When I was a kid, I use to keep my money under one of my dresser drawers. In order to get to it I would have to pull the drawer completely out. I had a huge sense of joy every time I had to put some more money into my stash and would marvel at the amount I was able to save. In hindsight, what a great hiding spot. I was outsmarting the thief who would check under my mattress. But, that cash was just sitting idle, losing money due to inflation. As we get older, secret hiding spots just won’t cut it. But where do you put your money?
When investors are looking for safe, high yielding, investments, treasury bonds can offer an attractive solution. Certificate of deposits (CDs) or high interest rate savings accounts can be useful as well, but they do not offer the tax advantages of treasury bonds. When treasury bonds are offering the highest rate of interest among all three options, it’s a no-brainer given their liquidity, safety, and tax advantaged nature.
Tax Advantage
Treasury bonds are only taxed at the federal level. Let’s assume an investor is in the highest tax bracket and living in a high local tax region such as NYC. The highest New York state tax bracket is 8.82% and the highest New York city tax bracket is 3.876%. Combined that is 12.70%. The top federal tax bracket is 37%. I recently purchased one-year treasury bonds at new issue for 2.75% while 1 year CDs were also at 2.75%. For CDs you have to pay federal, local, and city tax. That leaves the after-tax yield of treasuries at 0.35% higher than CDs, per the below breakout. While that may not seem like much, it’s a huge pick up in value given the average national saving account interest rate is 0.08%.
| One Year Maturity | Yield | Federal Tax Bracket | State Tax Bracket | City Tax Bracket | Combined Tax | After Tax Yield | |
|---|---|---|---|---|---|---|---|
| Certificate of Deposit (CD) | 2.75 | 37.00 | 8.82 | 3.88 | 49.70 | 1.38 | |
| Treasury Bond | 2.75 | 37.00 | 0.00 | 0.00 | 37.00 | 1.73 | |
| Difference | 0.35 |
How to get the best price
Treasury bonds are the most liquid investment and can be traded on any brokerage account. While most brokerage accounts say they do not charge a commission, they actually earn a small amount per bonds they sell in the mark up. For example, a broker will buy a treasury bond at 9.97 and then sell it to you at 9.98. There is no commission charge to you, but they are earning 0.01 on the bond which eats into your return. Plus, the best prices are reserved for the largest orders, typically higher than 250,000 or 400,000 in value. The way you get around this is buying at new issue. If you do a web search on “treasury auction schedule” you will see that the bonds are sold weekly to monthly depending on the maturity, without a mark up or a commission, and minimum size of 1,000.
Which bonds to buy
I tend to buy zero coupon bonds, which do not pay an interest rate, but rather you buy them at a discount and then get full face value in return. For example, the recent 1 year treasury bonds that I purchased were at a price of 97.32. In one year I will receive 100.00% of the face value. This equals a 2.75% return [2.75% return = (100 – 97.32) / 97.32].
The reason I buy zero coupon bonds verses bonds that pay interest monthly is that there is less reinvestment risk. If you are receiving interest payments monthly, then you will only be receiving a paltry 0.08% interest at the national savings rate on the money received if left in your savings account. With zero coupon bonds, since there is no monthly interest, you are always earning the intended yield on the entire investment until maturity. Simply put, zero coupon bonds are more efficient. They take up less of your time so you can devote more energy elsewhere.
Bond Ladder
Now you may not want to put all your money into a one year bond, but rather spread out the maturities. You do this for two reasons. One, you never know if interest rates are going up or down, so buying every three months will let you earn the changing rates. Two, it offers more liquidity as every three months some of your bonds are maturing and you can choose to do whatever you like with the money instead of having to go through the act of selling.
I purchased a 3 month, 6 month, 9 month (this had to purchase in the secondary market), and a 12 month bond. This is called bond laddering. It allows you to lock in longer term bonds while still having short term maturities in case the money is needed. Every three months as bonds pay off, I purchase a new 1 year bond at new issue. Please note that 9 month bonds are not available at new issue and you will have to buy from a broker and pay the mark up. But you only do this at first, since you will buy 1 year treasuries thereafter.
Phantom Tax
Since zero coupon treasury bonds do not pay interest, you still may be required to pay tax on the portion earned within the year. For example if you purchased 100,000 worth of treasury bonds at 2.75% on July 1st, you will have earned 1,375 dollars (100,000 * 2.75% / 2). You will have to pay tax on that amount. I do not claim to be a tax expert on any more of the specifics than that, but ultimately you will give this information to your accountant.
How to check yields
I check yields on the Fidelity website. Click on ‘News & Research’, then ‘Fixed Income, Bonds, and CDs’. You do not need an account to use this service. While new issue yields are not posted, they will be in the range of the yields given in the secondary market.
Conclusion
While treasury bonds in the long term are not a great investment to grow your money, they are a great alternative to holding cash. Long term money should be invested in the stock market with a time horizon of 5 to 10 years, or potentially longer.