Do Bonds Have a Place in Your Portfolio Even at Today’s Low Interest Rates?

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Do Bonds Have a Place in Your Portfolio Even at Today's Low Interest Rates?

The old adage that says, “Make your money in stocks, but keep your money in bonds,” might be true, although perhaps less so today than in the past. Over the long run, real wealth is created by owning stocks, according to Wharton Professor Dr. Jeremy Siegel. Siegel, author of the bestseller Stocks for the Long Run, has traced inflation-adjusted returns for stocks and bonds all the way back to 1800 and makes a convincing argument for owning stocks rather than bonds.

However, there is a time and place for bonds in our investment lives even at today’s low interest rates. That is especially true for those who have a low risk tolerance or those concerned with preserving principal. This is because the rate-of-return is generally known the moment you invest in a bond. The interest rate is fixed and the date of maturity is fixed. This is not true of buying stocks.

Bonds represent a debt obligation with fixed terms which generally cannot be changed. The bondholder lends money to government entities or corporations and receives interest and the return of their principal upon maturity. The pricing of a bond by the market during its life represents the assessment of the credit quality of the lender and the current interest rate environment.

In an inflationary environment, investors in bonds run the risk their principal will buy less than it did when it was lent. To compensate for this risk, bonds might be priced at a discount or carry a higher interest rate. To deal with the risks of inflation, the U.S. Government began issuing Treasury Inflation-Protected Securities (TIPS), which are Treasury bonds that pay a semi-annual fixed interest rate. This interest is then applied to the principal, which fluctuates in response to changes in the Consumer Price Index (CPI). The interest is taxable, whether realized or unrealized.

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The chart above shows an example of how the principal and interest for a TIPS issued in 1999 increased over time until maturity. Inflation adjustment to the principal is cumulative. Annual interest is equal to the sum of the two semi-annual interest payments. Source: TreasuryDirect.gov

Unrealized TIPS income that is added to the principal as a result of increasing inflation is subject to a phantom income tax, payable on accrued principal but not received as a routine interest payment. This creates a problem for investors who want to own these bonds in their taxable accounts. To compensate for this tax issue, the financial markets came up with the latest bond twist-Inflation-Protected InterNotes (IPIs). These are bonds that pay a monthly coupon consisting of two parts: a fixed amount, stated at issuance, plus an inflation-adjusted amount, calculated monthly based on the year over year change in the Urban CPI. The investor is still paying tax on the interest but at least they have it in pocket rather than waiting for the bond to mature.

The interest amount is reset monthly, and they receive par value at maturity. These are notes issued by public corporations, not the U.S. Government, so their pricing and coupon rates, as well as their secondary market prices, will reflect the credit, interest rate and secondary market risk unique to that company. Despite the attractiveness of the inflation-adjustment features, these bonds are not without risk. Investors should be aware of credit market risk, risk of default, interest rate risk and general business risk, and they should carefully examine the prospectus of the issuer as well as market conditions before making the decision to purchase an IPI bond.

As inflation increases, the interest payment will increase; as inflation decreases, the interest payment will decrease. Depending upon the terms of the issuer, there may be a minimum floor amount of interest paid regardless of inflation or deflation. Since the US Treasury began issuing TIPS in 1997, inflation has averaged 2.7% putting the yield for inflation adjusted securities below what conventional bonds paid for similar maturities. To make matters worse, in 2009 the rate of inflation was negative. Some believe the US economy may be entering a period of higher inflation during which TIPS and IPIs could thrive.

Rick’s Insights

  • Over the long run, real wealth is created by owning stocks, according to Wharton Professor Dr. Jeremy Siegel.
  • TIPS adjust the principal of the bond for inflation which is taxed each year even though it isn’t actually received until the bond matures.
  • IPIs pay the inflation adjustment along with a regular interest payment and do not adjust the principal.

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