After rolling over my IRA to my solo 401k at Fidelity, I want invest a small sum in the solo 401k account in short-term fixed income. I went and looked at my  options.

Treasuries

I can buy Treasury notes from Treasury auctions. Fidelity doesn’t charge me any fee for that. The problem is the yields are so low. According to Bloomberg, the current Treasury yields are:

If I buy an equal amount in these, my average yield will be 1.29%. I’d like to do a little better than that.

Bond Funds

Fidelity has a low cost short-term Treasury bond index fund. The problem is because it invests in Treasuries, the yield on the bond fund is also very low. A bond fund can’t earn more than the underlying bonds do.

Fidelity also has a short-term bond fund which invests in Treasuries and government agency bonds (~40%), corporate bonds (~25%), and other bonds. It’s more expensive. I’m also wary of the alphabet soup in the fund: MBS, ABS, CMBS, CMO.

Vanguard has a short-term investment grade bond fund. Fidelity charges $75 for the initial purchase and $5 for each subsequent purchase if I set up an automatic investment plan. The Vanguard fund invests less in Treasuries and government agency bonds (~10%) and more in corporate bonds (~60%). It also has about 20% in asset-backed and mortgage-backed bonds (securitized credit card and consumer loans). The yield on the Vanguard fund is little higher than the yield on the Fidelity fund because the Vanguard fund has less in Treasuries and more in corporate bonds, and because it’s less expensive.

The duration of a bond portfolio indicates its sensitivity to interest changes and the amount of time it takes to recover from an interest rate increase. Because interest rates are low, I’d like to keep my duration low.

Bond ETFs

Like index funds, ETFs have low expense ratios. The commission on purchasing an ETF is a lot lower than the $75 Fidelity charges for buying a Vanguard fund. I already know a Treasury ETF can’t do any better than Treasuries I can buy myself. If I buy an ETF, I’m only interested in a corporate bond ETF.

Vanguard Short-Term Bond ETF (BSV) is the ETF equivalent to its short-term bond index fund. It has 70% in Treasuries and agency bonds. iShares Barclays 1-3 Year Bond ETF (CSJ) invests primarily in corporate bonds. I like its portfolio. The problem is it trades at 1% premium to the underlying net asset value (NAV). If I put $10,000 in it, I’m paying an extra $100 plus a $11 commission. That’s more than what I’d pay if I buy the Vanguard open-end fund.

CDs

CDs offer a unique advantage to retail savers. When you buy Treasuries or bonds, either directly or indirectly through mutual funds or ETFs, you are competing against institutional investors. They set the price; you follow. You may also pay a markup to some middlemen unless you buy in Treasury auctions.

Retail savers rule in CDs. Institutions with hundreds of millions to invest can’t be bothered to open a $250,000 CD here and there. Treasuries will never be “on sale.” On the other hand, different banks will have different eagerness to attract deposits at different times. When one bank wants money more badly than another, they will have a “sale” on their CD rates. As long as the CDs are FDIC insured, you don’t care who’s putting the CDs on sale.

If you don’t mind the hassle of opening and closing accounts, you can shop the highest rates wherever they are. Bank Deals blog publishes a weekly summary of the best CD deals. Bank Deals is better than BankRate.com because Bank Deals does not limit itself to banks that pay its operator for the lead. As I’m writing this, the best deals I see on Bank Deals with a low minimum deposit requirement are:

If you compare these rates with the Treasury yields, you see the CD yields are much better. An equal amount in these CDs will earn an average yield of 2.86%, versus 1.28% in Treasuries. The best rate CDs have a higher yield and a lower risk than bond funds and ETFs that invest in corporate bonds.

Brokered CDs

Unfortunately opening accounts wherever the best deals are is not an option for me in my solo 401k account. My money has to stay within Fidelity.

Fidelity sells brokered CDs. These CDs are also FDIC insured. Instead of selling directly to individual savers, some banks sell their CDs through brokers. There is no fee for buying brokered CDs, but the best rates on brokered CDs don’t match the best rates on retail CDs. Here’s what I see in Fidelity:

There’s quite a gap between these yields and the yields on best available CDs. If I put an equal amount in these CDs, I will have an average yield of 1.96%, still higher than the Treasury yields. The yield is somewhat lower than that on corporate bond funds and ETFs, but CDs have less risk.

Secondary CDs

Fidelity also sells secondary CDs. These are CDs other investors wanted to get out of before the maturity date. If I buy them, I take over the remaining term, very much like when one buys a bond on the secondary market. They are still FDIC insured. Fidelity charges a fee of $1 per $1,000 (min. $8). If the interest rate on the CD is above market, I will also have to pay a premium. I see these secondary CDs in Fidelity:

When someone wanted to get out early, they will have to offer a better yield than comparable new issue CDs. If I put an equal amount in these four CDs, I will get an average yield of 2.66%, higher than the yield on new issue CDs, matching the yield on corporate bond funds and ETFs with lower risk.

