TIPS Auction Step By Step: Place Order

This is part three of the TIPS auctions series. Previous posts in this series were:

• TIPS Auction Step By Step: Know the Schedule
• TIPS Auction Step By Step: Read the Announcement

If you are interested in TIPS but you don't want to be bothered with auctions, you can buy TIPS in a mutual fund or ETF. See Individual TIPS Or TIPS Mutual Fund.

Say you decided to buy some TIPS from the auction. How do you place your order? Although it's an auction, you don't really enter a bid as you do in an eBay auction. Only financial institutions who buy TIPS in the millions bid in the auction. You get to tag along with a so called "non-competitive bid" which you means you accept the final price from the auction no matter what it is. And that's not a bad thing. Because all orders -- from the big guys, and you -- get the lowest price (highest yield) from the auction, your small non-competitive bid for $10,000 is treated the same as a $100 million bid from a bank. Isn't that nice?

If you are going to buy TIPS in a taxable account, you can buy them from TreasuryDirect. If you want to buy in an IRA, you have to use a brokerage account. Fidelity and Schwab are good brokerage choices because they don't charge any fees for buying TIPS at auction or on the secondary market. You can also buy from Vanguard Brokerage Service, but you may have to pay a $10 fee unless you have over $100k with Vanguard.

I don't have an account with TreasuryDirect so I can't show you how to place an order there.

In Vanguard Brokerage Service, it's under View and trade bonds or CDs, then Treasury Auction. Vanguard Brokerage Service requires a minimum order of 10 bonds or $10,000 in face value.

In Fidelity, it's under Trade Fixed Income, then Search Inventory, then TIPS (Auction). The minimum order size at Fidelity is 1 bond or $1,000 in face value.

Enter the number of bonds you'd like to buy (1 bond = $1,000 in face value). You cannot specify any price limit because your order will be a noncompetitive bid.

The official closing time for this 10-year TIPS auction is 12:00 noon Eastern Time on July 10, 2008. If I were to buy from this auction, I'd make sure that my order is placed before 4:00 p.m. Eastern Time on July 9, 2008. That is before the end of the business day prior to the auction date.

Next step: wait for the auction result.

TIPS Auction Step By Step: Read the Announcement

This is part two of the TIPS auctions series. The previous post in the series was TIPS Auction Step By Step: Know the Schedule.

If you are interested in TIPS but you don't want to be bothered with auctions, you can buy TIPS in a mutual fund or ETF. See Individual TIPS Or TIPS Mutual Fund.

The Treasury Department publishes auction announcements on their website. The announcement for the upcoming 10-year TIPS auction on July 10 came out today (link). It's close enough to the auction date now. If you've been thinking about it, you should decide now whether you want to buy from this auction.

1. Estimate the Yield. You will not know what the yield will be until the auction is over, but you can take a guess using the current yield on existing bonds which are traded on the secondary market. I use the Daily Treasury Real Yield Curve Rates published by the Treasury Department and the yield charts by Federal Reserve Bank of St. Louis: 5-year, 10-year, and 20-year.

The current yield on a 10-year TIPS is 1.43%. The yield from the auction should be around that number. Remember this 1.43% number is the real yield, which is above and beyond the reported inflation number. The current real yield is below the average real yield we've seen in the past few years, although the reported inflation number is higher than before. You have to decide yourself whether this is a good yield for you or not. For me, I decided to skip this auction and look at the 20-year issue coming up in about two weeks. Sometimes the yields on 10-year and 20-year TIPS are close to each other ("flat yield curve") but at this time there is a large difference ("steep yield curve"). As you can see from the chart below, the 10-year (blue line) was close to the 20-year (red line) in 2006 and most part of 2007. Lately it has dropped below the 20-year by quite a bit.

If you decide to buy the 10-year TIPS and you'd like to get a handle on how much money you will need, you will need some data from the announcement to do the calculation.

2. New Issue vs. Reopening. The 10-year TIPS this time is a new issue, which means it's a brand new bond the market has never seen before. If it were a reopening, it will say so in the announcement. The next auction for a 20-year issue is going to be a reopening, which means the Treasury Department will issue additional bonds with the same terms as the existing bonds they sold before. A difference between a new issue and a reopened bond is the stated interest rate or the "coupon" rate. The coupon rate on a new issue is determined by the auction. It's set to the nearest 0.125% below the high yield in the auction. The purchase price is also adjusted accordingly. For a reopened bond, the coupon rate is fixed. The auction will determine only the price. Another difference between a new issue and a reopened bond is the inflation adjustment. Because a reopened bond has been on the market for some time, it has accumulated some inflation adjustment. A reopened bond typically costs more in nominal dollars unless its coupon is significantly below the current market yield.

3. Important Dates and Index Ratio. The announcement contains many data points but only these are relevant for estimating how much a bond will cost.

• Issue Date: the date you will officially own the bond
• Maturity Date: the date they will pay you back
• Dated Date: the date from which the interest payment will be calculated
• Interest Rate (reopening only, not applicable to new issues): the coupon rate
• Index Ratio: the principal adjustment factor

4. Estimate Dollars Needed. Plug in the data you gathered from above together with your yield estimate into my TIPS pricing spreadsheet. You will see roughly how much you will need for each bond. By my estimate, with the yield within +/- 0.10% from 1.43%, you will need between $988.82 and $1,000 per $1,000 face value.

