Inflation-Indexed Bonds

Should you worry about inflation? Although inflation rates are relatively low, there is no guarantee that we won't return to the double-digit inflationary nightmare of the 1970s. Even at today's low rates, inflation steadily erodes the purchasing power of your investments.

Conventional bonds offer little or no protection against inflation. Stocks have historically generated inflation-beating returns in the long run, but short-term returns are volatile and there are no guarantees.

What about gold? Although often touted as an inflation-hedge, gold is subject to unpredictable supply and demand fluctuations that can wreak havoc on its returns. After reaching a peak price of $850 per ounce in 1980, gold is now selling for about $290 per ounce.

Inflation-indexed bonds are the only investment vehicles with guaranteed inflation protection. Two types of inflation-protected bonds are offered by the US Treasury: TIPS and I Bonds.

We'll focus on TIPS today and save I Bonds for next month.

TIPS, or Treasury Inflation Protected Securities, are issued every three months in alternating 10- and 30-year maturities. You can buy them through a financial broker or directly from the government via TreasuryDirect www.publicdebt.treas.gov/sec/sectrdir.htm .The minimum investment is $1000. Like other government bonds, previously-issued TIPS can be bought and sold on the open market.

TIPS are indexed to the rate of inflation. For example, if you buy a $1000 TIPS and inflation rises 2% during the year, the principal value of your bond will be adjusted upwards by 2% ($20). The next year, your semiannual coupon payments will also be 2% higher because they are calculated based on the higher principal. The result is more money in your pocket. When the bond reaches maturity, you will receive the entire inflation-adjusted total in a lump sum. You are also guaranteed to receive no less than the par amount at which the security was issued ($1000), which means that TIPS offer protection against deflation as well as inflation.

Since they were first introduced in 1997, TIPS have returned 3.3 to 4.0 percent above the rate of inflation. This compares favorably to intermediate and long-term government bonds, which have averaged 2.2 percent over inflation since 1926. To put this in perspective, the average inflation rate over the past forty years has been 5.2 percent. At that rate, TIPS would return close to 9 percent annually. Whatever happens with inflation, TIPS provide you with guaranteed protection. If you invest $10,000 in TIPS today, you'll have $10,000 in real purchasing power at the maturity date, in addition to your semiannual coupon payments.

Although TIPS are exempt from state and local taxes, they are not tax-friendly. You are required to pay annual federal income tax on both your coupon payments and your unrealized income from the inflation-adjusted principal. For this reason, TIPS are best suited for IRAs and other tax-advantaged accounts. For taxable accounts, you're better off with I Bonds, but more on that next month.

March 1, 2002

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