Government bonds are the most popular type of bond used by many investors and savers because they have the full faith and credit of the US government. Being relatively safe, they are appropriate for investors who cannot tolerate many risks and are looking to preserve your capital. The problem is that they generally pay low returns relative to other investments and face significant inflation risks. Therefore, investors who predominantly use bonds in their portfolios as part of a retirement planning strategy or to finance a child’s education may do themselves a disservice due to the damaging effects of inflation.
To remedy this situation and continue to maintain the attractiveness of US government bonds for investors, the US Treasury issued inflation-protected bonds with a yield indexed to the rate of inflation. There are three maturities for this type of bonds issued at 5, 10 and 20 years. These issues are available for purchase in $ 1,000 increments through financial advisors, banks, and TreasuryDirect.
Characteristics of inflation-indexed bonds
• They are guaranteed a rate of return higher than the rate of inflation.
• They protect the investor’s capital from inflation by indexing the capital to the consumer price index (CPI).
• They protect interest from inflation by providing the investor with semiannual interest payments based on the semiannual interest rate applied to the new inflation-indexed principal value.
• They guarantee a return on principal even if inflation drops.
The time to buy is during periods of high inflation
Inflation-protected bonds are a good decision when an investor’s outlook for inflation is that inflation will increase in the coming years. For example, if you buy a $ 1,000 bond and the consumer price index increased by 3%, the value of your starting capital will also increase by 3% to $ 1,030. Assuming the bond’s coupon rate is 3%, you will receive interest payments based on the new principal amount. If the following year the CPI increases to 4%, the principal will adjust from $ 1,030 to $ 1,071.20 and your interest payment would increase from 3% to 4%, paid twice a year.
How does this structure compare to the ordinary bond, one that is not protected against inflation? Well, assuming that the inflation rate is 3% and the yield on the unprotected 10-year Treasury bond of $ 1,000 is 6.3%, the real yield on this security would be 3.3% obtained by subtracting the inflation rate from the title note. After a year, that bill would be valued at $ 1,063, but you would lose $ 30 of that gain due to the erosive nature of inflation, leaving you with a bond worth $ 1,030. So it makes sense to buy inflation-indexed securities if you think inflation will pick up.
Benefits and Drawbacks of Inflation Protected Securities
Profits
• Guaranteed to beat the inflation rate.
• Guarantee the return of the principal.
Drawbacks
• Some expenses can grow at rates above the inflation rate.
• It could generate bad results when there is deflation.
• Subject to federal taxes, which may not justify lower interest rates.
Be careful when buying inflation-protected bonds for expenses like a college education, because that strategy is not practical. College tuition costs exceed the rate of inflation. For the 2008-2009 academic year, college costs, including tuition, fees, and room and board, increased by an average of 5.8%, which was substantially more than the increase in the Consumer Price Index (CPI) .
Although it is a fact that these inflation-indexed bonds are exempt from state and local taxes, federal income taxes still apply. It is also important to understand that you will have to pay taxes on any increase in principal annually; however, the increase in principal will be paid to you only once the bond matures. So if you find that your bonds do not pay enough interest income to cover your capital increase tax bill in a given year, they may not be suitable investments for you unless you invest in these bonds through a tax-deferred account such as a retirement account.
Indexing for inflation is especially attractive to investors who are retiring or close to them. After all, during periods of inflation, inflation protection can make all the difference in protecting the retiree’s capital.
Things to bring
• Inflation-indexed bonds offer protection against inflation.
• Semiannual interest payments are based on the interest rate applied to the value of the principal indexed to inflation.
• These bonds are exempt from state and local taxes, but federal taxes apply.
• Investors must pay taxes on increases in the bond’s principal value in a given year, while the increase in principal will be paid to the investor only when the bond matures.
• It can be sensible to invest in inflation-indexed bonds in a tax-deferred retirement account.
• Inflation-protected bonds make more sense in periods of high inflation.