In times of unknown predictions, presidential races, terrorist threats and the uncertainty of the future, most people are secure that the cost of almost everything is going up. Inflation has been with us for almost all long as the bureau of labor statistics has been measuring it. For example, the US Department of Labor, Bureau of Labor Statistics has listed in its consumer price index that in July 2004 the consumer price index is 189.4% of what the same costs were in 1984. An average rate of 9.47% per year for twenty years (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt). Yet, current inflation is projected at approximately 3%. www.inflationdata.com. In the same time, bond ladders with bond maturities no greater than 10 years have yielded an average rate of return of 7.6% according to Crestmont Research.(www.CrestmontResearch.com). Yet, current yield on Treasury Inflation Protected Securities, TIPS, recently yielded 2% for the ten-year issue. Our times are very unusual and puzzling for many, even the financial gurus who provides us opinions that the markets could move in either direction. Yet inflation is still here, so it is appropriate to discuss investment strategies that automatically adjust for inflation.
This article will discuss the benefits, determents of Inflated adjusted savings bonds, I bonds, and TIPS.
What is a TIPS bond?
A TIPS, or Treasury Inflation-Protected Securities, is a particular type of marketable Treasury security, a bond. A TIPS bond pays interest semi-annually, every six months, and principal at its maturity. The key difference between a TIPS bond and a regular US Treasury bond is that the interest and maturity value are tied to inflation. The amount of interest earned, and the face value of the bond will change.
Even though the bond has a fixed interest rate at the time of purchase, interest is paid semiannually based on the adjusted face value of the bond. The face value of the bond, is adjusted based on the Consumer Price Index. As the face value increases, due to inflation, a bond holder is paid more interest, as more face value, or principal of the bond is owed at maturity. If, however, deflation occurs, a built-in safeguard does not allow the principal value to fall below the bonds initial face value. If deflation would occur, then the interest payment would decrease, as less face value or principal is due, hence less interest would be due.
TIPs can be ordered directly from the government, on line, or if one seeks professional management of a TIPS fund, many of the large mutual fund houses offer TIPS funds. Check out Vanguard, Pimco, Fidelity, etc.
What is the problem with TIPS?
If you do not hold a TIPS in a retirement fund, you may have "phantom" income. Phantom income occurs when the inflation adjustment increases the amount of principal you are owed. This increase in maturity value, principal, is considered current taxable income, even though you do not receive the principal increase until maturity. (Ouch!) That is why retirement plans are suggested by many to hold these bonds. On the other hand, like most US Treasury obligations, TIPS interest income is exempt from state and local taxes for those of you in high tax states and counties!
Even though inflation protection exists, interest rate protection does not. That is why TIPS could be an important component of a bond ladder, 10-year ladder or less, but should not constitute an entire bond portfolio as it would not protect an investor from rising interest rates, and lost investment opportunity. But at least you know your rate of return will always beat the inflation rate!
I BONDS
I bonds have many similar features to TIPS, and some distinctions which we will discuss in subsequent paragraphs. I bonds are 30-year US Savings bonds that are adjusted semi-annually for inflation. They are offered in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. As a US Savings Bond, Income taxes on I bonds earnings, principal, and interest, may be deferred until maturity, in which case all income tax is due at maturity. Conversely, the income may be reported annually, in which case taxation is due annually. Interest income on I bonds are NOT paid until maturity. This may create phantom income, for the I bond holder, if the holder chooses to pay tax annually on accrued interest income.
I Bonds have exceptional downside protection. With I Bonds, the bonds redemption value will not decline. This means that the accumulated income and principal adjusted for inflation can only go up, never down. Therefore, if deflation does occur, the I bond accrued value will not decline.
I bonds have liquidity but must be held for at least six months after initial purchase in order to be redeemed. A penalty exists, relative to losing three months of interest, if an I bond is redeemed prior to 5 years after purchase.
CONTRASTING I BONDS AND TIPS BONDS
I Bonds are US Savings bonds and are offered in smaller increments than TIPS. TIPS are sold in minimum increments of $1,000 whereas I Bonds are sold in denominations in as little as $50, face value. I bonds are inflation indexed for up to 30 years, whereas TIPS are being offered by Treasury in 5, 10- and 20-year offerings.
I bonds also offer a distinct feature from TIPS relative to deflation. A TIPS bond you will recall cannot decline below its face value due to deflation. A TIPS bonds face value, can decrease in value but not lower than it face value. An I Bond will not decline in value, but can only go up.
I Bonds offer potential tax deferral, whereas TIPS bonds do not.
TIPS Bonds will have market value fluctuation, whereas an I Bond has a fixed and determinable redemption rate. Unlike TIPS, which may be purchased without limit in multiples of $1,000, I Bond purchases are limited to a maximum of $30,000 per calendar year.
CONCLUSION
Inflation and market risks are here to stay. Historically good times and bad, inflation is always present. Money has always had a cost to borrow it. Therefore, if we can at least protect ourselves from the loss of value due to inflation, and have our rate of return adjust only upwards based on inflation, we can eliminate part of the risk of owning a fixed income security. Tie that together with liquidity, within certain parameters, and you have a government backed vehicle, that provides products that may be considered as part of your fixed income portfolio.
