the best value right now.
Yields are so high, relative to straight Treasuries, that you may well score a capital-gains bonanza when prices swing back to normal.
I still like the three mini-bonds I told my readers about in the September issue of Profitable Investing, but especially the HSBC Finance Corp. 6% Notes of 2033 (HTN).
Unlike most of its rivals, London-based HSBC Bank recently said it wouldn’t need—and thus would decline—a cash infusion from the British government. This is an important testimony to the bank’s strength. Lately, the bonds, which carry a low double-A rating from the two major agencies, were quoted at a yield to maturity of just over 8%. (Join Profitable Investing today to get my latest buy under price.)
If you prefer a basket of corporate bonds for greater diversification, consider an Exchange-Traded Fund (ETF), iBoxx Investment Grade Bond Fund (LQD). LQD attempts to mimic the entire investment-grade corporate bond market (no junk).
The fund operates on a shoestring, charging…
…only 15 cents a year per $100 under management. Monthly distributions. Recent yield: 6.3%.
TIPS From Uncle Sam
Perhaps the most surprising bond bargain, though, comes courtesy of the U.S. Treasury. Since 1997, the government has issued Treasury Inflation-Protected Securities (TIPS), bonds whose principal adjusts in step with the Consumer Price Index. (See also: "Your Recession Survival Guide.")
Thus, if you buy a $1,000 TIPS bond and consumer prices rise 3% in a year, the principal value of your bonds will increase to $1,030. The interest paid on the bond will also go up by 3%.
Last spring, investors were maniacally chasing inflation hedges, including TIPS. The real (inflation adjusted) yield on some TIPS maturities fell below zero, meaning that you were lending money to the government for a guaranteed loss of your purchasing power. Dumb!
The wheel turns, however—and now, suddenly, the crowd is worried about depression and deflation. TIPS prices have plunged, driving up real yields to as much as 3% recently.
While 3% real isn’t a Megabucks payoff, it’s a good return historically for an instrument as safe as U.S. Treasury bonds. (At 3% real, a 3% inflation rate pushes up the face value of your bonds 6% in a year.) In addition, today’s real yield is the highest since 2002, so you’re getting the best deal in six years.
The Treasury issues TIPS in three maturities: five, 10 and 20 years. Minimum purchase, if you buy them online directly from the government, is only $100. Because the 10-year is auctioned most frequently (the first month of each quarter), that’s the maturity I generally recommend for individual investors. For details on how to submit a bid, visit www.treasurydirect.gov.
The only thing I don’t particularly like about TIPS is that…
…our favorite Uncle taxes you on both the interest and the implied appreciation of the bonds each year, even though you don’t receive your principal back until maturity. To beat this nasty little surprise, I suggest holding TIPS in a tax-sheltered retirement account if you can.
Retire With Vanguard
Ah, but the Treasury doesn’t offer retirement accounts, does it?
True enough. However, you can buy TIPS through a no-load mutual fund like Vanguard Inflation Protected Securities Fund (VAIPX)—and Vanguard will gladly let you stick your fund shares in a retirement account.
Another convenience of dealing with Vanguard: You can invest odd amounts whenever you like, once you’ve satisfied the $3,000 minimum to set up an account. Vanguard collects a microscopic management fee, resulting in total operating expenses for the fund of only 20 cents a year per $100 invested.
Any disadvantages to a fund?
If you buy at auction, you’re guaranteed to get back at least your original investment at maturity, even if the U.S. economy goes into a deflationary tailspin. A mutual fund, on the other hand, is constantly buying and selling securities, so there’s no fixed maturity to the portfolio.
Still, I’m persuaded that the ease and convenience of the Vanguard fund make it the best vehicle for most investors. You won’t get rich overnight with this fund, but it will help you preserve capital when the stock market is ailing—and will protect your purchasing power when inflation rears its head.
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