A Tip of the Hat to TIPS

For conservative investors, inflation-protected Treasurys are a low-risk way to reap some decent returns.

If the past two years have taught us anything, it's that a happy portfolio is a diversified one. Pretty much every investor out there now fully understands the need to allocate at least some of an investment portfolio to relatively safe and less volatile fixed-income assets. The catch is to find investments that pay out more than the measly rates offered by money-market accounts, without taking on much risk.

So how about an investment that offers the security of a money-market account but is likely to provide more than twice the yield? That's what you get with inflation-protected U.S. Treasurys. These bonds pay a respectable rate of return, are as safe as anything can be in this world, and they protect you against the ravages of inflation. Granted, inflation hasn't been much of a concern over the past few years, but if history is any indicator, we can reasonably expect that inflation will once again raise its ugly head in the future. As you'll see below, even with inflation as low as 2%, you'll come out ahead with inflation-protected securities versus nonprotected ones.

As with most investments, though, before you invest, you need to understand the tax picture. So here's a tutorial on the two types of inflation-protected government securities currently available, including an explanation on how they'll affect the tax bill from Uncle Sam. I'll start with the type I believe is the better deal for most investors:

Treasury Inflation-Protected Securities (TIPS)
So-called TIPS have been around since 1997. Recent issues have been 9½-year and 10-year Treasury notes and 30½-year Treasury bonds. Both pay a fixed-cash interest rate, which tends to be in the 2% to 3.5% range.

Now, you're probably thinking that these rates sound abysmally low. And they are -- that is, until you add on the inflation adjustment. You see, each cash interest payment is based on an inflation-adjusted principal amount, using the consumer price index (CPI) as the inflator. What this means is TIPS investors receive an inflation-protected rate of return in the form of: 1) the semiannual cash interest payments based on inflation-adjusted principal balances, plus 2) a larger inflation-adjusted principal payment at maturity or upon sale in the secondary market. (More on the secondary market later.)

For example, say you buy at par (face value) a $10,000 10-year TIPS note paying 2% interest. If inflation runs at 3% during the time you own the note (about what people expect these days), your return will equate to a 5% interest rate on a garden-variety Treasury note. And if inflation turns out to be higher than 3%, you're protected. Why? Because you're guaranteed to earn 2% on top of inflation. In contrast, people who invest in standard Treasury notes won't receive anything to compensate them for higher-than-anticipated inflation.

Here are some numbers to put rate-of-return comparisons into proper perspective. Right now, 2% TIPS 10-Year notes maturing in January 2014 are trading in the secondary market at 102 22/32 to yield 1.67%. Remember, that rate is before the inflation adjustment. Meanwhile, your garden-variety 4.0% Treasury notes maturing in February 2014 are trading at 98 13/32 to yield 4.21%. What does it all mean? Just this: If you believe inflation will exceed 2.54% over the next nine years, the TIPS notes look like the better bet. Of course, the opposite would be true if inflation turns out to average less than 2.54%.

Tax Tips for TIPS
Unfortunately, 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. Even worse, you must pay at your regular income-tax rate, which these days can be as high as 35%. This is especially painful because you won't actually collect any TIPS principal adjustments until your issues mature or you sell them in the secondary market. Nevertheless, the IRS wants its share right now.

But there's an easy solution to this seeming tax dilemma: Buy TIPS only for your tax-advantaged retirement accounts (traditional or Roth IRAs, 401(k)s, Keoghs, SEPs, etc.). That way, the unfriendly tax treatment has no impact, since your TIPS are safely ensconced in a tax-deferred or tax-free account. Putting some TIPS into your retirement accounts makes sense anyway, since for those nearing or in retirement, a main concern is protecting your retirement nest egg against inflation.

Of course, TIPS can also be held in taxable accounts, but this generally isn't advisable unless you're in a very low tax bracket. That said, if you do choose to hold TIPS in a taxable account, the cash interest payments and principal adjustments are completely exempt from state and local taxes.