There is one caveat in secondary CDs: the FDIC call. The CDs are insured by FDIC for their face value plus accrued interest. If the CD’s interest rate is higher than market and I have to pay a premium, the premium I pay is not protected by the FDIC. In essence, I’m short a call option at par to the FDIC.

For example, paying $1,052.71 for a $1,000 CD from Capmark Bank with an interest rate of 4.7% will give me a yield of 2.87% if Capmark Bank doesn’t fail before the CD matures on October 29, 2012. If it fails tomorrow, I only get back $1,000 from the FDIC, and I lose $52.71. That’s a risk in buying secondary CDs.

If I buy secondary CDs, I will limit myself to CDs selling below 100 or CDs issued by well known too-big-to-fail banks.

Structured Products

Savers don’t like low interest rates. That’s for sure. I was waiting for someone outside a bank branch the other day and I saw some brochures and forms the in-branch investment advisors stacked by the window: index linked CDs and absolute return funds. They are targeted at people who are not satisfied with their CD rates. People want something for nothing. The advisors in the bank branches have a ready audience.

If you want safety, go with safety. If you want to take risks on the stock market for its higher expected return, go with the stock market. Blend the two and you will have a balanced portfolio. The structured products only enrich the producers and the advisors. I won’t touch them with a ten-foot pole.

After weighing all my options, I decided to do a mix of new issue brokered CDs and secondary CDs. This CD ladder I put together will have an average yield comparable to corporate bond funds and ETFs, but the CDs will have lower risk. The FDIC insurance comes as close to a free lunch as it can get.

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Software picked, likely related articles at The Finance Buff:

• No Change in I Bond Fixed Rate
• I Bonds Rate Guess for Nov. 1, 2006
• Brokered CD and Bank Failures

I think the 3.75% tax free yield together with the short maturity (< 3 months) make these IOUs attractive even at face value. Yet no brokerage firms I have account with buy them from the IOU holders, let alone sell them to customers. I’m guessing that’s because these IOUs are in paper form, which makes them difficult to buy, sell, and transfer. The brokerage firms’ computer systems are just not set up for these.

A legit broker-dealer called SecondMarket* has set up a process for buying and selling these IOUs. It looks quite convoluted to me.

SecondMarket: So How Does It Work?

Sellers:

• Enter IOU into the system. Wait 48 hours for verification with the state.
• Fax or e-mail copy of IOU and government issued ID
• Listing appears at the price seller sets
• Review and accept bids
• Sign documents. Mail in original IOU.
• Receive money from SecondMarket

Buyers

• Sign up. Wait 48 hours for qualification check. A buyer must have a net worth of at least $1 million or an income of at least $300,000 in the last two years.
• Bid on IOUs
• Sign documents. Send money to SecondMarket. Buyer also pays a 1% fee.
• Receive IOU from SecondMarket

* SecondMarket is regulated by FINRA (BrokerCheck). It’s also a member of SIPC (membership search) and Municipal Securities Rulemaking Board (MSRB membership list).

For the time being, California IOUs remain off limit for small investors like me. Even if I qualify, the 1% transaction fee makes them not worthwhile unless the IOUs can be bought at a discount to face value.

What are the alternatives if I’m interested in muni bonds? There are mutual funds and ETFs that invest in short-term municipal bonds in many states across the country. The yield, however, is less than half of that on the California IOUs.

There are also mutual funds and ETFs that invest only in California, where the yield is the highest in the country, but these are of longer maturity, which involve more risk.

None of these is as good as the California IOUs. Too bad I can’t buy them easily.

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• Tax Equivalent Yield Calculator Updated
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The longer term TIPS became very attractive in October 2008, relative to the historical real returns on bonds. I was tempted to buy more TIPS and/or lock in the good yield for longer time by selling my shorter term TIPS bonds for longer term TIPS bonds. An amateur like me thinks that’s the best thing to do. What about the professional bond fund managers? Did they also see the longer term bonds as a good buying opportunity?Vanguard has a TIPS fund: Vanguard Inflation Protected Securities Fund (VIPSX and VAIPX). They report their portfolio holdings four times a year, after the end of each quarter. The latest holdings are on their web site. I tracked down the quarterly holdings in 2008 from the reports they filed with the SEC. There were only fewer than 30 TIPS bonds ever issued. The Vanguard fund owned about 25. The small number of holdings make it easy to compare the portfolio changes from one quarter to the next. Because market prices fluctuate, I compared the changes in the face amount, which reflect the fund managers’ buying and selling activities.