Next step: place order if you are going to buy it.

TIPS Auction Step By Step: Know the Schedule

There will be two auctions for Treasury Inflation Protected Securities (TIPS) in July. I will follow these auctions in a series posts. This is the first post in this series.

Tentative Auction Schedule. How do you know when they will hold an auction for what? The Treasury Department publishes a tentative auction schedule a few months in advance. Although it is said to be tentative, the schedule is pretty much set once it's published. I've never seen an auction being canceled or moved. The schedule includes auctions for Treasury bills, regular ("nominal") Treasury notes and bonds and TIPS. The TIPS auctions are shaded in blue so they are easy to spot.

There are three dates in the schedule.

1. Announcement Date. The Announcement Date is when they publish a formal announcement. The announcement will contain more detailed information about the bond being auctioned. You can't place an order until the Announcement Date.

For the next two auctions, we know the Announcement Dates are Monday July 7, 2008 for a 10-year TIPS issue and Thursday July 17, 2008 for a 20-year TIPS issue.

2. Auction Date. The Auction Date is the date when they actually hold the auction. The cutoff time is specified in the announcement, usually around 12:00 p.m. Eastern Time. Your order must be received on or before the auction cutoff time on the Auction Date. If you place order through a brokerage account, the brokerage firm may impose its own cutoff time before the official cutoff time to allow itself time for transmitting your order to the Treasury. For example the current cutoff time at Vanguard Brokerage Service is 9:30 a.m. Eastern Time for online orders or 10:00 a.m. Eastern Time for phone orders. To play it safe, I usually place the order at least one business day before the Auction Date.

For the next two auctions, the actual Auction Dates are Thursday July 10, 2008 for a 10-year TIPS issue and Tuesday July 22, 2008 for a 20-year TIPS issue.

3. Settlement Date. The Settlement Date is the date when you actually pay and receive the bonds. You must have enough cash ready on this date.

For the next two auctions, the Settlement Dates are Tuesday July 15, 2008 for a 10-year TIPS issue and Thursday July 31, 2008 for a 20-year TIPS issue.

Next step: wait for the announcement on July 7.

Bought 20-Year TIPS

I bought more TIPS today. For people not familiar with TIPS, they are inflation indexed bonds. See previous post TIPS: Inflation Linked Bonds for more information.

Like everybody else, I feel the threat of higher inflation. A tank of gas cost me $58 last week. For the longest time it was $30-35. I still remember the exact gas station where I filled up when it crossed $40 for the first time a few years ago. Pretty soon it will be over $60. I don't even have a big car.

The price for inflation protection actually came down lately. The following chart shows the yield on 20-year TIPS (click on it to enlarge). A higher yield means a lower price.

Source: Federal Reserve Bank of St. Louis.

I bought some 20-year TIPS at a yield of about 2.2% (red line in the chart). Although it's way below the 2.8% peak level in summer 2007, the yield has been much lower this year. It was at a low of 1.6% just 3 months ago. 2.2% is in the middle between the recent peak and trough. So I think it's a reasonable price for more inflation protection. I chose 20-year TIPS because they have the highest yield (lowest price) and they offer inflation protection for the longest time.

I bought on the secondary market through Vanguard and I had to pay a $40 commission. It's OK because I want to lock in to this price now. Fidelity and Schwab don't charge a commission for buying TIPS online. The next TIPS auctions will be on July 10, 2008 for 10-year TIPS and July 22, 2008 for 20-year TIPS. If the yields remain attractive, I will buy more then.

Related Post: Individual TIPS Or TIPS Mutual Fund

See Also:

• Bogleheads Wiki, Treasury Inflation Protected Securities

Imported Spreadsheets to Zoho

I mentioned in another post that I started using Zoho recently. Zoho offers a suite of "office" software online. They have online word processor, spreadsheet, presentation and many other types of software that traditionally resides on a local computer. Having these software online lets me access my documents from anywhere. It also lets me share my documents with the world without requiring Microsoft Excel. My experience so far has been very good. I have created a few Excel spreadsheets and linked to them on this blog in the past. Zoho's spreadsheet program correctly imported them without glitch. Here they are if you'd like to use or bookmark them:

ESPP Rate of Return - Calculates the annualized return from Employee Stock Purchase Plan (ESPP) purchase and sale. See previous post Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal.

TIPS Pricing - Estimates how much cash you will need for buying TIPS at auction. See previous post TIPS: Inflation Linked Bonds.

Not Too Thrilled About 1.2% I Bonds

A reader asked a few weeks ago if I'd write something about the Series I Savings Bonds (or "I Bonds" in short). I was thinking of doing it but I now see Jonathan at My Money Blog already did a very good job on this topic. There is also a long thread on the Bogleheads forum about it.

If you are not familiar with I Bonds, please read:

• I Savings Bonds
• I Savings Bonds In Depth
• Comparison of TIPS and Series I Savings Bonds

I'm not going to repeat what Jonathan and Bogleheads already wrote. The gist of it is that if you buy I Bonds at the end of April 2008 and hold the bonds until July 1, 2009, you will earn about 4.5% a year for holding the bonds for 14 months. Think of it as a 14-month CD at 4.5% APY, state income tax free. If you decide to hold longer, you will earn 1.2% plus inflation adjustment.

