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Sunday, May 07, 2006

This new issue of I-bonds might be a good buy

The financial press that mentions I bonds at all (a scant few, admittedly) is complaining that the rates that got reset this month were low at a 2.41% are really low compared with prevailing interest rates of 4.5% or more. What they are ignoring is that the real rate went up from 1% to 1.4%. In the long run, the real rate is what you care about, since the inflation adjusted rate will fluctuated with CPI. This series of I bonds are a really good buy if you believe that inflation is going up in the long run (which I think is a good bet). If I hadn't already loaded up on them this year, I'd be buying more. In fact, this might indeed be motivation for me to go down to the local bank and buy paper I bonds. The rate resets again in October.


md said...

May I ask what percent of your portfolio is in I Bonds? Are you planning to keep your I Bonds for the full thirty years? I assume they are not an emergency fund but part of your long-term investment plan. Does the state tax exemption play a role in your decision to invest in I Bonds?

I'm going to put on my tinfoil hat here, and ask: Doesn't it bother you that it's the Bureau of the Public Debt, a government agency, which (indirectly) determines the inflation rate? And that the government has an interest in keeping the nominal inflation rate artificially low? As in "I say the inflation rate is 1%, therefore it is so, despite the fact your healthcare just went up 20% and gas 100%..."

Ok, tinfoil hat off now. I thought about Treasury Bonds a few years ago (late 90s), but the payoff seems so low ... I am looking for more growth in my portfolio. For the short-term (say 1-2 year horizon) I keep a liquid cushion in savings accounts and CDs.

For example, I recently opened a 1-year CD at INGDirect which gets 5% - since this is an emergency fund I want to be able to withdraw it without penalty in a year if necessary. I'm right now looking at TreasuryDirect to try to decipher what I'd get if I went for a year or two with an I Bond and had to withdraw the money. Current fixed rate is 1.4%, but the composite rate is 2.41%. If the CPI-U increases sharply, this rate will increase sharply as well. Still, I think the CD will perform better than an I Bond over the next year or so. Hard to say in the long-term.

Then of course there's the tax consideration, which I didn't look into. CT state taxes are pretty high but I guess nothing compared to CA...

Piaw Na said...

Sure. I'm running a classic Grealey 82% stocks, 14% bonds, 4% cash portfolio. My intention is split between the two types of bonds 7% standard bonds (right now in a Vanguard Bond Fund, but I'm thinking I can do better by laddering bonds myself), and 7% in I-bonds. Because of the $30k a year limit, I can't put the full 7% allocation in it, but I'm slowly inching up there year after year.

It doesn't bother me that the CPI is computed by the same government agency. As David Swensen points out in his book, this actually gives the government an incentive to keep inflation low, which is a good thing. Sure, they can potentially tweak the index, but the CPI is monitored by enough academic economists as well as Wall Street (remember, TIPS are also indexed by CPI) that there'll be a big outcry about any such manipulation. The government might not care what Brad De Long says, but it certainly cares about Wall Street.

I'm very willing to tie myself in to long term positions on things like I bonds. First, the amount of money is small, and second, my emergency cash is parked in a tax exempt money market fund, earning something like 5% after taxes. My intention is to be opportunistic about rolling over my I bonds. Every time the real rate goes up, I'm going to redeem existing bonds at a lower real rate and exchange them for new bonds with a higher real rate. This leads to a lumpy I bond schedule, but I think it's worth doing. The other interesting thing is that you only pay taxes when you redeem, so redeeming has to be done carefully and under tax-controlled situations.

md said...

(When you said "Grealey" did you mean "Greaney" or did you really mean "Grealey"? - I'm not familiar with a "Grealey")

I recall reading some fishy stuff about the CPI. I went hunting for it and found a couple of pages on it:
Fleckenstein Feb 2004
Fleckenstein Mar 2004

He may be wearing a tinfoil hat also, but his arguments make some sense to me.

In response to "First, the amount of money is small..." I'd respond with the classic "but then your upside is small, so why bother?" Is it that you are trying to hedge severe inflation? Maybe buying energy is better.

Please be aware that I'm not questioning your investment portfolio seriously, I'm more or less arguing for the heck of it. I'd like to invest in an inflation hedge myself (which I think I did, via energy for a while, that's another story), but isn't there anything better than I Bonds?

