Inflation Protection for Fixed-Income Investors

This week, Gail has a few ideas for those whose incomes depend on the interest earned by their investments: you can do better than CDs!

Dear Gail-

I can't believe today's interest rates! I'm retired and living on fixed income. My bank just told me I could get 1.6% if I rolled over my CD which just matured -- big deal! There's got to be something else I can do with this money which would pay me more. I'm in my 70s and can't afford a lot of risk, but I also can't live on these interest rates. Do you have any suggestions?

Thank you,

Leona

Dear Leona,

As a matter of fact, I do!

While today's low interest rates (the lowest in 45 years) have been a bonanza for folks with mortgages, they've made it tough on those who rely on the interest their investments earn. But there are a couple of ways you can increase the income your money is generating: Treasury Inflation Protection Securities, or TIPS, and Series I Savings Bonds.

Although both are interest-bearing securities issued by the U.S. Treasury (search), this doesn't mean they are risk-free. However, depending upon your circumstances, you can significantly reduce your exposure to one type of risk: inflation, i.e. the risk that over time, your dollar won't buy as much as it used to. Both TIPS and Series I bonds are designed to prevent this kind of erosion of your purchasing power.

With most bonds, although the actual value of the bond will fluctuate, the principal remains a set amount. With TIPS, the Treasury Department adjusts the principal by an amount indexed to the Consumer Price Index (CPI)* on a monthly basis. This means that, in a nutshell, unlike most bonds issued by the government or corporations, TIPS go up in value when interest rates go up. In addition, you receive a guaranteed, fixed interest rate for the life of the bond. For instance, the 10-year TIPS which were auctioned in October pay an interest rate of 1 7/8%. The next batch of TIPS will be auctioned off in January.

Because their value is tied to inflation and, indirectly, rising interest rates, Treasury Inflation Protection Securities can help fixed-income investors sleep at night without the worry of losing purchasing power. But they're not a panacea.

For one thing, in exchange for the inflation protection, you give up some return. TIPS pay a lower interest than comparable Treasury bonds (search). Jim Swanson, a strategist at MFS mutual funds, says as of the last week in November, the 10-year regular Treasury note had a yield-to-maturity of 4.19%. The yield-to-maturity on the 10-year TIPS was 1.89%. The difference of 2.29% is what he calls the "break-even inflation rate." In other words, says Swanson, TIPS investors "are expecting that their principal will be adjusted by 2.29% annually to make up for the difference" in the yield.

If the annual inflation rate exceeds 2.29% for the next 10 years, the TIPS will produce a higher total return (interest + principal increase) than the 10-year note. But if inflation runs below 2.29%, the regular Treasury note will outperform. "The implicit question for TIPS investors is 'What do you think inflation will be?' over the life of your TIPS," says Swanson. "If you believe inflation will be declining over the next 10 years, it's crazy to buy a TIPS."

And while you can never get back less than the "par" or "face value" of the TIPS (generally $1,000), you CAN get back less than you paid for it. That's because, like all bonds, their value fluctuates. If you buy existing TIPS in the bond market, as opposed to buying new issues directly from the government, you'll pay more than $1,000 per bond. Falling interest rates in the past year mean the value of older bonds, paying a higher rate, has gone up.

Swanson worries that, "People think they are protected from the loss of principal with TIPS and they're not. There is price risk. If you hold a TIPS to maturity, you'll get your principal, plus the inflation rate back." And that could be more -- or less -- than what you paid for the TIPS.

For example, according to Swanson, as of Nov. 25, the 9-year TIPS which matures in 2012 and pays 3.3%, was selling for $1120. Hold it until it matures, and you'll get back $1,000 plus whatever inflation was added to that over the next 9 years. "But," Swanson cautions, "if inflation is flat (virtually unchanged), your bond could be worth $1,030." In other words, you will get back $90 less than you paid for the bond.