The fund’s holdings were not static. As investor bought or sold fund shares, the managers also bought and sold bonds. The managers also traded bonds for whatever reasons they saw fit. The trades were not proportional to all the holdings. They bought and sold some bonds but left alone some other bonds. However, at a high level, the managers kept the portfolio relatively stable. Here’s a breakdown of the fund’s positions by maturity:

The seemingly big change between Q2 and Q3 in percentages invested in bonds maturing less than five years and 5-10 years is primarily due to how a bond maturing in July 2013 is classified. It was 5 – 10 years in Q2 and it dropped down to less than five years in Q3. If we ignore that change on the boundary, we can say that the fund’s portfolio didn’t change much in 2008.This exercise shows that the professional managers for the Vanguard TIPS fund didn’t go crazy on long term TIPS in Q4 2008. They either didn’t see the higher yields as a buying opportunity or they chose not to take advantage of it. Although the Vanguard TIPS fund is not an index fund, it behaves like an index fund. If you invest in the fund, you are pretty much investing in substantially all the bonds in the market. The fund managers do not pick the “best” bonds. Nor do they time the market by shifting maturities materially. They do some trading, but not much. It’s hard to say whether this kind of inaction is good or bad. On one hand, you may be disappointed if you buy the fund hoping the managers will chase the “sweet spots” wherever they may be at any point of time. On the other hand, if you attempt to chase the best values yourself with individual bonds, you may fare even worse. After all, the managers are veteran professionals. They know what they are doing.

Investment Manager BiographiesJohn Hollyer, CFA, Principal

• Portfolio manager.
• Advised the fund since 2000.
• Worked in investment management since 1987.
• B.S., University of Pennsylvania.

Kenneth E. Volpert, CFA, Principal, Head of Taxable Bond Group

• Portfolio manager.
• Advised the fund since 2000.
• Worked in investment management since 1981.
• B.S., University of Illinois.
• M.B.A., University of Chicago.

If you care to see the raw data for the portfolio holdings, the spreadsheet is here:

Spreadsheet: Vanguard TIPS Fund Portfolio Changes 2008

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Software picked, likely related articles at The Finance Buff:

• Bought 20-Year TIPS
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While the stock market was in turmoil, the real yields on Treasury Inflation Protected Securities (TIPS) rose to an attractive level. The real yield on 10-year TIPS broke the magic 3% number, a level that hasn’t been reached for many years. Many TIPS buyers including myself thought the high real yields in the first few years after TIPS first came out in late 1990s were a fluke. The real yields were high because TIPS were new and illiquid. I thought we’d never see 3% again. It’s amazing how fast things change. Back in the spring, the 10-year TIPS real yield was under 1% while the 5-year TIPS real yield was negative (please note all yield numbers for TIPS are expressed as real yield, which is on top of inflation).

It’s always hard to explain why the market moved the way it did because previously when the stock market ran into trouble, the bond prices went up (real yields down ). The concern for deflation was raised as one possible explanation for the rising TIPS real yields. A poster on the Bogleheads forum asked whether the real Yield to Maturity (YTM) number quoted when an investor buys a TIPS on the secondary market will still hold if there is deflation instead of inflation.

It’s a good question. So I created an online spreadsheet for the calculation.

Spreadsheet: TIPS During Deflation

I drew the following conclusions from the spreadsheet exercise:

1. As long as there is cumulative inflation between the date you purchase the bond and the date the bond matures, and you hold the bond to maturity, the actual real Yield to Maturity (YTM) will match the real YTM quoted at the time of the purchase. It doesn’t matter whether the bond was purchased at the initial offering or purchased a few years later on the secondary market.

If you buy bonds with a long maturity, say 10 years or more, it’s hard to imagine there will be cumulative deflation for that long. Even Japan didn’t have deflation for more than a few years. It doesn’t matter if there is deflation in some years and inflation in some years, as long as there is net cumulative inflation between the purchase date and the maturity date, the above conclusion holds true. If you don’t believe we will have net deflation lasting a decade or longer, you can skip the rest of the conclusions because they become only academic exercises. Plus if we have deflation for that long, there are probably bigger problems to worry about than TIPS yields.

If you buy TIPS with short maturities, like a 5-year TIPS, it’s possible to have deflation for 5 years. Read on.

2. If there is net cumulative deflation, there’s a chance your real YTM can increase but it will never go lower than what you were quoted when you bought the bond. The possible boost to real YTM comes from the par floor feature in all TIPS. United States Treasury will pay the deflation adjusted principal at maturity or the face value, whichever is higher. If there is net cumulative deflation between the date the bond was originally issued and the date the bond matures, you will be paid more than the deflation adjusted principal value and therefore your real yield will be higher. Please note the relevant date is the original issuing date, not the date you purchased the bond if you bought on the secondary market. It’s possible that even if there is only deflation after you bought the bond, the bond itself could still experience net inflation during its full lifespan due to inflation between the original issue date and your purchase date.

