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United States Treasury Securities

The United States Treasury, since the very first Administration under George Washington, has been borrowing more money than many folks feel is prudent by issuing “government bonds.” The 13 states had amassed a huge amount of debt during the American Revolution, and Washington’s Treasury Secretary, Alexander Hamilton, was convinced that the new federal government should absorb all that debt and start financing it by issuing government securities to investors. Ever since, investors who feel that the US Government is a worthy borrower have been able to turn their money over to the folks who printed it in the first place, receive modest rates of interest on that money, and after a certain period of time get the money right back, without lifting a finger. If you want to lend money to the US Treasury short-term, you buy a Treasury bill (T-bill). If your time frame is 2-10 years, you buy a Treasury note (T-note). And, if your time frame is 30 years, you can buy a Treasury bond (T-bond). Generally, T-bills pay much lower yields than T-bonds because investors who are only willing to lend their money for a few weeks at a time don’t generally receive high interest rates from the borrower. If T-bills offer yields of 2%, 30-year T-bonds might be yielding more like 4 %. If interest rates are high and T-bills currently pay 4%, T-bonds might be offering 6%. So, why doesn’t everybody just buy the T-bonds, then? Because not everybody wants to tie up her money for 30 years. See, even though someone holding a 30-year T-bond could sell her bond to another investor at any point, the price she receives could be much lower than she paid. Why? If the new interest rate environment reflected in auto loans, mortgages, etc. is higher than when that T-bond was issued, that T-bond’s market price will drop. If your T-bond issued a few years ago pays you a flat 4%, for example, when today’s T-bonds are offering 6%, you might have to sell your T-bond for much less than you paid for it. Which would stink, since these are government-guaranteed securities. The only excuse for losing money on US Treasury securities is that you had to sell before the thing matured, which is a pretty lame excuse, actually. With T-bills, T-notes, and T-bonds, all you really have to do is know how long you can set the money aside and stick to the plan. If you can only part with this money for a year or less, buy a T-bill. If you can truly put the money aside for 30 years, buy a T-bond and enjoy the higher return. You won’t get rich on either investment, but your security is guaranteed against default by the United States Treasury, the same people who guarantee the value of the 10’s and 20’s sitting in your wallet.

Municipal Bonds, Part 2

Municipal bonds fund all kinds of construction projects. Many roads, schools, soccer stadiums, airports, and convention centers have been built with the money raised when a municipal government issues municipal bonds. A municipal government includes everything from a state government down to the local school, library, or museum board. When these municipal entities need to raise money, they issue bonds to investors. Usually, the investors are in high tax-brackets and are looking for some interest that is tax-free at the federal level, and also tax-free at the state level if the bonds are issued inside the investor’s state of residence. Now, if a high-tax-bracket resident of, say, Maryland, buys a municipal bond issued within the state of Maryland, the interest he receives is exempt from taxation at both the federal and state level. Not surprisingly, the rate of interest the bonds pay is lower than what corporate bonds pay. But, since this interest is tax-free, the municipal bond often offers a higher yield than a comparable corporate bond after we figure in the taxation. For example, let’s say you were looking at two 10-year bonds rated AA by S&P, one a taxable corporate bond, the other a tax-exempt municipal bond. The municipal bond has a 7% yield, while the corporate bond yields 10%. Which one should you buy? Actually, we don’t know yet. Not until we factor in your tax bracket. Believe it or not, if you were in the 30% federal tax bracket, these two bonds would be exactly equal. The municipal bond would pay you $70 per bond tax-free. The corporate bond would pay you $100, but then the federal government would take back $30 of it, leaving you at exactly the same place. If you were in the 35% bracket, the municipal bond would edge out the corporate bond. An equivalent corporate bond would have to yield 10.77% to match the municipal bond for an investor in the 35% bracket. Since it doesn’t (it only offers 10%), the investor in the 35% bracket would purchase the 7% municipal bond and come out ahead versus buying the 10% corporate bond.
Does that imply that lower-bracket investors typically don’t come out ahead buying municipal bonds? It does. And, if you’re investing in a tax-deferred account (401k, 403b, IRA, etc.) you do not buy municipal securities as a general rule. If you did that, you would end up turning what was supposed to be tax-exempt interest into withdrawals taxed at ordinary income rates. In other words, using our example above, you’d be getting 7% instead of 10% and then also paying tax on that money when you start taking withdrawals from the account. Which makes no sense. We’ll talk in more detail about how tax-deferred accounts work later. For now, remember that we’re still just introducing you to the basics involved with investing.

