Many TSP investors mistakenly believe the TSP F Fund and TSP G Fund are nearly interchangeable bond funds, with the only difference being that the TSP F Fund offers a slightly higher rate of return in exchange for some undefined but minimal risk when compared to the TSP G Fund, which provides a slightly lower return but is backed by the US Government. In fact, the two funds are not at all similar and are appropriate investments in different phases of the economic cycle.

I will go into a great deal of detail below, but here is the nutshell:

The TSP G Fund

The TSP G Fund is for all purposes what we call a cash investment. It is the same as a bank account or a certificate of deposit (CD). You cannot lose money when you are invested in the TSP G Fund and there is very little fluctuation in the rate of return which you will receive. While it does not have a high rate of return (particularly in this era of artificially depressed interest rates), it does provide a higher rate than any similar investment in the cash investment category. Because the only income generated by the TSP G Fund comes from interest earned on the special securities which it holds (the value of the securities held in the TSP G Fund cannot be traded and therefore do not change), it correlates exactly with interest rates. When those go up, the income generated by the TSP G Fund goes up, and when interest rates go down, the G Funds returns follow.

The TSP F Fund

The TSP F Fund is a bond index tracking fund. This means the TSP invests in exactly the basket of bonds and other securities which that index tracks. The bonds in the TSP F Fund generate income through the interest which is paid on these bonds, but the bonds held in the fund also go up and down in value as interest rates change which results in a gain or loss on the value of the underlying bonds. As a result, when interest rates go up or down, the TSP F Fund moves in the opposite direction (has a negative correlation). When interest rates go up, the value of the TSP F Fund goes down, and when interest rates fall, the value of the TSP F Fund goes up. The TSP F Fund also sees capital losses when bond issuers default and fail to make payments to the bond holders.

The role of the F Fund and G Fund in TSP allocation investment strategy

For the purposes of the economic cycle investment strategy which we follow, the TSP F Fund is used only during the recession phase of the cycle. As the economy slows and contracts, the Federal Reserve lowers interest rates in an effort to stimulate growth. This results in an increase in value (capital appreciation) for the bonds held by the TSP F Fund. This capital appreciation added to the interest income which the bonds generate will significantly outpace the returns of the TSP G Fund during these periods. As interest rates flatten out and prepare to rise, if I am still looking for a safe haven from the stock funds I will switch my allocation to the TSP G Fund. Note that when interest rates are flat, the TSP F Fund will outperform the TSP G Fund slightly, but typically by less than one percent which I am willing to forgo for the absolute certainty that I will not lose money if interest rates spike up.

TSP F Fund and G Fund Performance Comparison

I am going to go into some detail of the TSP F Fund and G Funds performance histories here to demonstrate how their performance correlates with what I have described above. Please remember that my point is not to show that one is better than the other overall. These funds are each the best choice for allocation during certain phases of the business cycle, and are each the worst possible choice during others.

When we look at interest sensitive TSP fund (the F Fund and G Fund) returns, you have to bear in mind that US interest rates have been trending consistently lower since the creation of the Thrift Savings Plan which results in returns skewed towards the TSP F Fund. At this point, interest rates have nowhere to go but up, and as a result many experts believe that bond funds like the TSP F Fund will do relatively poorly over the next decade or more.

The first Thrift Savings Plan funds were created in 1987 and 1988. To create a larger data set, I have combined what the returns would have been for the ten years prior to creation based on the indexes or securities which the various Funds track with the TSP returns so we can look at 1979 through the end of 2012. (If you want to look at the table which includes that pre-inception data, you can do that here: Extended TSP Fund Performance Table ).

The picture (or chart) below, in this case, probably really is worth a thousand words. Note the rapid rise in interest rates in 1979 and 1980 corresponds with 7.2% and 8.5% advantages to the TSP G Fund, while the plummeting rates in 1982 saw the simulated TSP F Fund returning a whopping 31%. While less dramatic, the following years showed the same pattern repeat every time interest rates moved in one direction or the other, with the TSP F Fund actually having negative returns in 1994 (-2.96%) and 1999 (-0.85%).

The TSP G Fund in Detail

The TSP G Funds investment objective is to produce a consistent rate of return which is higher than inflation while avoiding default risk and market price fluctuations. The TSP G Fund invests exclusively in a very short-term U.S. Treasury security which is specially issued only to the TSP. This security provides interest rates similar to those of long-term Government securities, but without risk of loss of value and the ability to trade on a daily basis. The earnings consist entirely of interest income on the security.

Put simply, using the TSP G Fund, you can earn roughly the same interest rate as someone who is locked into an investment in Treasury bonds for seven to ten years, while you are tied to it only for a day.

If you want to invest in something similar to the TSP G Fund outside your Thrift Savings Plan, you cant. It is a one-of-a-kind security issued only to federal employees through the TSP.

The TSP F Fund in Detail

The TSP F Funds investment objective is to match the performance of the Barclays Capital U.S. Aggregate Bond Index, a broad index representing the U.S. bond market which includes U.S. Government, mortgage-backed, corporate, and foreign government sectors of the U.S. bond market. The TSP F Funds earnings consist of interest income on the bonds and gains (or losses) in the value of the securities.

Many investors do not understand what causes the value of bonds to go up and down and the dramatic impact a small change in interest rates can have on the value of a bond (or bond fund such as the TSP F Fund). Lets take a simple example. Lets say the TSP F Fund is holding a bond paying 4% interest and that bond is selling for $100. Now let’s say that interest rates have risen to 6%. That means that someone else can buy a new bond paying 6% for $100. Because yours is only paying 4%, that means the value of your bond will fall to $66.6667 in order to compete with the 6% bond.

A small rise in interest rates yields a huge drop in the value of bonds. You are getting $4 per year in yield, so In this case the drop in value is the equivalent to the interest you would earn in 8.5 years.

The same thing happens in reverse when interest rates fall. That 4% bond will be worth considerably more if interest rates drop to 2%.

The only time this doesnt impact you is when you hold your bonds to maturity. That’s when you get your full $100 back. But the index which the TSP F Fund tracks doesnt hold bonds to maturity – it uses an indexing approach to investing, which means that it is a passively managed fund which remains invested according to its investment strategy without regard for conditions in the bond market or the economy. The TSP F Fund is constantly buying and selling bonds so that it holds a certain percentage of each type of bond in the market.

If you want to invest in a mutual fund or exchange traded fund (ETF) similar to the TSP F fund outside your government TSP, it is most similar to the Vanguard Total Bond Market Index mutual fund (ticker symbol: VBMFX), Vanguards matching ETF (ticker symbol: BND), or the IShares Lehman Bond Index ETF (ticker symbol: AGG).

Advanced TSP F Fund Investing

For those of you whose retirement investment accounts extend beyond the Thrift Savings Plan, I have written another post on an advanced strategy which can be employed when the TSP F Fund is indicated for allocation which you can find here: Advanced TSP F Fund Investing Strategy

Thanks for reading. As always, I am eager to hear your thoughts and questions on this subject below or on the Message Board. And if you found this worth reading, please help us out by sharing with your friends and colleagues with the sharing or email buttons below.