Using inflation-indexed securities in your portfolio.
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By Sue Stevens, CFA, CFP, CPA | 12-23-04 | 06:00 AM | Email Article

Although they initially met with a tepid reception several years ago, TIPS (Treasury Inflation-Protected Securities) and I-Bonds are finding a place in more and more portfolios. Each has a component that offers inflation protection. And even if we find ourselves in a deflationary environment instead of facing inflation, at least you will always get back the face value of the bond, and interest can never fall below zero.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Both TIPS and I-Bonds have a low correlation with other asset classes. In other words, they don't behave like most other bonds or stocks. That means they can be used to diversify almost any type of portfolio.

I-Bonds
I-Bonds are U.S. Savings Bonds that are designed to offer protection from inflation. 

The interest that I-Bonds pay comes in two parts: a fixed interest rate and a variable interest rate. The fixed-rate portion is set when you buy the bond. Remaining interest payments come from the variable-rate portion, which changes twice a year based on inflation, as measured by the Consumer Price Index (CPI). The most recent I-Bond is paying a 1% annual fixed interest rate and a 2.67% annualized variable interest rate. That means the composite rate is 3.67%. (Click here to learn how the composite rate is set.)

You can buy up to $30,000 worth of paper I-Bonds each calendar year at your local bank. In addition, you can buy up to $30,000 in electronic I-Bonds through TreasuryDirect. 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. Still, even minus the three-months' interest, the rate may beat other alternatives. For more on purchasing I-Bonds, visit TreasuryDirect's FAQ Web page

You purchase I-Bonds at face value, and you probably won't have to pay brokerage commissions. Each bond features a picture of an outstanding American:

  • $50: Helen Keller, advocate for individuals with disabilities           
  • $75: Dr. Hector Garcia, advocate for Mexican-American veterans' rights            
  • $100: Dr. Martin Luther King Jr., civil rights leader            
  • $200: Chief Joseph, Nez Perce, Native American leader            
  • $500: Gen. George Marshall, military leader and Nobel Peace Prize recipient            
  • $1,000: Albert Einstein, creator of theory of relativity and Nobel Prize winner            
  • $5,000: Marian Anderson, world-renowned African-American vocalist            
  • $10,000: Spark Matsunaga, Japanese-American World War II hero

You won't receive interest from your I-Bonds until you cash them in or they mature. So you don't have to pay tax on the interest as it accrues. This can be a significant advantage over a Treasury Inflation-Protected Security (see below) in a taxable account. 

At maturity or redemption, interest on I-Bonds is subject to federal tax, but not state or local tax. And if you meet certain requirements, interest may also be exempt from federal tax if you use the bonds to pay higher-education expenses. See Savings Bonds for Education for more details.

For all of these reasons, I-Bonds can be attractive candidates for many taxable accounts--but not all. In particular, investors in high tax brackets may lose the inflation-protection advantage of these bonds to taxes in a higher-inflation environment. How? If the money you receive from the fixed portion of the bond's interest is less than what you'd owe in taxes.

Say, for example, you bought a $1,000 bond that paid 3% in fixed interest and 7% in variable interest, reflecting an inflation rate of 7%. You'd earn 10% interest on the bond, or $100. If that $100 is taxed at a 35% rate, you'd owe $35 in taxes. Your aftertax income would be $65. But to keep up with a 7% inflation rate, you'd need to net $70. 

To sum up: I-Bonds can play important roles in many taxable accounts. They act as a hedge against inflation, are guaranteed by the U.S. government, and are affordable. And unlike a bond mutual fund, you'll always get at least the face value of your I-Bond back. On the downside, you may be able to earn a higher interest rate with other types of bonds. If you need to sell the bond less than five years after you bought it, you'll lose three months of interest. And unless investors are careful about choosing a bond with a fixed rate that makes more income than is taken away in taxes, these bonds may not offer much protection to those in the highest tax brackets if inflation rises significantly. 

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. However, 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.

Like I-Bonds, TIPS are guaranteed by the U.S. government and are exempt from state and local tax. Unlike I-Bonds, you'll have to pay tax on distributions. Uncle Sam is going to tax you 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 inflated principal until the bond is redeemed, but you'll be paying tax on the adjustments annually. If that tax is significant, you could find yourself in a negative cash flow situation--more is going out in tax payments than is coming in through interest payments. 

For those reasons, TIPS are most often recommended for tax-deferred accounts.

But consider this: If you put TIPS in most tax-deferred accounts (not Roth IRAs), they'll lose their state and local tax-exempt status. That's because when you eventually take securities out of most tax-deferred vehicles, they're taxed at ordinary income-tax rates at federal, state, and local levels. So, for investors in lower tax brackets, especially those who live in a state with high tax rates, TIPS may make sense in a taxable account or Roth IRA. 

You can buy TIPS either individually or through a few different mutual funds, including  Vanguard Inflation-Protected Securities ,  PIMCO Real Return , and  Fidelity Inflation-Protected Bond .

Individual bonds that are sold direct by the U.S. Treasury have five- and 10-year maturities (30-year maturities have been discontinued). You can also buy TIPS in the secondary market. Individual bonds sellfor as little as $1,000 and increase in increments of $1,000 up to $5 million. You can avoid transaction fees by buying direct at TreasuryDirect.

What If We Have Deflation?
Say we move into a deflationary climate before your inflation-indexed bond matures. What will you receive? 

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. 

How Do I Get More Information?

A version of this article appeared Sept. 11, 2003.

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Sue Stevens, CFA, CFP, CPA has a position in the following securities mentioned above: VIPSX VIPSX Find out about Morningstar's editorial policies.
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