Buying TIPS On Secondary Market, Part 1: Why Secondary Market?
After reading my posts on Individual TIPS Or TIPS Mutual Fund and TIPS Auction Step By Step, some members of the Bogleheads forum asked me to write a similar guide for buying TIPS on the secondary market. If you are not familiar with inflation indexed bonds Treasury Inflation Protected Securities (TIPS), I recommend you start with a fund or ETF, then progress to participating in a few TIPS auctions before you jump into buying TIPS on the secondary market. That way you will understand better how they work. If you are ready, here we go. This is the first installment of the Guide to Buying TIPS On the Second Market. For the sake of length, this guide is limited to issues related to buying TIPS. It does not cover holding TIPS or selling TIPS.
First of all, what does buying TIPS on the secondary market mean? It means you are buying the bonds from someone who already own them. Bond dealers make a market in these bonds. They advertise a price at which they are willing to buy ("bid") and a slightly higher price at which they are willing to sell ("ask"). This is very similar to how the stock market works. Like stocks, bonds also trade on the market every day at different prices by the minute. But unlike buying stocks, retail investors usually cannot get the current market price when they buy bonds. The market price is reserved for institutions who buy and sell millions of dollars worth of bonds. Retail investors can only buy from retail brokers who often add a markup. On the other hand when you buy TIPS from auctions, you pay the same price as the institutions pay. There is no markup.
Then why should we even consider buying on the secondary market? Because most of the time we have no better choice. The Treasury department only holds TIPS auctions a few times a year (it had 8 auctions in 2008). Because the secondary market is open all year round, sometimes the prices are attractive but there is no auction. If you want to take advantage of the attractive prices, you have to buy it on the secondary market. When Treasury holds an auction, it only does it for one bond. The secondary market has all issues trading all the time. If Treasury is doing an auction for a short-term bond but you want a long-term bond, you either have to wait or you have to buy it on the secondary market.
Because you are buying on the secondary market from an existing owner, not directly from the Treasury department, you need a brokerage account. You can't do it in TreasuryDirect. Almost any brokerage account will do, although different brokerage firms will have different pricing and commission structures. I will use Vanguard Brokerage Services (VBS), Fidelity, and Schwab as examples in this guide.
TIPS are still bonds, which are not tax efficient. For that reason, they are best bought in a tax deferred account. Using a tax deferred account also makes it easier for tax reporting. In a taxable account, there are issues like Amortization of Bond Premium (ABP) and Original Issue Discount (OID). Because I have never bought individual TIPS in a taxable account, I don't profess to have a thorough understanding of how to deal with ABP and OID. Read IRS Publication 1212 Guide to Original Issue Discount (OID) Instruments and Publication 550 Investment Income and Expenses, if you are interested. I avoid dealing with them by using a tax deferred account.
In part two of this guide, we will look at how to understand the quotes.
Software picked, likely related posts:
- Buying TIPS On Secondary Market, Part 4: What to Buy
- Buying TIPS On Secondary Market, Part 2: Understand Quotes
- Individual TIPS Or TIPS Mutual Fund
Comments
4 Comments on Buying TIPS On Secondary Market, Part 1: Why Secondary Market?
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Dave on December 28, 2008 |
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Greg on March 29, 2009 |
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I have a question regarding your "Buying TIPS on Secondary Market" spreadsheet. What is actually being displayed in the "accrued interest" field? It does not appear to be a dollar amount per bond. I really like the spreadsheet, but the accrued interest calculations don't seem to match with any of my previous TIPs purchases.
Dave – You are jumping ahead. 
The spreadsheet will be introduced in part 2 of this guide. The number in the accrued interest field is percentage of principal. I added some description to make it more clear.
Interesting post, but I think you should re-examine the conventional wisdom that TIPS should only be held in a tax deferred account. It's true that you have OID and ABP issues at tax time, but if you're already resigned to using an accountant, it's not that much of an extra burden.
And the so-called "phantom" income is only a problem if it adversely affects cash flow. The increase in the bond's value (on which you pay current taxes) is real, and increases their value on sale or maturity.
Finally, as treasury bonds, they are entirely exempt from state and local taxes — which can be considerable in high tax states like NY and CA. But if they're in an IRA or 401(k), it's all taxable as ordinary income by both the US and the states when it comes out.
Greg – I agree with everything you said. I don't use a CPA myself. Using a CPA just for bonds will add a lot to my cost. I still have room in my tax deferred accounts. If I put TIPS in a taxable account, I will have to put stocks in tax deferred accounts, which makes less sense. Tax efficiency is relative. TIPS in taxable is better than corporate bonds in taxable, because of the state tax exemption on TIPS.
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