December 22, 2009 by tfroberts

Recent brightening in the economic forecast should have you thinking about how you are going to deal with increased inflation when it arrives. It may seem counterintuitive to be investing to combat inflation when we continue to face short term deflation. Being ahead of the pack is where the money is made - remember buying equities in March 2009?

Inflation protected bonds/securities are not the only way to cover yourself with rising inflation however, they can be an important part of the mix.

When first issued several years ago, US government TIPS (Treasury Inflation-Protected Securities) and I-Bonds were not very well received since inflation was low and other investments generated higher returns. Today, individual and institutional investors, as well as countries, are starting to demand bonds with an inflation adjusted component. TIPS and I-Bonds have a low correlation with other asset classes; they don't behave like other bonds or stocks in the same economic conditions. They can be used to diversify almost any type of portfolio.

I-Bonds

I-Bonds are U.S. Savings Bonds that offer protection from inflation. The interest paid comes in two parts: a fixed interest rate and a variable rate. The fixed-rate portion is set when you buy the bond. The variable-rate portion changes twice a year based on inflation, as measured by the Consumer Price Index (CPI). The most recent I-Bond is paying a .3% annual fixed interest rate and a 1.53% annualized variable interest rate. That means the composite rate is 1.83%.

You can buy up to $5,000 worth of electronic and $5,000 paper I-Bonds each calendar year. You must hold these bonds for at least 12 months before cashing out. If you cash out before you've owned the bonds five years, you will lose three months' worth of interest. You won't receive interest from your I-Bonds until you cash them in or they mature. At maturity or redemption, interest on I-Bonds is subject to federal tax, but not state or local tax.

Treasury Inflation-Protected Securities (TIPS)

TIPS are government-issued bonds that, like I-Bonds, provide a hedge against inflation.

TIPS set their interest rates when they are sold. The bond's underlying principal rises and falls with changes in the inflation rate, and as it does so, the amount you'll receive as interest also changes, but at maturity you'll always get at least the par value of the bond.

Interest is paid out semiannually. When the bond matures, your final principal value is adjusted for inflation during the term of the bond. Unlike I-Bonds, you'll have to pay tax on distributions as you go. You'll pay tax at ordinary income rates for the semiannual interest payments you receive, as well as on the "phantom income" you receive as your underlying principal adjusts for inflation. You won't actually get this adjusted principal until the bond is redeemed, but you'll be paying tax on the adjustments annually.

What If We Have Deflation?

If we find ourselves in a continuing deflationary environment you will always get back the face value of the bond, and the interest rate can never fall below zero. With TIPS, the Treasury will pay you either the face amount or the inflation adjusted amount when the bond matures, whichever is greater. With I-Bonds, the combined interest rate can never fall below zero. So, in a deflationary environment, interest payments may be lower than you anticipated, but you'd still get back at least the full face value of the bond when it matures.

Check out TreasuryDirect.gov for details on purchasing bonds directly. You can also purchase these securities through mutual funds. Do your research carefully! Make sure the securities are purchased in the appropriate account to manage your taxes.