Yesterday Vanguard's "Total Bond Market" exchange traded fund with ticker symbol BND has a yield of only 1.58% with a premium to net asset value of $0.07 or a penalty of 0.08%. BND also has ten basis points or another 0.10% per year in annual expenses.
BND has significant risk of losing money should interest rates rise. For example, with an average duration of 5.3%, the NAV (net asset value) of BND will fall roughly 5.3% for a 1% jump in interest rates. This may be much more risk than you want to take with fixed income money you may need soon.
Buy Series I Bonds
I think Series I-Bonds issued by the US Treasury are a great alternative. They currently only pay 1.18% but this will go up if we see inflation higher than 0.59% in the next six months. I sold my BND holdings last month, a bit before the recent high but for a nice profit as they have too much risk for the potential reward for my taste.
Yesterday the Bureau of the Public Debt announced the new earnings rate of 1.18% for Series I (for Inflation) savings bonds issued from May 1, 2013, through October 2013.
Series I Bonds, or i-bonds, are a low-risk, liquid savings product. While you own them they earn interest and protect you from inflation. You may purchase I Bonds at TreasuryDirect.gov.
Earnings rates for i-bonds are set each May 1 and November 1. Interest accrues monthly and compounds semiannually. I-bonds held less than five years are subject to a three-month interest penalty. I-bonds have an interest-bearing life of 30 years. When the inflation rate is less than zero, a bond's earnings rate is less than its fixed rate, but the earnings rate is never less than zero. That means I-bonds NEVER GO DOWN IN VALUE, which is a big advantage over BND or any regular bond funds.
The composite earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the life of the bond, and the semiannual inflation rate.
The earnings rate combines a 0.00% fixed rate of return with the 1.18% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased 0.59% between October 2012 to and March 2013.
Fixed rate = 0.00%
6 month Inflation rate = 0.59%
Composite rate =[fixed rate + (2 x inflation rate) + (fixed rate x inflation rate)]
=[ 0.0000 + (2 x 0.0059) + (0.0000 x 0.0059)] = 0.0118 = 1.18%
Inflation Bond Facts:
- You pay taxes on the income when you cash them in so they grow and compound tax deferred.
- I Bonds earn interest from the first day of their issue month.
- You can redeem them at any time after a twelve-month minimum holding period
- They are an accrual-type security
- They increase in value monthly and the interest is paid when you redeem the bond
- I Bonds are sold at face value; i.e., you pay $50 for a $50 I Bond
- I Bonds grow in value with inflation-indexed earnings for up to 30 years
- If you redeem I Bonds before they're five years old, you'll forfeit the three most recent months' interest; at or after 5-years old, you won't be penalized.
- Annual rates compounded semiannually
- Maximum purchase (per calendar year): $10,000
I bond fixed rates are determined each May 1 and November 1. Each fixed rate applies to all I-bonds issued in the six months following the rate determination.
Series I Bonds are a better alternative to individual TIPS (Treasury Inflation Protected Securities) or the exchange traded TIP: funds TIP and TIPZ with maturities under 20 years because their "fixed rate" never goes below zero. Currently TIPS with maturities of 5, 7 and 10 years have negative base (real yield) rates of 1.38, 0.94 and 0.64 percent, respectively.
- New Earning Rates for Older I-Bonds
- Best Time to Buy I Bonds: Near the end of the month since you get credit for the full month you hold them. Make sure you leave enough time for funds to clear.
- Best Time to Sell I Bonds: At the start of the month since interest for the prior month is computed on the first of each month. You don't earn interest for fractional months so sell only after the new interest shows up in your account, usually the first of the month.
- I Bond Composite rate = [Fixed rate + (2 x Inflation rate) + (Fixed rate x Inflation rate)]
Strategy: I sold all my BND holdings but at the very least you should take enough profits to put aside to buy iBonds in six months or right now. You can only buy $10,000 worth of iBonds per calendar year. If you don't hold any from earlier in the year when they paid 1.76% and you don't care about deferring taxes on interest income, then I would put the $10,000 into a savings account listed here such as Everbank where they guarantee 1.25% for the first 6 months. After six months and before the year ends, I would use the money in that savings account to buy $10,000 worth of iBonds before the year ends.
Disclosure: I own Series I Bonds in my personal account with base rates between 0.00% and 3.00%. That means I get as much as 3.00% if inflation falls to zero percent. Thus, I have no plans to sell these 3.00% i-Bonds until they stop paying interest in 2031.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclosed at the end of my article.