Is it a good deal? It is a good deal if you shift over existing money in bonds or if you would otherwise buy a CD. The highest yielding 1-year CD is about 4%. Money market funds yield less than 3% which may go up or down.

I will still buy the bonds but I'm not too thrilled about them for several reasons.

First you can't really use I Bonds as an emergency fund because there is absolutely no possibility to redeem them in the first 12 months, not even if you are willing to forfeit interest. For I Bonds bought in April 2008, the earliest you can get your money back is April 1, 2009. You have to be sure you have adequate money elsewhere and you won't need the money before that date.

Second if you are thinking of buying I Bonds but you are not contributing the maximum to your 401(k) and Roth IRA, you are better off increasing your contribution to your 401(k) and Roth IRA. Although I Bonds are tax deferred, they are like a non-deductible IRA. A non-deductible IRA should have a lower priority than 401(k) and Roth IRA. I Bonds are OK if the money is intended for short-term savings, not as a long-term investment for retirement.

Third, the purchase limit makes the difference really small versus a 1-year CD. The maximum amount a person can buy is $5,000 in electronic bonds and $5,000 in paper bonds, for a total of $10k. A married couple can buy $10k for each spouse. Even at $20k, an extra 1% over a 1-year CD is only $200, before federal income tax. After tax it's $150 or less. It's nice to have extra $150 but it's hardly earth shattering.

Finally, if you are thinking of buying I Bonds because you are hesitant to invest in the stock market, that's market timing which usually doesn't work. Just last week, the stock market went up 4.3% in a week. It'll take a whole year for I Bonds to do that. I know I'm comparing apples to oranges and it's unlikely stocks will go up 4% every week, but it's not inconceivable that in a few years you will find you would've been better off adding the money to your investment portfolio rather than chickening out into I Bonds.

Let me share some personal experience. I bought I Bonds in September 2001 at 3.0% plus inflation. These bonds are considered "golden" because many think rates will never be that high again (the current rate is only 1.2% plus inflation). A $100 3.0% I Bond bought in September 2001 is worth $144 today. If $100 was put into a balanced fund like Vanguard STAR Fund at the same time, it'd be worth $164 today, or 14% more. I also bought I Bonds in March 2003 at 1.6% plus inflation. A $100 I Bond bought then is worth $125 today. The same investment in Vanguard STAR Fund would be worth $173 today. That's 38% more. I'm still holding these I Bonds with no regret. I'm just showing you that buying I Bonds should not be a substitution of investing in a diversified stocks/bonds portfolio.

In the end I will still buy some I Bonds before the end of April. I will shift some money currently in tax-exempt funds into I Bonds. In doing so I will pick up an extra $100 or so. But that's it. It's not something worth getting too excited about. My fresh cash will still go to the stock market.

A Business That Punishes Its Largest Customers

Here's a Jeopardy question.

A financial service charges no fee if you have less than $100,000 with them. If your account has $100,000 or more, they charge you $100 a year account maintenance fee. If you create multiple accounts, each with less than $100,000, then you will pay no fee for all your accounts.

The answer: What is Legacy Treasury Direct?

"Legacy Treasury Direct is a program in which investors buy Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS) directly from the U.S. Treasury, without a broker.

Established in 1986, Legacy Treasury Direct allows customers to conduct transactions through the Web, over an automated phone system, or by mail.

... ...

If your account holds more than $100,000, we charge an annual fee of $100."

Most financial services reward their larger accounts with freebies or lower fees because larger accounts are less costly to maintain and more profitable to the business. Not U.S. Department of Treasury. They punish their larger customers with a fee other customers don't pay. If you break up your large account into several small ones, then you avoid the fee altogether. Don't you love how our government runs its business?

This question came up on Bob Brinker's Money Talk program on the radio two weekends ago. A woman caller said she got a notice from the Treasury Department about the fee being increased from $25 a year to $100 a year(!). She asked Brinker what to do. Bob Brinker totally blew the question. He said she would have to transfer the account to a broker and pay maintenance fees and commissions or buy CDs instead of Treasurys. Not true. There are several options for avoiding the fees and still investing in Treasurys if that's what the woman wants.

• Stay with Legacy Treasury Direct but break up the account into two or more smaller accounts, each with less than $100k.
• Migrate to the new TreasuryDirect, although she will lose the ability to conduct business by phone or by mail because the new TreasuryDirect is online only.
• Transfer the Treasury securities to Fidelity or Schwab, neither of which charges annual maintenance fees or commissions for purchasing Treasury securities online at auction or on the secondary market.

You can't trust what's being said on the radio or TV, even if the person sounds like an expert.

How a Callable Bond Worked

The Federal Farm Credit Banks (FFCB) bond I bought in February finally got called. For more info about federal agency/GSE bonds, see my previous post Agency Bonds for Higher Yield Over Treasury.

A callable bond means after a certain date, the bond issuer can redeem the bond early, before the bond's stated maturity date. When the issuer exercises that option, the bond is "called." It's similar to refinancing a mortgage, only in this case I'm the lender while the bank is the borrower. It makes sense for them to call the bond because they can borrow money at a lower rate now. Actually I'm surprised they didn't call it sooner. My 9-year 5.81% FFCB bond became callable after May 22, 2007. Since then, the 10-year Treasury yield went down from 4.8% to 4.0%. Yields on money market funds and online savings accounts also went down. Through this time, my bond was earning 5.81%, state income tax free, until it was called last week.

