| Welcome to Schwab | Investment Products | Research & Strategies | Advice & Retirement | Active Trading | Banking & Lending |
|
| Welcome to Schwab | Investment Products | Research & Strategies | Advice & Retirement | Active Trading | Banking & Lending |
|
 Call us at 866-232-9890  Send us an email |
Q&A: Government Bondsby Rob Williams, Director of Income Planning, Schwab Center for Financial ResearchAugust 19, 2009 Key points
Treasuries
Are US Treasuries really a safe investment? If by "safe," you mean are you likely to be paid back when your bonds mature, and to receive regular interest payments as promised? Then the answer is yes. On the other hand, if by "safe" you mean prices won't change if you need to sell before maturity, then no. Treasury prices change daily, depending on current market interest rates. If current market rates (i.e. yields) rise, the price of a bond with a lower coupon payment will fall. If rates fall, the price of a bond with a higher coupon payment will rise. New investors would pay more or less today for that same bond, based on the coupon and the current market rate. This is the value reported on your financial statements, and the price you'd likely receive if you chose to sell before your bonds mature. The same is true of bonds held in individual bond funds or exchange-traded funds as well. The math can be complicated, but this rising/falling effect increases the longer the time left until maturity. The longer the time, the more an investor would have to accept, or benefit from, a higher or lower coupon rate. Here's an extreme example, based on the dramatic swings in Treasury interest rates during the past 13 months, showing that if rates rise, the value of longer-term bonds drops faster (prices can drop even without credit risk): Interest rate risk
Source: Source: Bloomberg, then-current five-, 10- and 30-year Treasury as of June 27, 2008. "Safe" can also mean several other things, including:
Annual total return, Treasuries versus S&P 500
Source: Bloomberg, Barclays Capital Indices, as of August 12, 2009. Returns include both interest payments and change in price. If Treasury prices can change, is nothing "safe" then? What should I do to maximize the benefits and limit my risks? Limit risk by investing in short- to intermediate-term Treasuries, if you believe that interest rates will rise. Though rates have begun to move upward since bottoming out on December 30, 2008, they're still near record lows. This is particularly true for shorter-term maturities, less than two years. Based on this interest-rate environment, we'd currently recommend an average maturity for more risk-conscious investors between five and seven years, maxing out around 10 years (adjusted, of course, depending on when you think you'll need your principal returned). You can do this with individual Treasury bills, notes or bonds, "laddered" by maturity; or with a combination of short- or intermediate-term government bond funds or exchange-traded funds (ETFs). If you purchase maturities much longer than 10 years, be prepared to hold to maturity and withstand greater losses (compared to shorter-term treasuries) in your bond investments before maturity if interest rates rise. Short-term Treasury bill rates are very low. Is this because money is still on the sidelines? During the credit collapse, there's ample evidence that investors "parked" their money in the safety of T-bills despite earning very little return, rather taking the risk of losing principal—particularly large banks and institutional investors. As financial markets continue to recover, money has begun to move out of the T-bill "parking lot" and back into other investments. This is a good sign that investors have been more willing to take on reasonable risk again, and a sign that markets continue to heal. Still, the amount of investor money in cash remains near record highs. Before it raises short-term rates, Federal Reserve Chairman Ben Bernanke has said that the Fed will continue to watch unemployment data, as well as further evidence that the economy has moved beyond its initial "bounce" toward more sustained recovery. If the Fed does raise its short-term federal funds rate—something it opted not to do in its August 12 Federal Open Market Committee meeting—it's likely to slowly eke into rising T-bill rates, and then into short-term cash investments like CDs and money market accounts. But the Fed has stated its desire to maintain a low interest rate "bias" for now, with all the tools available including continued, but slowing, purchases of Treasuries and government mortgage-backed securities to keeps rates low. Are Treasuries a good investment now and how to they compare to municipal bonds? For our views on Treasuries, see the comments above. When considering Treasuries compared to municipal bonds, start first with the account you’re investing in. If you're investing in tax-exempt accounts, no need to bother with munis—you'll generally find higher yields in Treasuries than the highest-quality municipal bonds because of the tax advantages. Then, consider whether you're willing to take on slightly more credit risk. Treasuries are backed by the US government; while munis are backed by various local government revenue sources, without the ability to print money to make sure their bills are paid. Still, legal protections for muni investors tend to be quite strong, and defaults virtually non-existent for investment-grade securities. Then consider your tax bracket, comparing tax-equivalent yields on an apple-to-apples basis: This chart shows the comparison, based on current Treasury yields and an index of high-quality munis. Treasuries versus AAA muni bonds
