TIPS on Inflation-Proofing
Your Portfolio |
Last week, the Federal Reserve left interest rates alone but indicated its concern about inflation. What will happen in the future is obviously uncertain, but no matter how high inflation may go, there are a couple of government investment vehicles that provide protection:
U.S. Treasury Inflation Protected Securities, or TIPS, have been around since 1997.
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Statement from the Fed
"The Federal Open Market Committee decided
(5/9/07) to keep its target for the federal funds rate at 5-1/4 percent...
Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.
In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." |
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They are marketable securities with principal and interest payments that are adjusted for inflation.
Series I U.S. Savings Bonds (I Bonds) are an inflation-adjusted version of the more-familiar Series EE Savings Bonds.
TIPS Basics
TIPS Notes and Bonds are issued in terms of 5, 10, and 20 years. Cash interest payments are made twice a year.
Recent issues have paid interest rates ranging from a high of 4.25 percent to a low of 1.625 percent. Of course, these interest rates sound pretty low, but please keep reading to find out about the inflation-adjustment feature.
TIPS investors receive an inflation-protected rate of return in the form of:
- The semiannual cash interest payments (at the fixed stated interest rate), based on inflation-adjusted principal balances, plus
- A larger inflation-adjusted principal payment at maturity or upon sale in the secondary market.
At maturity, if inflation has risen and increased the value of the underlying security during its term, the U.S. Treasury pays you the higher inflation-adjusted principal. On the other hand, if deflation occurred over the life of the security and decreased the security's value, Treasury pays you the original face value of the security.
In contrast, people who invest in garden-variety Treasury Notes won't receive anything to compensate them for higher-than-anticipated inflation.
Key Point: Like other debt instruments with relatively long periods to maturity, the market prices of TIPS Notes and Bonds fluctuate daily due to interest rate changes and other economic factors. However, interest rate changes that are due solely to expectations about future inflation rates should not drastically affect the market prices of TIPS instruments. (Daily prices and yields on all U.S. Treasury debt securities, including TIPS, can be found in The Wall Street Journal and other sources.)
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Tax Planning
Implications: |
With TIPS, the only bad news can be the tax rules. When you hold TIPS in a taxable account, you must pay current federal income taxes on both the cash interest payments and the inflation adjustments to the principal of the TIPS Note or Bond. Of course, taxes are due at your regular federal income tax rate, which can be as high as 35 percent.
Paying high ordinary rates is not good, because you won't actually collect any TIPS principal adjustments until the issue matures or is sold in the secondary market. Nevertheless, the U.S. Treasury wants its share now.
Fortunately, there's an easy solution to this tax dilemma. Only buy TIPS for tax-advantaged retirement accounts such as traditional or Roth IRAs, 401(k) plans, Keoghs and SEPs. That way, the unfriendly tax treatment has no impact, because the TIPS are safely ensconced in a tax-deferred or tax-free account.
Putting TIPS into retirement accounts makes sense anyway, because one of investors' main concerns should be protecting their retirement nest eggs against inflation. So TIPS and tax-advantaged retirement accounts are a good match.
TIPS can also be held in taxable accounts, but this generally isn't advisable unless you're in a very low tax bracket (like the 0 percent or 10 percent bracket). If you insist on holding TIPS in a taxable account, the cash interest payments and principal adjustments are exempt from state and local income taxes ... at least that's a plus.
Key Point: Another good reason to not hold these investments in taxable accounts is to avoid the complicated original issue discount (OID) rules that potentially apply whenever marketable debt securities, including TIPS, are purchased at a discount.
How to Buy: The minimum face value for TIPS Notes and Bonds is $1,000. Larger denominations are available in $1,000 increments. TIPS can be easily bought and sold in the secondary market through your broker, with commission charges that are generally reasonable. Transactions can be handled over the phone in just a few minutes. Also, several mutual funds are now devoted to investing in TIPS.
Finally, TIPS can be purchased upon original issue directly from the government through the Bureau of the Public Debt's online Treasury Direct program, which does not involve commission charges. Click here for more information. However, Treasury Direct is available only for taxable accounts.
Another Inflation-Adjusted Option: I Bonds
Beyond TIPS, there's another type of inflation-protected U.S. Treasury security: Series I U.S. Savings Bonds (or I Bonds).
I Bonds earn interest for up to 30 years or until redemption, whichever comes first, and receive favorable tax treatment. The investor doesn't owe tax for the accrued interest until the I Bonds mature or are redeemed for cash. So the federal income tax bill on I Bond interest can be deferred for up to 30 years. As a bonus, I Bond interest is completely exempt from state and local income taxes. (The same is true for EE Bonds.)
Unlike TIPS, I Bonds are mainly intended for small investors. Also unlike TIPS, I-Bonds cannot be held in tax-advantaged retirement accounts (the same is true for EE Bonds).
Specifically, paper I Bonds can be purchased at face value at most financial institutions in the following denominations: $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Electronically held I Bonds can be purchased direct from the government over the Internet. Click here for more information.
The maximum annual investment is $30,000. They can be redeemed for cash any time 12 months after purchase or later. However, redemptions within five years of purchase are hit with a penalty equal to three month's worth of interest.
Here's where the inflation-protection part comes in. The I Bond's interest rate is composed of two separate rates:
- A fixed rate of return determined at issue that applies for the entire 30-year life of the Bond and
- A variable rate of return equal to the current inflation rate, which is redetermined on a semiannual basis.
In computing the fixed part of the rate, the I Bond principal is increased to account for inflation. When all is said and done, the current annual rate, including the semiannual inflation adjustment, is 3.74 percent for all I Bonds issued between 5/1/07 and 10/31/07.
To summarize, there are a couple of I Bond advantages. First, they qualify for favorable tax treatment. Second, they can be purchased in small denominations, which makes them ideal for small investors, like kids saving for college.
Remember to store paper I Bonds in a secure place such as a safe deposit box.
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