 

Was that FFCB bond a good deal then? Well, yes and no. For the 9-1/2 months I owned the bond, my principal was never really at risk. I earned more interest than I could earn from any other similar low risk investment. After all taxes are taken into consideration, the yield on the bond was higher than that on any money market fund, bank savings account, or CD. It was a good investment. However, when I bought that 9-year FFCB bond in February, I could've bought a 10-year 4.625% Treasury note instead. The price at that time was 99.09 for a yield of 4.74%. Today the price of this note has become 104.85. Although the Treasury note paid 1.2% p.a. less than the FFCB bond, its price has gone up by 5.8%, which more than makes up for the lower interest. So I could've done much better.

That's how a callable bond works. If you buy a callable bond, you get a higher yield because you give the bond issuer an option to redeem the bond early. That option has value. That's why they are willing to pay a higher interest rate. If the market yield goes down after you buy the bond, your bond may be called and you give up the upward price appreciation you would otherwise get from a call-protected bond. If the market yield remains level, you collect the extra interest as your compensation for giving the borrower the early redemption option. If the market yield goes up, you still collect the higher interest and you lose less to the price depreciation.

I haven't decided what to do with the proceeds yet. I'm thinking of buying another callable agency bond like this 11-year FFCB bond paying 5.60%, callable after 3/11/2008. Because the interest rate has come down, there is less call risk now than earlier this year. Or I can add more money to my stock ETFs, either the Russell 2000 Value ETF (IWN) or the Vanguard REIT ETF (VNQ).

Tax Equivalent Yield Calculator Updated

Since I introduced my tax equivalent yield calculator in my post Which Vanguard Money Market Fund? in April, I've had very good feedback from people who used it. People told me it's the only calculator on the web that takes into consideration for Treasury fund, the standard or itemized deductions, and AMT. It has been viewed more times than any other post on my blog.

I added a new section for AMT-free tax exempt money market funds. Fidelity is the only place I know which offers this kind of funds. These funds do not invest in private activity bonds which are subject to the AMT. The AMT-free funds yield slightly lower than funds which include private activity bonds. But if you are subject to AMT, you may fare better in an AMT-free fund after you take into consideration the AMT.

For example, at the time I'm writing this post, the yield on Fidelity California AMT Tax-Free Money Market Fund (FSPXX) is 3.57%. The yield on Vanguard California Tax-Exempt Money Market Fund (VCTXX) is 3.73% but the Vanguard fund has 17.8% of its holdings subject to AMT. For a California resident in 35% AMT bracket and 9.3% California state income tax bracket, the Fidelity AMT free fund is better after tax. The Fidelity AMT free fund requires $25,000 minimum initial investment, although you can drop down to $10,000 after the initial investment.

	Quoted Yield	% in Private Activity Bonds	After Tax Yield	Tax Equivalent Yield
Fidelity CA AMT Free Money Market Fund (FSPXX)	3.57%	0%	3.57%	6.41%
Vanguard CA Tax-Exempt Money Market Fund (VCTXX)	3.73%	17.8%	3.50%	6.28%

The calculator is not limited to only Vanguard or Fidelity. You can use it for funds from any other company. Just enter the yield numbers for the funds you are considering. Following suggestions from Ron Lieber and Ari Weinberg at FiLife, I also changed wording on a question in the calculator to make it clearer. You can get to the updated calculator from the original post or access it directly from the hosting site or the alternate hosting site.

Although the calculator was made for money market funds, it works for regular bond funds too. Well, money market funds are bond funds, the very short-term kind. Bond funds also have different tax characteristics (if held in a taxable account, of course). For example here's a rundown on a few bond funds for the same California resident in 35% AMT bracket and 9.3% California state income tax bracket:

	Quoted Yield	After Tax Yield	Tax Equivalent Yield
Vanguard Intermediate-Term Bond Index Fund (VBIIX)	5.03%	2.80%	5.03%
Vanguard Intermediate-Term Treasury Fund (VFITX)	4.19%	2.72%	4.89%
Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX)	3.88%	3.88%	6.96%

For this fictitious California resident, the fully taxable bond fund has the highest quoted yield but it has lower yield after tax. The California state tax exempt fund has the lowest quoted yield but it has the highest yield after tax.

Of course when you choose a bond fund, you will have to consider other factors including credit quality and duration. These topics are out of the scope of this post. Please refer to two useful brochures from Vanguard on bond funds:

• Investing For Income
• Investing For Tax-Exempt Income

Ideally you want to place your bond funds in a tax deferred account so you don't have to worry about the difference in tax treatment. But if you are using a bond fund for an intermediate term goal, or if you don't have enough room in your tax deferred accounts, calculating the after-tax yield or the tax equivalent yield can help you make the decision.

I-Bonds Fixed Rate Pre-Guess for November 2007

I have written off I-Bonds as an attractive investment or even as a substitute for a 1-year CD. In case someone is still interested in I-Bonds, here is my pre-guess for the fixed rate to be announced on November 1, 2007.

For the inflation adjustment part, we have 5 out of 6 months of inflation data. If the September CPI comes out on October 17 at the same level as in August, the semi-annual adjustment will be about 1.25%.