Source: Bloomberg, as of August 12, 2009, based on government generic Treasury indices and BFV Muni GO AAA indices. Assume 9.2% state income tax with muni bonds tax-exempt in home state. Compare these tax-equivalent yields, substituting an individual bond you're looking to buy or the current yield on a government versus municipal bond fund, when making an investment decision. Are TIPS a safe investment for investors seeking income? TIPS (Treasury inflation-protected securities), like Treasury bonds, are backed by the full-faith-and-credit of the US government, which means repayment of principal at maturity is more likely to happen than with any other investment. They provide protection against inflation, if it rises faster than investors expect. However, TIPS don't generate much income when inflation is steady or falling. Their value is found in their inflation protection, so investors are often willing to pay for this protection in the form of lower yields than what they'd receive on regular Treasuries. On average, the "real" yield (the yield before inflation) on TIPS is 1.5% to 2% lower than regular Treasury bonds. Sometimes a little more, sometimes a little less, depending on the market's expectation of inflation down the road. If inflation is higher, the combination of principal appreciation from the inflation adjustment on TIPS as well as an increased interest payment is likely to perform better than a regular Treasury bond. However, if you're more reliant on income, the coupon payments on TIPS are still likely to be lower than those from regular Treasury bonds or other bond investments. What do you think about Series I savings bonds for inflation protection? Series I Savings Bonds (or I-Bonds) are a type of savings bond issued by the US Treasury, and vary slightly from TIPS. Differences include:
For Ginnie Mae, the short answer is yes, and for Fannie Mae and Freddie Mac, technically, no. Ginnie Mae, officially known as the Government National Mortgage Association, serves to guarantee pools of federally qualifying mortgage loans made, sold and packaged by other lenders. As a true government agency, Ginnie Mae bonds have always enjoyed the backing of the federal government against default (the same as Treasuries). Ginnie Mae guarantees that it will use full federal support to step in and make the interest payments due on Ginnie Mae bonds, should an individual mortgage in the pool default. So, Ginnie Mae bonds are as safe as Treasuries when it comes to return of principal and scheduled interest payments. Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are different. Technically, they're not government agencies, but government-sponsored entities (GSEs). While not officially backed by the government, many investors believed that the federal government would likely step in to support either of them if necessary. In September 2008, those beliefs proved true. The Treasury took control of both Fannie and Freddie to stabilize the market for mortgage-backed debt. The takeover did not add the explicit guarantee of the federal government to Fannie and Freddie bonds, but the companies do have access to government funds and remain under federal government control. Because of this, most experts believe that the Treasury, along with Congress, will continue to provide this support. To do otherwise would cause a further, potentially more catastrophic, collapse in mortgage and credit markets nationwide. Are Ginnie Mae bonds appropriate investments for someone in her mid-70s and retired? If so, is now a good time to invest? As detailed above, Ginnie Mae bonds are backed by the full-faith-and-credit of the US government, so they're considered as safe as Treasuries and generally produce slightly higher income than Treasuries (under most market conditions). Because of these features, they can be a good addition to a fixed income portfolio for retirees looking for slightly higher yields and government support. However, Ginnie Mae (along with Fannie and Freddie) bonds are backed by mortgages, and have different repayment characteristics than non-mortgage bonds as a result. Because mortgages can be refinanced and prepaid, principal can be paid back more quickly than scheduled. This is called "prepayment" risk, and can result in somewhat "lumpy" income, especially when there's lots of refinancing activity. So, it's not as good of a time to invest in Ginnie Maes when you think that mortgage rates will fall. Like regular non-mortgage bonds, the value can also fall if interest rates rise. So they're most reliable during periods where interest rates are relatively stable, or refinancing activity is low. Recently, the US government has been doing whatever it can to encourage refinancing at lower interest rates. The Fed has also committed to purchasing more than a trillion dollars in government mortgage-backed securities, to support demand and keep mortgage rates low. This is certainly a risk to an investment in Ginnie Mae bonds today, if this tide of Fed purchasing turns. Under any interest rate (or Fed policy) environment, you don't have to worry about whether you'll receive back your original principal investment. You just have to worry a bit more about when. Whenever a portion of the additional principal is paid back early, along with the interest and principal payments already scheduled, your future interest payments will be lower as a result. If you don't want to spend these early principal repayments, you'll also need to find a place to reinvest, possibly at a lower interest rate. Because of these features, Ginnie Maes should be considered as part, but not all, of a retirement bond portfolio, particularly for investors who rely on a highly predictable income stream. How much of a deficit can the United States run before it has ratings problems or trouble selling debt? The United States currently carries a AAA Standard & Poor’s bond rating, as do 18 other sovereign nations. For most of the time since there have been bond ratings, the US credit rating has never have been in doubt. But should you care about ratings, when it comes to the US government? Ultimately, will the United States have trouble borrowing money, at a reasonable price? Certainly there are practical limits, in terms of the costs of servicing debt and the demand for it in world markets. There are obvious macro-economic and policy concerns as well. We won't touch on those here, though there's little debate that confidence in the United States relies on the ability to manage these challenges. Even with a rising national debt, world-wide demand for Treasuries has remained largely stable (if not quite exuberant). Rates have risen recently, but only marginally off of record lows. The continued role of the US dollar as the world’s pre-eminent currency, and the relative appeal of alternatives, is key. If this were to change, interest rates would need to rise to attract investments to US Treasuries. This depends quite a bit on how we manage through the current fiscal crisis, as well as the strength of a rebound in the US economy. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment purposes only and not intended to be reflective of results you can expect to achieve. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0809-10261) Return to Top |
Research fixed income investments
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Facebook
LinkedIn
Twitter
Digg