It's actually pretty easy to convince myself that we'll see double-digit inflation and wind up thinking that now is a good time to put money into I Bonds... but then I think it's my excessive paranoia talking. After all, Greenspan has everyone convinced that we've got inflation under total control now - it will never happen again?

How can I get a tax exempt MM fund? Sounds great!

Piaw Na said...

Indeed, the upside is that in the case of severe inflation, you win pretty big even from a small position. It's definitely an insurance policy. I believe that the market for TIPS will respond heavily to any discovered tweaking in the CPI, so I'm assured that constant monitoring by the bond-market will take care of that.

What are the things that are better than I-bonds as an inflation hedge? International stocks. Like Warren Buffett did recently, you might want to consider a substantial portion of your stock portfolio to be in international stocks or to stocks that have significant international exposure. (Note that many American multi-nationals like MMM, Microsoft, and even Google already have significant international exposure, so you might not need to be as heavily weighted internationally as you think) I would not consider a 60/40 domestic/international exposure unreasonable. Most other countries are running trade surpluses, and the hope is that most of them (except Europe) will be running budget surpluses as well, so the temptation to print money isn't as high. In any case, if the dollar drops, inflaton goes up, but your foreign investments will do well.

Scott Burns also had a few suggestions for international bond funds, but David Sweeney dislikes them because currency speculation is a zero sum game and therefore in aggregate if you bought a weight basket of currencies you'd never make any money. An appropriate rebuttal to that is that all your current assets are in US dollars, so maybe it makes sense to buy foreign bonds to counterweight that! I still haven't decided where I stand on the foreign bond issue, but that of course didn't stop me from putting a small amount of money in a foreign bond fund and losing a small of money (though less now than at the start of the year) on the investment.

TIPS are also a good inflation hedge, but they have bad tax properties (basically, the tax comes due before the interest gets paid out) and therefore should only be held in a tax-exempt account.

Vanguard offers a series of Tax Exempt Money Market Funds, for various states, and has low costs and free checkwriting privileges (amounts > $250 only). They also have a series of Tax Exempt Bond Funds. I don't see CT on the list, so CT must have pretty low income tax rates to make it not worthwhile for municipalities to offer those.

md said...

What are the things that are better than I-bonds as an inflation hedge? International stocks

Would you say any international stocks would do; if inflation hits the US due to, say, high cost of energy, won't it hit all countries as well?

I do own some foreign equity, mostly in mutual funds. I've got about 7% of my portfolio in VPACX (Vanguard Pacific), in a SEP-IRA, and about 20% in an international index fund offered by my 401(k) plan.

I've probably got more exposure, like you say; for example, I hold some VWUSX, which is 9% foreign.

If I may ask, are you doing 60/40 yourself?

I'm not convinced that any of this will help me during an extreme inflationary period, though.... I should investigate TIPS, since I don't know much about them. But since I don't trust the CPI-U, I probably couldn't convince myself to buy them.

so CT must have pretty low income tax rates

LOL!! No really, take a look here. CT comes in ahead of CA, 10.5% compared to CA's 10.3%. Of course it varies depending on what your local taxes are.

I did a quick search and found this Fidelity Connecticut Municipal Money Market Fund with a "tax-equivalent yield of 5%".

Despite my initial excitement at this, I'd have to wonder if this is a smart move for me. My big pocket of change sitting in my INGDirect savings account is a true emergency fund. I don't consider it an investment, although I'd prefer for it to earn as much as I can get out of it. I like that it's FDIC insured and guaranteed not to lose value, unlike a MM fund.

Piaw Na said...

I myself is more aggressive. I'm at 50/50 domestic/international, with a hefty weighting in Emerging Markets (because of a tip from Brad De Long that has paid of dramatically). Like you, I believe that the dollar is due for a big drop, and don't quite believe the "Don't worry, be happy" folks that are sanguine about the current account deficits we are running.

According to William Bernstein, at one point T. Rowe Price took a $40 million hit to its bottom line to prevent its money market fund from dropping below $1/share, and several other financial companies also took something of a loss to prevent losing investor confidence in their money market funds. Of course, a true financial disaster would eliminate any ability for even the big financial firm to do so, but I think it's an indication of the relative safety of money market funds.