For the fixed rate part, I use the 5-year TIPS real yield as reference. The current 5-year TIPS real yield is about 2.2%. It was 2.06% on April 30, right before the previous announcement. My guess is that the I-Bonds fixed rate will stay the same at 1.3%, or go up to 1.4% if the Treasury department feels generous.

All together, the composite rate will be 3.8% - 3.9%, still lower than many other alternatives. Another big yawn.

Should the Fed Cut Interest Rates?

Everybody on Wall Street is waiting for what the Federal Open Market Committee will do to interest rates when they meet on Sept. 18. The Federal Funds Rate options market now implies a 50% probability for a .50% cut and a 30% probability for a .25% cut. The probability for the Fed Funds Rate remaining unchanged is less than 10%.

[Source: Federal Reserve Bank of Cleveland, as of Sept. 9, 2007.]

Should the Fed lower interest rates? I think they shouldn't.

First of all, the Fed stated again and again in the past they wanted to curb inflation. They can't declare victory yet. Inflation isn't low. The Consumer Price Index in December 2006 was 201.8. It was 208.299 as of July 2007, the latest available data point. This means for the first seven months of this year, inflation was 208.299 / 201.80 - 1 = 3.22%. 3.22% inflation in seven months is terrible. If this trend continues, we will have annual inflation rate above 5%. That's simply too high. Inflation isn't under control yet. The Fed shouldn't let their guard down.

Second, the economy is doing fine. GDP growth is healthy. Unemployment is low. The latest jobs number is a one time glitch. Except for the mortgage market, the rest of the economy is doing well. Apple's iPhone still sells like hot cakes, which means consumer spending isn't weak. The economy is doing fine on its own. It doesn't need stimulating. There's no need to cut interest rate.

Moreover lowering interest rate now will send the wrong signal. Wall Street wants a rate cut so their risky subprime mortgages will be worth more because bond prices go up when interest rates go down. Cutting the interest rate now will let the subprime lenders off the hook easily. We can't have the Fed come to the rescue every time there is a stock market sell off. Or else they will just take on more and more risks and expect to be bailed out by the Fed. Many people believe that the Fed's lowering the interest rate all the way down to 1% during the most recent bear market planted the seeds for the housing market bubble and the current subprime problem. I agree with that assessment. The Fed panicked. They cut the interest rate too low and raised it too slowly after the short recession was over. For a great article on how the Fed's policy led to the easy credits and today's subprime problem, please read How Credit Got So Easy And Why It's Tightening from the Wall Street Journal.

Will the Fed cut interest rate in their September 18 meeting? Given that the market predicted a less than 10% probability of the rate not changing, I'd say they probably will cut it. The market participants collectively are usually a lot smarter than anybody else. But I'll be very disappointed if the Fed caved in to pressure from Wall Street. Even if the Fed thinks the economy needs some boost, they should wait until their October meeting. Waiting merely one month won't hurt the economy. But it will send a strong signal to Wall Street and politicians that the Fed makes its decisions independently. The Fed is responsible for the economy. It's not responsible for putting a floor under the stock market. They should make that point very clear.

Risks in Money Market Funds

Reader Kim asked, referring to my post Which Vanguard Money Market Fund? in April,

"In light of the current sub-prime meltdown, some people are questioning whether they should move out of Vanguard Prime MMF into something safer, like Vanguard Treasury MMF. Your blog helps calculate return under different scenarios but leaves off the risk aspect.  Would it be of interest to you to add in some additional calcs. to quantify the risk v. return aspect to give a better picture on each fund?  I am very interested in this issue because it is often neglected.  Thanks!"

I left off the level of risks in the different Vanguard money market funds because I thought (and still think) that difference in risks is only theoretical. The Vanguard Treasury Money Market Fund (VMPXX) and the Vanguard Admiral Treasury Money Market Fund (VUSXX) invest only in Treasurys. They are the safest because the Treasurys are guaranteed by the full faith and credit of the U.S. government. The Vanguard Prime Money Market Fund (VMMXX) invests in high quality, very short term debt issued by corporations. It also holds Certificates of Deposit with banks both in the U.S. and overseas. See the list of holdings from the SEC filing as of May 31, 2007. The various tax-exempt money market funds invest in debt issued by state and local governments and their agencies. These are still safe because Vanguard only invests in issues with high credit quality.

If someone is really worried about these money market instruments defaulting, they should look at the stocks part of their portfolio because those companies would have to go bankrupt first before they default on their money market debt. If you invest in the stock market at all, don't worry about the money market fund. If there were massive defaults, you would likely lose a lot more money from the stock market than from money market funds. In such a scenario, money market funds would be the least of your concerns. 

I don't worry about the theoretical risk difference between the different Vanguard money market funds. However for many people the extra safety afforded by the Treasury money market fund comes for free. The Treasury Money Market Fund yields a bit less, but because the interest income on Treasurys are exempt from state and local income tax, its after-tax yield can be higher, or at least not that much lower, than that of the Prime Money Market Fund. When the Treasury Money Market Fund yields higher after tax, it's a no-brainer. Even if it still yields a bit less, the difference you give up for the peace of mind may very well be worth it. It depends on how much you have in the money market fund. For example if a Texas resident (no state income tax) in 25% federal income tax bracket has $10,000 in a money market fund, the difference between the interest earned from the Treasury and the Prime money market funds is $33 a year after tax. Although I'd be fine investing in the Prime Money Market Fund, if giving up $33 a year gives someone the peace of mind, I have no problems with it. We blow much more than $33 a year on many other stuff.

