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TIPS on Inflation

The surge of government borrowing in both the United States and abroad has raised serious inflation concerns for many investors. The higher interest charges the government will have to pay, they reason, will push interest rates up, in order to keep our bonds competitive and attractive to investors. Given the current high unemployment rate, though, core inflation, which is driven by wage increases and rising commodity prices, seems a distant worry. Still, long term investors have legitimate concerns about inflation in the future and the damage it can do to investments and purchasing power.

There is a good deal of conflicting information concerning what investment policy or strategy is most effective in an inflationary environment. Many investors believe that stock market investments represent the best hedge against inflation, although severe inflation is generally bad for both companies and their stockholders, and the markets in general. Gold is often considered an inflation hedge, although it has proven a pretty imprecise one in the past. The most effective means of hedging against inflation, we think, became available to investors when the US Government began issuing two types of bonds; Treasury Inflation Protected Securities, or TIPS, and I Bonds, a savings bond. Both of these bonds are specifically designed to provide inflation protection.

TIPS have some unique characteristics. Unlike ordinary bonds, whose maturity value is fixed, the maturity value of TIPS is adjusted according to changes in the CPI, or consumer price index. When the CPI rises, the principal of a TIPS bond increases. Conversely, when the CPI decreases, the principal of the bond will decrease. At maturity, you receive the adjusted principal or the original principal, whichever is greater.

Since TIPS have a fixed coupon rate, the interest payments will also increase (or decrease) with changes in the CPI. Here’s a simple example. You own a $10,000 TIPS with a 2% coupon. Your initial annual interest payment would be 2% of 10,000, or $200. During the following year the CPI has increased by 3%. Your new bond principal is $10,300. Your coupon rate is still 2%, but it is now applied against the new inflation adjusted principal of $10,300, so your new interest payment is 2% of $10,300, or $206.

TIPS are issued in maturities of 5, 10 and 30 years, in increments of $100, with the initial interest rate determined by auction.  They can be purchased directly through the US TreasuryDirect program, or through banks, brokers or bond dealers on the secondary market. TIPS do not have to be held to maturity; there is an active secondary market, and the bondholder can sell at a market price based upon the coupon and maturity of the bond, current inflation expectations, and current interest rates. This might be more (or less) than their original purchase price.

I Bonds are US savings bonds, but specifically designed to provide inflation protection. They are available online in electronic format through the TreasuryDirect program, as well as in paper form through banks, credit unions, and most savings institutions. Unlike TIPS, I Bonds cannot be bought or sold in the secondary market. Purchase limits are in effect for I Bonds; they are $5,000 per Social Security number, for any calendar year. Electronic bonds can be purchased in amounts of $25 or more, while paper bonds are issued in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000.  Like TIPS, the rate of return on an I Bond is a combination of a fixed coupon rate, set at purchase, and the inflation component, which is adjusted semi-annually each May and November. The adjustment is based on changes in the consumer price index.  Interest on I Bonds accrues over the life of the bond, which can be up to 30 years. I Bonds can be redeemed after a one year holding period and up to a five year holding period by paying a penalty equal to the most recent 3 months interest. There is no penalty after 5 years. The current interest rate on I bonds is .97%, which will be valid through October 31, 2010

You should also be aware of the special tax treatments of these bonds; in the case of TIPS, it may affect your choice of accounts in which to purchase them.  While the current interest portion of TIPS returns is paid to you each year and is taxable that year, the change in value due to the inflation component is also taxable the year it is received, although no payment is involved. Investors can avoid this “phantom tax” problem by holding TIPS bonds in a sheltered account such as an IRA.  Taxes on I Bonds can be deferred until maturity, or declared annually. Interest on both types of bonds is subject to Federal tax, but exempt from state tax.  Additional information, along with current rates and offerings, can be found on the Government’s website www.Treasurydirect.gov.

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