In addition, if you've built a reasonable bond ladder (5 years of I bonds, for instance), you'll always have a new bond maturing every year, so your emergency funds don't have to as conservative. But that's really an individual taste thing. It is doubtful that the extra 1% you eke out by going with a tax exempt fund would make a big difference to your overall financial picture. It is certain that your stock/bond allocation will have a bigger effect on your ultimate financial outcome.

P.S. Yes, I meant Greaney.

md said...

because of a tip from Brad De Long that has paid of dramatically

Did you read that on his site? I was sort of hunting around for something specific but didn't find anything recent. I did find this 2000 article from Fortune but that seems kind of old.

It is doubtful that the extra 1% you eke out

Yeah, I know, that's why I haven't put much consideration into it.

Ditto on the bond ladder. I've been thinking about doing a CD ladder, or something similar, for years, but interest rates suck so much it doesn't make sense. I have been doing so much better with equity, and I don't want to put too much of my portfolio into conservative investments... but who knows how long that will last.

I guess it might make sense to start an I Bond ladder. I'm waffling on the idea of raging inflation, don't know what to believe. I've been thinking for several years that it's going to happen "soon" and it never does.

Piaw Na said...

No, Brad De Long doesn't give financial advise on his site, I had the privilege of meeting Prof DeLong a year or so back, and being the kind of person I was, I asked him how one could win financially with the Republicans running the 3 branches of government.

If you're almost fully allocated in stocks, having a little bit of bonds (even as little as 10%) can do a lot to smooth out your returns. And there's a number of studies that show that rebalancing within such a portfolio yields a Rebalancing Bonus that can significantly boost returns.

It makes sense when you think about it: rebalancing essentially forces you to buy more stocks when they are low, and sell them when they are high, which is ultimately the secret to success.

So I wouldn't waffle --- I'd decide on an allocation and stick to it.

md said...

Hum, I have tended to ignore bonds since reading Bogle's Common Sense on Mutual Funds. I don't own a copy, so I'd have to go to the library to review, but if memory serves me, he made it sound like bond funds were too expensive and performed too poorly to be worthwhile, and he practically convinced me to sock everything into the S&P 500 (which I did not actually do, ok).

But my portfolio has changed so much since I read that book (five or six years ago), that it might pay off to read it again; I might read it differently at this point.

In fact, my portfolio has pretty much been on autopilot over the last two years, and it's probably long overdue for some attention. These discussions I've been having with you have motivated me in that direction.

I'll take a look at the rebalancing article that you linked to. I've never felt a need for a very disciplined form of rebalancing nor a specific allocation. I tend to take money out of a stock or fund when I think it is becoming unreasonably priced. I actually do dollar-cost averaging into Vanguard index fund(s); this should have a similar effect (i.e. buying more stocks when they are low, and less of them when they are high, although not selling any).

It could be that bonds (of some sort) are a good idea, now that I've managed to accumulate a substantial sum. I have a hard time abandoning the technique which has worked pretty well for me over the years. But maybe it would be prudent, given the weird times we have entered.

Now I'm going to go read Timothy Middleton's article about how DCA is all bunk...

md said...

Oops, it turns out that Timothy Middleton uses DCA differently from the way I do.

Dollar-cost averaging is similar to, but not the same thing as, investing regularly scheduled amounts, such as contributions from every paycheck to a 401(k) plan. It's the alternative to investing a lump sum, such as an inheritance or an IRA rollover, typically over four calendar quarters.

When I say DCA, I mean "investing regularly scheduled amounts...". That's what I meant in my above comment.

That brings up an interesting question... if you can afford to, should you max out your 401(k) contributions as early in the year as possible, or should you try to spread them out over the year? Every year I've been maxing out earlier and earlier... I wonder if it matters at all.

Piaw Na said...

I think a naive reading of Bogle would tell you to put all your money in equity and nothing anywhere else. And if you can stomach the risk, that's historically been the right thing to do.

But if you read the literature, there's a lot of evidence out there that adding a little bit of bonds to your portfolio reduces risk a lot while reducing returns only very slightly.

I agree with Middleton. Lump sum investment does indeed seem to be the best solution, so I have a tendency to max out my 401(k) contributions at the start of the year (to attract the matching funds earlier, and to put the money to work earlier). It also has the effect of forcing me to watch expenditures very carefully at the start of the year, which isn't a bad thing at all.