10-Year TIPS Auction on July 12

The Treasury department announced today there will be an auction for $8 billion 10-year TIPS on 7/12/2007. The latest yield curve data show the 10-year yield at 2.79% as of 7/6/2007. If the yield holds at this level, it's very good. I think the auction result will be a few basis points higher, perhaps at the 2.85% level. According to the action plan I made last month, I will skip this auction and look at the next auction on 7/24/2007 for the 20-year issue instead. If it hits 3.0%, I will buy some. If not, I will wait.

Agency Bonds for Higher Yield Over Treasury

I invest my short-term money in a Vanguard money market fund and Treasury Bills. There are many great posts by other bloggers about purchasing T-Bills. I'm not going to repeat the topic. See posts by Jonathan, Ricemutt and Sun.

Earlier this year, I also tested water with Agency bonds for slightly higher yield over Treasury for the same maturity. Agency bonds are bonds issued by a federal government agency or a Government Sponsored Enterprise (GSE). A GSE is a entity not officially part of the federal government but created by laws enacted by Congress. Although most Agency/GSE bonds don't have the guarantee by the full faith and credit of the U.S. Treasury, they are still rated AAA. You get a slightly higher yield for taking slightly higher risk. Some of the Agency/GSE bonds enjoy the same state income tax exemption as Treasurys. Since I live in a state with high state income tax, I only buy bonds from these issuers, namely

• Federal Home Loan Banks (FHLB)
• Federal Farm Credit Banks (FFCB)
• Tennessee Valley Authority (TVA)

because the interest on their bonds are exempt from state income tax. I avoid bonds from these other issuers because their bonds are fully taxable by the states:

• Federal National Mortgage Association (FNMA or "Fannie Mae")
• Federal Home Loan Mortgage Corporation (FHLMC or "Freddie Mac")
• Government National Mortgage Association (GNMA or "Ginnie Mae")

Fidelity sells new-issue bonds from Federal Home Loan Banks and Federal Farm Credit Banks at face value ("par") without any commission or fees. Some bonds are callable, meaning that the issuer can pay back the bonds, with interest, sooner than scheduled, but only after a certain date ("call date"). Some bonds are "call protected" which means that the issuer cannot prepay before the bonds mature.

The first GSE bond I bought was a 5-month call protected bond from FHLB. The interest rate was about 0.20% higher than comparable T-Bills. After 5 months, I got paid principal plus interest, just like a CD. Very straight forward. For example today Fidelity has a 6-month call protected FHLB bond at 5.25%. The investment yield on the 6-month Treasury Bills auctioned yesterday was 5.01%. The FHLB bond is 0.24% higher than the comparable Treasury.

The second GSE bond I bought was a 9-year bond from FFCB. It is callable on any day 3 months after the issuance date. It has an interest rate of 5.81% while at the time of the purchase the 10-year Treasury was yielding 4.69% and 3-month Treasury was yielding 5.17%. It looked like a win-win: If it's called I get higher than the 3-month rate. If it's not called, I get higher than the 10-year rate. The call date came and went. The bond hasn't been called yet. I'm still enjoying 5.81% state tax free, until they decide to call it. [Update: see how this bond turned out in How a Callable Bond Worked.]

What's the catch then? For short term, non-callable GSE bonds, there isn't much as long as you are willing to hold them to maturity. They usually come in terms between 3 months and 1 year. The minimum purchase is either $5,000 or $10,000, as opposed to $1,000 for T-Bills. I haven't seen a 28-day GSE bond offered at Fidelity online although someone on Fatwallet Finance said you can buy those by phone with a $200,000 minimum purchase (way out of my league). There's a slightly higher risk than Treasury but I don't think it's material because FHLB and FFCB bonds are AAA rated. For longer term callable GSE bonds, you also have to be willing to hold them for the full term and live with the uncertainty of the call. If the interest rate goes down, they are more likely to call the bonds. You get your money back, plus interest. You just don't have the higher interest for as long as you wanted. I don't see it as a big deal either. Interest rate low? Time to move on to something else.

While it's nice to have a slightly higher yield over Treasury of comparable terms, with the same state income tax exemption, you also have to put things in perspective. Unless a large amount is involved, a 0.24% advantage is not much in dollars. 0.24% on $50,000 is $120 a year, before tax, perhaps somewhat meaningful. 0.24% on $5,000 is only $12 a year before tax.

Reference:

• The GSE Debt Market: An Overview at InvestingInBonds.com
• Agency/GSE New Issue Offerings at Fidelity Investments

Individual TIPS Or TIPS Mutual Fund

[Last updated on March 25, 2008: Treasury lowered the minimum purchase of individual TIPS from $1,000 to $100. Fidelity and Schwab no longer charge commission for online orders of individual TIPS.]

