Whenever prices start to rise, people often worry about inflation, and with good reason. The real return on an investment is not how many more dollars are in your account, but how much more you can buy with the money you have. Here we look at how inflation negatively affects your investments, and how inflation-protected securities (IPS) can help.

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A High Return Is Not Always a High Return
To examine just how damaging inflation can be, let's look at what happened in the U.S. during the 1970s and '80s. From 1970-74, the rate of return on six-month certificates of deposit (CDs) had risen from 7.64% to 10.02%, which made many investors ecstatic (see this data release from the Federal Reserve). And then the rates took another jump in 1979, going from 11.42% to 15.79% by 1981. But what was the real rate of return that these happy investors received on their money?

In 1972, inflation was just over 3.25%. By 1974, it had risen to 11%. And in 1980, it spiked to over 13.5% (see this chart by the Federal Reserve Bank of Cleveland) - while a CD paid 12.94%. Holders of CDs actually lost 0.56% in purchasing power that year because of inflation! More specifically, if you had put $10,000 into a CD, your account statement would have shown $11,294 by the end of the year. Yet that money would have bought only $9,769 worth of goods in terms of the previous year's dollars. But that number doesn't even take income taxes into consideration, which would've just made things worse.

The figure below charts the rate return on the six-month CD and inflation between 1970 and 1982. Note how inflation is extremely close or even higher than the rate on the CD during this period.

CTInflation3.GIF


Investments that Offset Inflation

Inflation-protected securities (IPSs) can work as a hedge against the loss in purchasing power that your fixed-income investments - such as bonds and fixed annuities - may experience in times of rising inflation. (For more on how IPSs work and offset the harmful effects of rising prices on investments, see Inflation-Protected Securities - the Missing Link.) IPSs are available in different forms, each of which we review below.

Treasury Inflation-Protected Securities
Treasury inflation-protected securities (TIPS) offer the safety of the U.S. government, ensuring you'll get your money back. You can buy them without using a broker (see this page on the Bureau of Public Debt website). However, the interest rate on TIPS is lower than what's offered on standard Treasury notes (but TIPS pay interest on the inflation-adjust principal rather than the nominal principal). This spread represents what the market expects the annual inflation rate will be over the next 10 years.

You won't receive income from your TIPS until you sell it or it matures. You will, however, have to pay income taxes each year on the increased value of the principal. But you can avoid this "phantom tax" when you hold the TIPS in a tax-deferred account, such as an IRA.

Municipal and Corporate Inflation-Linked Securities

Municipal inflation-linked securities are issued by various government entities. The semi-annual interest payments are less than you might receive from similar term Treasury bonds, but these payments change with the consumer price index. Plus the income tax treatment is the same as that for regular municipal bonds. Therefore, with inflation-linked securities, depending on your tax bracket, you could possibly come out ahead when compared to fully taxable bonds including TIPS.

You can purchase corporate inflation-linked securities with as little as $1,000 through your broker. The yields on these securities adjust monthly for inflation increases. As these securities are issued by companies and carry more risk, the yields are usually higher than comparable Treasuries. But remember, there is no government backing, so there is the chance that the company might not meet its obligations.

Inflation-Linked Certificates of Deposit
Inflation-linked certificates of deposit are sold through brokers in minimum investments of $1,000. They are insured by the Federal Deposit Insurance Corporation and adjust interest rates annually based on changes in inflation. The yields on these securities are less than regular CDs or comparable Treasury notes.

Inflation-Linked Savings Bonds
Inflation-linked savings bonds (I Bonds) are backed by the full faith and credit of the U.S. government, and you can buy them direct from the Treasury Department or your local bank. They are sold at face value and grow with inflation-indexed earnings for up to 30 years. Federal income tax on the semiannual, compounded earnings is deferred until the bonds mature or you cash them in. And I Bonds are exempt from state and local income taxes. Therefore, they may be suitable for taxable accounts.

Like all bonds, I Bonds are meant to be long-term investments; however, you can cash them in anytime after 12 months. But if you cash a bond within the first five years, you'll forfeit the three most recent months' of interest.

IPSs Are Not Without Risks

Fees to your broker are built into IPSs, just as fees are built into mutual funds, so when you buy IPSs, the amount that goes to your broker is not explicit. Also, since IPSs typically pay lower interest rates than fixed-rate investments, they do not perform as well as regular fixed-income securities when inflation trends downward. When inflation declines, the yields on long-term bonds decline, so the prices of the bonds you're holding go up. This increase in long-term bond prices means that investors are shifting more assets into safer investments, indicating that they believe that slow economic growth is a bigger threat than inflation (if inflation were a bigger threat, they wouldn't put their money into investments where their money is locked in for the long term).

Furthermore, any bond with an inflation-adjusted element could be more volatile than one without it. So if interest rates started rising, the value of your IPS could decline (the result of interest rate risk). And if inflation doesn't rise together with interest rates, your yield to maturity on an inflation-protected security might be just as high as what you would have received with a bond that is not inflation protected.

Summary

More and more financial institutions are marketing IPSs to investors who believe inflation will rise in the coming years. These investments can be as individual securities or as mutual funds. So before you put down your money, make sure you understand the fees. And compare taxable verses tax-free yields.

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