Thursday, October 16, 2008

I Opened a Treasury Direct Account!

No, I'm not running for the hills... Yet... (I joke! I joke!) But, the recent stock market crash did give me some food for thought.

Why Buy Bonds?
Investing in bond funds is safer than investing in stocks but this recent stock market crash made me sufficiently concerned that bond funds alone are an insufficient means of providing income as well as capital preservation in retirement.

Suze Orman's book, The Road to Wealth, defines a bond as

[A] debt security, or IOU, issued by a corporation or government agency in exchange for the money you lend it. In most instances, bond issuers agree to repay their loans by a specific date and to make regular interest payments to you until that date. ... With most bonds, the issuer must give you your investment money back, at face value, on the maturity date of the bond.

A bond fund, on the other hand, is

[A] mutual fund that is made up entirely of bonds. Bond funds come in all shapes and sizes, just as bonds do, but the interest rate on a bond fund is not fixed, as it most often is on a single bond. Bond funds pay income every month, however, and investors like knowing they can rely on that check. ... Bond funds do not have a maturity date. ... Because bond funds don't have maturity dates, you can't be sure how much of your original investment you will get back when you sell your shares.

So, in essence, bond funds have the advantage of being more liquid than individual bonds but they don't guarantee the return of your principal.

My bond fund (PTRAX) in my 401k demonstrates this perfectly. PTRAX (PIMCO Total Return/Intermediate-Term Bond Fund) pays dividends regularly, but as of October 18, my cost basis for the fund is $15,848.59 but the current value (including the reinvested dividend) is only $15,107.25 (or, -$741.34, or -4.68%). (Of course, the loss in this bond fund is nothing compared to the losses in my equity funds!)

Why Savings Bonds?
My recent attempt to invest in a short-term California muni-bond was thwarted by the minimum purchase amount. My Scottrade account also has a prohibitive minimum amount of $5,000-$10,000 (and $1,000 increments thereafter) to purchase various bonds.

Sigh... what's a small (and I mean small) investor like me to do?

According to CNN Money's site, U.S. Treasurys are the safest, most liquid investments on the planet next to cash. Per Suze Orman, the U.S. Treasury's Series I Bonds are perfect for non-retirement account money:

  1. that you want to keep safe and sound,

  2. don't need current income from, and

  3. will not need to withdraw for at least 5 years.

Series I bonds have a variable interest rate (4.84% through October 31, 2008) that is tied to the consumer price index (CPI) and thus provide protection against inflation. If inflation goes up, so does the interest rate on these bonds (theoretically).

Many talking heads on CNBC are flappin' their gums about a deflationary economy. But I'm betting that we're headed more towards a '70s-style stagflation. But what do I know? Notwithstanding my bachelor's degree in Economics, I clearly can't read economic tea-leaves (and I still have quite a ways to go to fully fund my emergency fund), so my preference is to only invest a small amount.

The beauty of Series I bonds is that you can purchase the bonds electronically in $25 denominations at TreasuryDirect's website.

Another advantage of the Series I bonds is that the interest on the bonds are tax-deferred until I redeem the bond. Even when I do redeem the bond, I will only have to pay federal tax (all I-bonds are exempt from state income tax, with some exceptions).

For those with little ones, interest earnings on the I-bonds may be excluded from Federal income tax when used to finance education.

The drawback of I-bonds is that I can't redeem the bonds for at least 6 months and I will get penalized with 3 months' interest if I redeem in less than 5 years.

(Please note my disclaimer on the sidebar.)

My Plan
I've been living one pay raise behind this year. Rather than increasing my discretionary spending by the amount of my raise, I've been funneling my raise (approx. $30/paycheck) into my savings. I'll just start investing $25/month in the Series I bond instead.

This will give me some inflation protected income in the future. Perhaps I can use some of the proceeds from the I-bonds as a down payment for my first house. :-D