How to Buy TIPS
The minimum face value for TIPS notes and bonds is $1,000. Larger denominations are available in $1,000 increments. TIPS are marketable securities, so you can easily buy and sell them on the secondary market through your friendly brokerage house. Based on my experience, the commission charges are reasonable, in the range of $50 to $100 on a $25,000 investment. Your transactions can be handled over the phone in just a few minutes.

If for whatever reason you do decide to hold TIPS in a taxable account, you can purchase them upon original issue directly from the government through the Bureau of the Public Debt's online "Treasury Direct" program. This way, you avoid any commission charges. For more information about Treasury Direct and TIPS in general, click here.

Finally, you should know that there are also several mutual funds now devoted to investing in TIPS, such as the Vanguard Inflation-Protected Securities fund (VIPSX). It has a minimum investment of $3,000 for taxable accounts and $1,000 for retirement accounts. Now to me, it seems silly to pay ongoing expense charges if you plan on holding your TIPS for a long time or until maturity. But if you want added diversification and a professional at the helm who can trade the portfolio to take advantage of interest-rate changes, then you might want to consider a fund. Just be sure to look for funds with really low expenses. (With an expense ratio of 0.25%, the Vanguard fund certainly passes that test.)

Series I U.S. Savings Bonds
Beyond TIPS, there's one other type of inflation-protected U.S. Treasury security: Series I U.S. Savings Bonds (so-called I Bonds). These are kissing cousins of the more-familiar Series EE Savings Bonds. Like EE Bonds, I Bonds earn interest for up to 30 years or until redemption, whichever comes first.

Also like EE Bonds, I Bonds receive very favorable tax treatment. You don't owe the IRS anything for the accrued interest until your I Bonds mature or you redeem them for cash. (For this reason, I-Bonds cannot be held in tax-advantaged retirement accounts, since they're already tax-deferred.) So the federal income-tax bill on your I Bond interest can be deferred for up to 30 years, which is obviously, quite nice. And as a bonus, I Bond interest is completely exempt from state and local income taxes. (Ditto for EE Bonds.)

For small investors, I Bonds have the advantage of being purchased at face value in small amounts. You can purchase them at just about any financial institution in the following denominations: $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. The maximum annual investment in I Bonds is limited to $30,000. I Bonds can also be purchased direct from the government over the Internet (to learn more, click here). They can be redeemed for cash (again at just about any financial institution) any time six months after purchase or later. However, redemptions within five years of purchase are hit with a penalty equal to three months' worth of interest.

And here's where the inflation-protection part comes in. The I Bond's interest rate is actually composed of two separate rates: 1) a fixed rate of return determined at issue that applies for the entire 30-year life of the Bond, and 2) a variable rate of return equal to the current inflation rate, which is redetermined on a semiannual basis. The current fixed rate is 1%. That rate applies to all I Bonds issued between Nov. 1, 2004, and April 30, 2005. The variable rate is announced each May and November and is currently 2.66%. The fixed rate is combined with the current variable rate (the inflation adjustment part of the deal) to determine the overall I Bond interest rate to be paid over each six-month period. Interest then accrues monthly and compounds twice a year. In computing the fixed part of the rate, your I Bond principal is increased to account for inflation. Granted, this is a bit confusing. But when all is said and done, the current rate, including the inflation adjustment, turns out to be 3.67% for all I Bonds issued between Nov. 1, 2004, and April 30, 2005.

While 3.67% is nothing to write home about, it's significantly better than money-market accounts are paying these days. Still, that 3.67% rate won't match what you can earn on TIPS held in tax-advantaged retirement accounts (because the fixed rate on TIPs is higher than the fixed rate on I Bonds), which is why I don't think the I Bonds are as attractive as TIPS.

But since they can be purchased in small amounts (and they're automatically tax deferred), they're ideal for small investors, or can be handy gifts (e.g., for grandparents making a contribution towards a grandchild's college fund). Granted, a few years ago this might not have sounded like much, but these days, I think we can all appreciate the beauty of a steadily growing stash that's not going to give us any big surprises.

Revised on January 12, 2005