Municipal Bonds

Across the street from my office sits an old brick industrial building that was supposed to be turned into a major townhouse/condo development. Unfortunately, the developers borrowed $15 million but sold only one condominium, and now the property sits in foreclosure, owned by a very unhappy bank. So the park district, whose land presses right up against the foreclosed property, would like to use the building for offices, conference rooms, exercise rooms, and also some green space after tearing down the back part of the massive and outdated structure. They need $6 million to acquire and re-hab the property and, therefore, want to raise that amount by issuing municipal bonds. So in a recent election, a majority of Forest Parkers voted to allow the park district to raise property taxes slightly in order to create the funds needed to pay off a $6 million bond issue. At this point, the park district is still in negotiations with the bank sitting on the foreclosed property. But, assuming they can work out the price, the park district will end up buying the property and issuing $6 million worth of general obligation bonds in order to finance the project. The bonds will pay investors tax-exempt interest at the federal level. Illinois residents will also escape income tax on the bond interest, which is why I might just buy a few bonds, myself. The bonds will be offered by a group of broker-dealers who form a temporary syndicate just long enough to get the bonds sold to investors, give the park district its $6 million and keep a percentage as their profit or spread. And then most investors will probably hold the bonds until maturity, collecting tax-exempt interest checks every six months along the way. Meanwhile, some investors may want to turn those bonds into cash before maturity; if so, their broker-dealer will either find a buyer on the secondary market and charge a commission to complete the sale, or the firm will buy the bonds themselves and make a markdown when acting in a principal capacity.

Credit Quality

Bonds rated AAA, AA, or A by S & P and Fitch (Aaa, Aa, or A by Moody’s) are not likely to default. They pay a lower yield than low-rated corporate bonds, but also a higher yield than you can get on US Treasuries. It’s all about trade-offs when you’re trying to invest. If you choose the absolute safety of US Treasuries over riskier corporate bonds, you will sleep better, but your yield will be much lower. If you choose T-bills over T-bonds based on your unwillingness to set aside money for a long period of time, you simultaneously improve your liquidity and lower your yield. Within the world of corporate bonds you can buy sleep with high-rated securities but, therefore, sacrifice some yield. On the other hand, if you chase after high yield by purchasing low-rated corporate bonds, you could watch a $1,000 bond drop to zero when the company hits a snag and declares bankruptcy.Corporate bonds pay regular streams of interest, but that income is taxable by the federal and state governments. If you’re wealthy and living in a high-tax state such as Maryland or Massachusetts, you might be taking in an 8% income stream from the corporate bond but then sharing close to half of that with the government in Washington, DC and the one in your own state capital. Ouch. To get a break from such nonsense, many people purchase the next type of fixed-income securities.

Corporate Bonds

If you buy a bond issued by a corporation such as General Electric or The Home Depot, and the bond pays 5% interest, each bond kicks out $50 of interest income to the owner each year. At the end of the term, the investor receives $1,000 per bond. We hope. See, sometimes corporations get into trouble and can’t pay the interest or—even worse—can’t repay the $1,000 of principal owed on each bond. They turn to the bankruptcy courts, and bondholders will be lucky to receive even a few dollars for the bonds that were supposed to be worth $1,000 at maturity. Doesn’t happen every day, but this risk of a default has to be considered when buying a corporate bond. Investors accept low yields on government-guaranteed US Treasury securities, but they demand higher yields on corporate bonds because of the risk of default.

Fixed Income Securities

We haven’t talked about stock yet, but when we do we’ll see that common stock is nothing but a share of any profits that a company might—or might not—generate at this point. Common stock doesn’t promise any particular rate of return. Many times the return is negative 100%. Unfortunately, many investors don’t find this out for many years, meaning that the money that could have been earning some interest in our “safe money” category didn’t and, worse, is all gone now. As Jerry Seinfeld has said, sometimes when you try to put your money to work for you, it ends up getting fired. Why would anyone buy common stock then? Because you can make an unknown and unlimited return on your investment. It is not unheard of for people to see the value of a stock investment go up by a factor of 10 or more. Put $20,000 into Company ABC, and in a few years, you’re sitting on a position worth $200,000. It happens. And, so does that negative 100% thing.
Bonds, on the other hand, pay a fixed stream of income to the investor. That’s why the industry calls them “fixed-income securities.” If you want to smooth out the returns in your retirement account, putting your money into “fixed-income” is a good way to do it. While stock prices rise and fall on wild mood swings of greed and panic, a bond that pays, say, 8% interest, is going to keep on paying the same old 8% interest year after year until the thing matures. Yes, rising interest rates will cause the market price to drop, but if you’re not going to sell, and you don’t mind seeing your account statements take a temporary hit, you actually might not care so much.

How Bad Is It?

Not only are Americans generally responsible for meeting their own financial goals for retirement these days, but also the typical American with a 401(k) or other plan is absolutely confused by the whole process. While some find the shift empowering, most Americans find it terrifying. Do they face their fear and rise to the occasion? Heck no. According to the Employee Benefit Research Institute only about 60% of American workers are currently putting money away for retirement, and the average 401(k) balance is only about $86,000.
$86,000. How long could you live on $86,000? Couple years? Not only are retirement accounts drastically under-funded, but also the participants are frighteningly under-educated about the investments that go inside the accounts. Can you explain what a share of common stock is? Preferred stock? Real estate investment trust? How is a mutual fund similar to or different from a variable annuity? If interest rates rise, what happens to the value of your bond mutual fund? What is the Dow, anyway, and why should you care?
This is some serious stuff we’re talking about here, and by the time we’re done, you’re going to understand what all these crazy investment terms actually mean and how they will dictate when and if you get to retire. So, unless you plan on winning the lottery or inheriting a fortune from a rich uncle, I invite you to pour yourself a refreshing drink, maybe make yourself a sandwich, and start facing the question that few Americans are currently brave enough to ask themselves: how am I ever going to retire?