A reader asked about TIPS mutual funds in the comments to my action plan for TIPS. Just like there are mutual funds which invest in stocks, there are mutual funds which invest in TIPS. The Vanguard Inflation-Protected Securities Fund (VIPSX) is a popular choice because of its low 0.20% expense ratio. Similar funds from Fidelity or T. Rowe Price charge double what Vanguard charges. There is also an ETF iShares Lehman U.S. Treasury Inflation Protected Securities Bond Fund (TIP), whose expense ratio is also 0.20%, but it only makes sense if you have a no-commission brokerage account like WellsTrade or Zecco because otherwise you would have to pay brokerage commission for each trade. There's another newer ETF SPDR Barclays Capital TIPS ETF (IPE) with 0.1845% expense ratio. Vanguard also filed an application with the SEC for an ETF based on its fund. It's not on the market yet.

Buying TIPS through a mutual fund (or ETF) is a good idea, because it gives you a lot of convenience for a small price. Pros for investing in a fund include:

1. Buy at any time without a transaction fee. Although there is no charge to buy individual TIPS bonds at auctions through certain places (Fidelity, Schwab or TreasuryDirect), the auctions only come up a few times a year. If you want to buy individual TIPS bonds when there's no auction, you must use a brokerage account. Some brokerage firms charge a commission for bond orders. Fidelity and Schwab charge nothing for online orders. Vanguard charges minimum $40. There is also a small bid-ask spread when you buy on the secondary market. Or you will just have to wait until the next auction, but the prices will have changed by then.

2. Instant diversification. A mutual fund holds about 20 bonds with different maturities. You get all of them with one purchase. If you are buying individual TIPS bonds, they don't come on auction at the same time. You must wait for the turns or pay commissions to establish your positions.

3. Sell at any time without a transaction fee. If you have individual TIPS bonds, there is no fee if you wait until they mature. If you want to sell before they mature, you may have to pay a commission. TreasuryDirect charges $45.

4. Buy or sell for any random amount. Minimum additional investment in the Vanguard TIPS fund VIPSX is $100. Want to buy $456.78? No problem. The individual TIPS bonds are in $100 increments.

5. Reinvest interest payments immediately without charge. If you have individual TIPS bonds, you must hold the interest payments elsewhere. Reinvesting in another TIPS bond is also subject to the auction cycles and $100 increments.

6. Easy tax handling (for taxable accounts only). TIPS bonds in a taxable account have a unique phantom income issue. I won't go into the details here. The fund shields that issue away from you. You receive regular dividends from the fund and get a 1099 at the end of the year, just like any other mutual fund.

All of these convenience come at a cost of 0.20% a year for the Vanguard TIPS fund VIPSX. That's $20 a year for each $10,000 invested. If you have $100,000 or more for TIPS, Vanguard's fund offers Admiral shares which cut down the expense ratio to 0.11%, or $11 a year per $10,000 invested. It seems very reasonable to me. Why bother buying individual bonds then? Because,

1. Low expenses. If you buy at auctions and hold to maturity, there is no extra expense. If you buy a large amount of TIPS, you can save money by building your own fund with individual bonds. Fidelity, Schwab and TreasuryDirect charge no fee or commission if you buy at auctions and hold to maturity. Fidelity and Schwab don't charge commission for secondary market orders either. Even if you buy on the secondary market, as long as you buy in chunks of $10,000 or more and hold the bonds to maturity, a one-time commission is a lot less than having to pay an ongoing expense year after year.

2. Be your own fund manager. You get to decide what maturity you buy. When you buy fund shares you buy a basket. The fund's (experienced) managers decide what to buy and when to buy. With individual bonds, now you become the (amateur) manager for your own fund. Want short maturities? Buy 5-year notes. Want long ones? Buy 20-year bonds.

I've bought all of these before, the Vanguard TIPS fund VIPSX, the iShares ETF TIP, and the individual bonds. They all worked the way they're supposed to. Right now I'm buying individual bonds and holding them to maturity because I want to save the ongoing expenses.

Buying at auctions and holding to maturity is not that hard. You just have to know when the auctions are coming up and make a decision on whether you want to participate. The Treasury department publishes a tentative auction schedule a few months ahead. If you buy at least $10,000 at a time, the secondary market is also very cost effective. If the the yield becomes attractive between auctions, I will not hesitate buying on the secondary market. After all, for a 20-year bond, paying a one-time 0.2% commission beats paying a 0.2% expense every year for 20 years.

TIPS Action Plan

Since I wrote about TIPS yield on the rise, TIPS yield continued to climb.

If you are not familiar with Treasury Inflation Protected Securities or TIPS, which are inflation indexed treasury bonds, please read my previous post TIPS: Inflation Linked Bonds.

I'm amazed by how much the real yield rose in a very short time. 3.0% isn't too far out of reach. Here's a chart showing the yield changes since May 1, 2007, a mere a month and half ago.

As the yields go up, TIPS become more attractive both relative to regular ("nominal") bonds and also on an absolute basis. Larry Swedroe, co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need, suggested a shifting strategy toward TIPS in his book which he also shared in a post on the Bogleheads forum.