3. All else being equal, a TIPS bond with a lower index ratio at the time of the purchase can receive a higher boost to real YTM during deflation. The index ratio reflects net inflation from the original issuing date to the date you buy the bond on the secondary market. A lower index ratio gives you a better chance for a bonus from deflation.

4. All else being equal, a TIPS bond with a lower coupon rate can receive a higher boost to real YTM during deflation , although the boost to real YTM is not as sensitive to the coupon rate as to the index ratio.

In short, when you buy a TIPS bond on the secondary market, be confident that your real YTM will never go lower than the quote even if there’s deflation after you buy the bond. If the real YTM and maturity are comparable between two bonds, first choose the bond with a lower index ratio, then choose the bond with a lower coupon rate, for a better chance for a bonus from deflation. Finally, remember all these finer points are moot unless there is net cumulative deflation from the purchase date to the maturity date. If there is no net cumulative deflation, all bonds receive the quoted real YTM. One should never say “never” but it is very unlikely to have net cumulative deflation for many years.

If you’d like to play with the spreadsheet, go ahead. Like all my other spreadsheets, the numbers in blue are inputs. The other numbers are calculated from the inputs.

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Software picked, likely related articles at The Finance Buff:

• Buying TIPS On Secondary Market, Part 4: What to Buy
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• TIPS Auction on April 12, 2007

This is the fourth installment in my TIPS auction series. The previous posts in this series were:

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

The auction for the 10-year TIPS is completed today. The Treasury Department publishes the official auction results on their website. The results for this auction show that the yield is 1.485%. Because this is a new issue, the coupon rate is rounded down to the nearest 0.125%, which is 1.375%. Each bond of $1,000 face value will cost $989.81282.

This is within my previous estimate of between $988.82 and $1,000. It also matches the result calculated by my TIPS pricing spreadsheet if you plug in the 1.485% yield (of course you don’t know this number until now).

The auction results also show some other interesting data points. Total $8 billion worth of bonds were sold in this auction. Total bids received were $14.6 billion. The orders from retail investors (”noncompetitive bids”) were only $88 million, which were 0.6% of the total bids or 1.1% of the total bonds sold. Yet this 1.1% of orders received the same price as what the big guys received. That is a very good deal to individual investors.

We can also see that from the Treasury Department’s point of view, selling TIPS is a hundred times more efficient than selling Savings Bonds. They were able to sell $8 billion worth of bonds in one morning. According to this news article, the total sales of savings bonds (series I and EE combined) in the last ten years were:

If you were in charge of selling bonds at the Treasury Department and you know you can sell more TIPS in one morning than what you can sell I Bonds in an entire year, plus you don’t have to print or mail those paper bonds, what would you prefer to do? No wonder they set the rate on I-Bonds so low (currently at 0%). TIPS are a win-win for both the Treasury Department and the investors.

Next step: If you placed an order in this auction, you will receive the bonds on July 15, 2008 (Issue Date) and pay $989.81 per $1,000 face value. If you didn’t buy in this auction, a new announcement for a 20-year TIPS will come out on July 17, 2008.

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Software picked, likely related articles at The Finance Buff:

• TIPS Auction Step By Step: Know the Schedule
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• TIPS Auction Closed at 2.691%

This is part three of the TIPS auctions series. Other posts in this series are:

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

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 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. You can also buy from Vanguard Brokerage Service, but you may have to pay a $10 fee unless you have over $100,000 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: read the auction result.

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Software picked, likely related articles at The Finance Buff:

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

This is part two of the TIPS auctions series. The other posts in the series are:

• TIPS Auction Step By Step: Know the Schedule
• TIPS Auction Step By Step: Place Order
• TIPS Auction Step By Step: Read the Results

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.

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Software picked, likely related articles at The Finance Buff:

• TIPS Auction Step By Step: Know the Schedule
• TIPS Auction Step By Step: Place Order
• TIPS Auction Step By Step: Read the Results

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. Other posts in the series include:

• TIPS Auction Step By Step: Read the Announcement
• TIPS Auction Step By Step: Place Order
• TIPS Auction Step By Step: Read the Results

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: read the announcement on July 7.

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Software picked, likely related articles at The Finance Buff:

• TIPS Auction Step By Step: Place Order
• TIPS Auction Step By Step: Read the Results
• TIPS Auction Step By Step: Read the Announcement

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.

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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.

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