Moreover, any adjustment (increase) to your principal based on inflation is an accounting entry only. You do not receive anything. However, you still have to pay federal income tax on this amount. You'll also pay federal income tax on the interest you receive. (TIPS are not subject to state or local income tax.) So, depending upon your tax bracket, municipal bonds might give you a higher AFTER-tax income. Or, consider holding TIPS in a tax-deferred account such as your IRA where you pay no current income tax on the income or gains.

Or, consider Series I Savings Bonds. They're a relatively new type of Savings Bond where the interest rate is a combination of the inflation rate, plus a fixed amount over this. The rate on I Bonds issued last month is 2.19%. This consists of the 1.08 percent (annualized) rate of the Consumer Price Index* plus the minimum guaranteed rate of 1.10%, which remains the same for the life of the bond. In other words, I Bonds purchased between now and April 30th will always pay 1.10% more than the rate of inflation.

The combined interest rate is adjusted twice a year (on Nov. 1 and May 1) to reflect the change in the CPI for the preceding six months. As the Treasury Department says on its website, "Inflation-indexed I Bonds are designed to offer all Americans a way to save that protects the purchasing power of their investment by assuring them a real rate of return above inflation."

One downside to I Bonds is that, unlike TIPS, you receive no current income. Instead, the interest is added to the value of the bond, which can be purchased at face value (a $100 I Bond costs $100) in denominations ranging from $50 to $10,000. Like all U.S.Treasury securities, I Bonds are exempt from state and local income tax. Federal income tax based on the increase in the bond's value, is not owed until you cash it in- which can be as long as 30 years.

I Bonds have similar characteristics as Series EE Savings Bonds. If you qualify, the proceeds escape federal income tax as well, provided the money is used to pay for tuition and fees at a college or other post-secondary school. You can own them as an individual or have co-owners. You can also name a beneficiary who will assume ownership of the I Bond when you die. You cannot exchange Series EE Bonds for Series I Bonds or vice versa.

The downside to I Bonds is their lack of liquidity. You can't just take them to your broker and have him/her sell them for you. You've got to turn them in at a bank which accepts Savings Bonds. If you don't time it right, you can lose as much as 6 months worth of interest. Also, there's a penalty equal to 3 months' worth of interest if you cash in an I Bond before you've owned it for 5 years.

There's a wealth of information about both Treasury Inflation Protected Securities and Series I Savings Bonds on the Treasury Department's website: www.treasurydirect.gov. A number of mutual funds invest in TIPS, either exclusively, or for a part of their portfolios. TIPS can be bought on the open market through your financial advisor. Both TIPS and Series I Savings Bonds can be purchased directly from the Treasury at the above website.

By the way, if you're tired of schlepping to the bank to buy or redeem Savings Bonds, you can set up an account at www.treasurydirect.gov to purchase them. Instead of receiving the actual paper bonds, your account will record the serial numbers of the Savings Bonds you own, so you never have to worry about misplacing or losing them. You can also sign up to buy a certain dollar amount each month. The money will be electronically transferred from your checking account for the purchase. You can redeem your bonds online, too, and have the proceeds wired to your bank. And if you live long enough to have your Savings Bonds mature, the Treasury Department will automatically redeem them for you.

Losing track of when your Savings Bonds mature is a bigger issue than you might think. According to Pete Hollenbach, Director of Legislative and Public Affairs at the Treasury Department, $11.4 billion worth of U.S.

Savings Bonds are no longer earning interest, yet consumers continue to hold on to them, essentially giving a free loan to the government. So dig out that shoe box and take a look at those bonds you -- or your grandmother-- bought years ago. Hollenbach says if they've matured, "cash them in and put them to work." Don't know if your Savings Bonds are still paying interest? Find out by clicking on "Treasury Hunt." (Who says the folks in Washington don't have a sense of humor?)

Hope this helps!

Gail

*Although we tend to only hear about "the Consumer Price Index (CPI)," in fact, the inflation rate is calculated several different ways. TIPS are tied to the CPI-Urban, i.e. the Consumer Price Index based upon the average change in the cost of living in several U.S. cities.

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