YOUR 401(k) #13: Treasuries, tips, & muni bond funds
What are bonds and bond funds?
As explained in YOUR 401(k) #7: Asset Classes, fixed income securities, aka bonds, are called fixed income because they pay you interest income at a fixed rate. When you invest in bonds, you are, in essence, loaning money to an organization for a set period of time. In return, the borrower promises to pay you back by a certain date (the maturity) with some interest on top. The interest a bond pays is called its coupon.
With some bonds, the interest is paid in full at maturity when the borrower returns your original investment. Other bonds pay interest semiannually (every six months), quarterly (every four months), or monthly.
- For example, let's say you invest $100 in a 1-year bond that pays a 4% annual coupon.
- Today, you'd pay $100 for the bond.
- At the end of one year, you'd get your $100 back with $4 of interest on top.
- Or, let's say you want to invest $1000 in a 1-year bond that pays 8% semiannually (simple interest, not compounded).
- Today, you'd pay $1000 for the bond.
- In six months, you'd receive your first $40 coupon payment (the first of two semiannual payments).
- In six more months, once the year is up, you'd get your $1000 back plus your second $40 semiannual coupon payment.
- Added together, your two $40 coupon payments equal $80, or 8% of your $1000 investment.
Bond funds, then, invest in a variety of bonds and aim to earn income via coupon payments for their investors. That's why bond funds are often called income funds, and you may see them referred to as such in your retirement or brokerage account.
Just like equity funds, bond funds choose which bonds to invest in based on their fund's objective, or strategy. Some funds only invest in short-term bonds, while others prefer long-term bonds. Some only buy low risk bonds, whereas others specialize in high risk, aka junk bonds. And others still will only invest in government bonds, while some prefer to stick with bonds issued by companies.
Let's explore government bonds further.
The US federal government borrows money from investors to pay for all types of projects. The bonds that it sells are called Treasuries. When you hear someone talk about "buying Treasuries", what they're really referring to is loaning money to the government. Treasuries come in lots of different flavors depending on their maturity, or how long your money is locked up for.
T-bills are loans to the government for periods of 1-month, 3-months, 6-months, or a year. Because your money is invested for such a short period of time, T-bills are considered liquid, cash-like investments. This means that they may be a good place to park your emergency fund. Their short maturities also lessen your exposure to interest rate and inflation risk, which means your money is quite "safe" when invested in them. However, because they're "safe", they only pay a tiny coupon. The current rate on a 6-month T-bill is about 0.42%.
If you buy T-bills directly, outside of your retirement account let's say, you actually buy them at a discount. When the bill matures, the government pays you the full price (called the face value or par value). The difference between the price you paid and the amount the government gives you back is the interest.
For example, the current rate on a 1 year T-bill is 0.60%. That means you may pay $99.40 for a $100 T-bill. When the year is up, the government will pay you the full $100 back. The extra 60 cents is the interest earned on your investment.
T-notes are loans to the government for 1 to 10 years. Because your money is locked up for a bit longer, the government pays you a slightly higher interest rate. The current rate on a 10-year T-note is ~1.56%, and you receive coupon payments semiannually, or twice per year.
For example, if you buy a $100 10-year note, every six months you'll receive half of the $1.56 coupon, or 78 cents. Over 10 years, you'll receive 20 coupon payments of $0.78 each for a total of $10.56 on your original $100 investment. Not exactly sexy, considering your $100 was locked up for a full 10 years. However, if you're looking for a safe place to park some cash for a while that will still earn you money, T-notes may be a good option.
T-bonds are loans to the government for 10 to 30 years. Again, the government offers you a higher interest rate to lock up your money for a longer period of time. But not that much more - the current rate on a 30 year T-bond is about 2.3%.
T-bonds also pay interest semiannually, so if you bought a $100 30-year T-bond, you'd receive about $1.15 every six months. Over the course of 30 years, you would receive 60 payments of $1.15, or $69 total.
Another type of government bond that you can invest in is called TIPS, which stands for Treasury Inflation-Protected Securities. TIPS funds are often offered in retirement accounts, and can come in handy during certain economic environments. So make sure to keep an eye out for them!
How do they work? Typically, bond prices fall when interest rates/inflation increase. To combat this, TIPS are designed so that their face value increases as inflation increases. A larger par value means your coupon payments increase too.
For example, let's say you bought $100 TIPS that pay 1% per year. If inflation jumps 10%, the value of your TIPS would (in theory) increase to $110 (10% higher). Since you're still entitled to a 1% coupon payment, the value of your payment increases to $1.10 (1% of $110 vs the original 1% of $100).
Finally, there are municipal bonds, or munis for short. These are issued by state and local government entities, as well as school districts, airports, etc. The money raised through muni bond sales is used to pay for renovation and expansion projects, among other things. The income investors earn is exempt from federal taxes, and may be exempt from state taxes for residents of that state.
While municipal bonds, as a whole, are considered to be relatively low risk investments, some borrowers do default on their bonds. In other words, they find themselves unable to pay certain coupon payments over the course of the loan and/or can’t pay investors back at maturity. Just look at the pickle Puerto Rico has found itself in with its municipal bonds. When something like this happens, a court typically steps in, divvies up the borrower’s assets, and pays out what it can to investors. If there’s not enough value to go around, not everyone will get all of their money back.
But don’t let that scare you! As stated, government bonds, especially Treasuries, are considered very low risk investments. Depending on the current economic environment and your risk tolerance, government bonds may have a place in your portfolio.
* * IMPORTANT * *
While the government guarantees your principal when you invest directly in Treasuries and TIPS, it does NOT guarantee shares of bond funds. So if you're investing in Treasuries or TIPS via a bond fund in your retirement account, there's no guarantee that you'll get your money back.
If interested in investing directly in Treasuries or TIPS, you can learn more information at treasurydirect.gov or by talking to a financial advisor.