Real Yield	% of bonds in TIPS	Maturity
< 1.5%	0%	< 5 Years
1.5% - 2.0%	0 - 25%	5 Years
2.0% - 2.5%	25 - 50%	10 Years
2.5% - 3.0%	50 - 75%	15 Years
> 3.0%	75 - 100%	20 Years

I modified Mr. Swedroe's strategy table and came up with my own. Basically I'm shifting more slowly towards TIPS than what Mr. Swedroe suggested because I "require" or "demand" higher yields. Here's my plan:

Real Yield	% of bonds in TIPS	Target Maturity	Action
< 2.0%	0%	N/A	Not interested in TIPS
2.0% - 2.5%	25%	5 years	Buy 5-year
2.5% - 3.0%	50%	5 years	Buy more 5-year
3.0% - 3.5%	75%	10 years	Buy 20-year
3.5% - 4.0%	100%	15 years	Buy more 20-year
> 4.0%	100%	20 years	Sell 5-year, buy 20-year

The yields right now land in the highlighted row. I already completed my action step. I bought more 5-year TIPS when the yield reached 2.5% on June 1, albeit a little too soon in retrospect, but when I bought it there was no way of knowing whether yield reached a top.

My next milestone is 3.0%. There are two scheduled TIPS auctions in July. A 10-year new issue on July 12 and a reopened 20-year on July 24. If the yield on the 20-year TIPS reaches 3.0%, depending on how close the auction date is, I will buy more 20-year either at the auction or on the secondary market.

TIPS Yield On the Rise

When I sold two bond ETFs in March for house cleaning, I intended to buy more 5-year TIPS in the auction in April. However when April came, the expected yield wasn't attractive to me. So I took a pass and parked the money in Treasury Bills. Lately, the TIPS yield has been rising. The 5-year TIPS auction on April 24, 2007 came out to 2.114%. A little over a month later, the yield rose to 2.58% on June 1, 2007. Although it's still below the 2.691% yield I got last October, it's pretty close. According to this chart from St. Louis Fed, the current TIPS yield is close to the highest level in the last few years.

Source: Federal Reserve Bank of St. Louis.

If you are not familiar with TIPS, please note the yield numbers are after inflation.

Why did this happen in such a short time? I have no idea. The market determines the prices. We get to decide whether we want it or not at that price. 2.1% in April wasn't attractive to me. 2.5% is now. The next TIPS auctions are in July, for 10-year and 20-year terms. I prefer 5-year and the next auction for 5-year TIPS notes won't come until October. Because I want to lock in the attractive 2.5% yield now, I bought some 5-year TIPS on the secondary market. I had to pay a brokerage commission, but the commission only reduces my yield by about 3 basis points or 0.03%.

What does the higher yield mean in dollar terms? In real dollars, investors paid $99.465161 per $100 on 4/30/2007 when the auction settled. I paid $97.4375 for the same bond on 5/31/2007. A price decline of 2% in one month looks trivial for stocks -- sometimes stocks go up and down by 2% in a day. For bonds, it's a bigger deal because it's like getting an extra year of interest only a month later.

References:

• TIPS: Inflation Linked Bonds
• RSS feed for daily TIPS yield curve

Tax and Inflation Penalize Savers

I bought some EE savings bonds in May 2002. Today is the first day I get to redeem them without penalty. Each $100 saved back then is now worth $118.40. This is one of my worst investments in the last five years. My return on these EE savings bonds is 3.44% a year over the last 5 years. Inflation, measured by the Consumer Price Index, averaged 2.81% a year in the same period. So it looks like I came out slightly ahead of inflation. But wait, I have to pay tax on the interest. After tax and inflation, I lost money. I loaned my hard earned money to the U.S. Treasury for 5 long years. Now they paid me back less than what I loaned them. How sad. Tax and inflation penalize savers. No wonder Americans are said to have low savings rate. I think taxing inflation is wrong.

I-Bonds Fixed Rate for May 1, 2007

The Treasury Department announced today the new fixed rate for I-Bonds sold between May 1, 2007 and October 31, 2007. I previously guessed that the fixed rate would remain unchanged at 1.4% and I thought any change would be on the down side. Someone on the old Vanguard Diehards forum guessed it would go up to 1.8%. And alas, we were all too optimistic. The Treasury Department reduced the fixed rate on I-Bonds to 1.3%. The composite rate, including the inflation adjustment, will be 3.74% for I-Bonds sold in the next 6 months. Neither the 1.3% fixed rate nor the 3.74% composite rate is attractive relative to alternatives such as TIPS, T-Bills, money market funds or bank savings accounts. Goodbye, I-Bonds, don't call me until your fixed rate reaches 2.0%.

I-Bonds Rate Guess for May 1, 2007

The Bureau of Labor Statistics released Consumer Price Index data for March 2007 this morning. Now I can turn my pre-guess for I-Bonds Rate for May 1, 2007 into a real guess.

Over the 6-month period which will be used for determining the next inflation adjustment, the CPI rose by 1.21%. If the Treasury department keeps the current fixed rate unchanged at 1.4%, the composite rate for I-Bonds sold between May 1 and October 31, 2007 will be 3.84%. That rate is lower than what you can get from bank savings accounts, money market mutual funds and Treasury bills.

My guess is that the new fixed rate on May 1, 2007 will be unchanged. This will slightly narrow the gap between I-Bonds fixed rate and the real yield on 5-year TIPS. When the yield on 5-year TIPS rose last year, I-Bonds didn't follow. Now the TIPS yield is down a little bit, I-Bonds probably won't follow either.

I-Bonds have become a big yawn because the Treasury department purposefully allowed them to fall behind the market yield. I will probably redeem my old 1.6% I-Bonds when they reach their 5-year anniversary.