Using Inflation-Indexed Bonds in Your Portfolio

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Improve your portfolio's diversification with these new types of bonds.

By Sue Stevens, CFA, CFP, CPA | 02-22-01 | 06:00 AM | E-mail Article

I'm talking about two types of securities here: I-Bonds (a type of savings bond) and Treasury Inflation Protected Securities (also called TIPS). Both have a low correlation with other asset classes; in other words, they don’t behave like most other asset classes. That means they can be used to diversify almost any type of portfolio.

Today I’ll talk about what makes these securities so unique and how you might use them in your 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 3.4% fixed interest rate and 1.52% variable interest rate.

You can buy up to $30,000 worth of I-Bonds each year at your local bank or online at Public Debt. You must hold these bonds for at least six 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 purchase I-Bonds at face value. You don't have to pay any kind of brokerage commission. 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, civil rights leader
$200: Chief Joseph-Nez Perce, Native American leader
$500: General 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.

Let’s take an example. Say 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 36% rate, you'd owe $36 in taxes. Your after-tax income would be $64. 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, and they are guaranteed by the U.S. government. They 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 on 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 you're careful about choosing a bond with a fixed rate higher than your tax rate, these bonds may not offer much protection to investors in the highest tax brackets if inflation rises significantly.

Treasury Inflation Protected Securites (TIPS)
Treasury Inflation Protected Securities, or 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. As the bond’s principal value rises and falls with inflation, the amount you’ll receive as interest also changes.

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 a tax-deferred account, they'll lose their state and local tax-exempt status. That’s because when you eventually take securities out of a tax-deferred vehicle, they’re taxed at ordinary income-tax rates at federal, state, and local levels. But 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.

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

Individual bonds are sold with 10- and 30-year maturities. You can buy TIPS for as little as $1,000 in increments of $1,000 up to $5,000,000. Avoid transaction fees by buying direct at Treasury Direct.

For more information about TIPS, read Eric Jacobson's "Don't Skip the TIPS" and a piece by Dallas Morning News columnist Scott Burns called "The Inflation Protection Gift Horse From the Treasury". Those with real ambition can tackle Ibbotson's "TIPS as an Asset Class".

What If We Have Deflation vs. Inflation?
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, you might not receive any interest, but you'd still get back the full face value of the bond when it matures.

Where Do I Go for More Information?
Mel Lindauer and a few other participants on the Vanguard Diehards conversation forum have done a great job putting together an in-depth tutorial on I-Bonds. They’ve also compared TIPS and I-Bonds.

Other resources include:

The Bureau of Public Dept at Public Debt and Savings Bonds
bondsonline.com
1-800-4US-BOND
1-800-487-2663 for current rate information

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

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