Are inflation-indexed bonds right for you?

Key Points

• Features of Inflation-Indexed Bonds
• Best Purchased in Periods of High Inflation
• Inflation-Indexed Performance
• Inflation and Yields on Long-Term Treasuries
• Points to Remember

Government bonds are a mainstay of many savers and long-term investors because they carry the full faith and credit of the U.S. government. The problem is, they can pay low returns relative to other investments, and risk being outpaced by inflation. Hence, investors who use bonds to save for retirement or for their children's education may experience an investment shortfall, due to the erosive effect of inflation.

In an attempt to remedy this situation and encourage more people to increase their savings, the Treasury Department in January 1997 issued inflation-indexed bonds with a return linked to the inflation rate. The program issues 5-, 10-, and 20-year maturities. These issues are available for purchase in $1,000 increments through brokers, banks, and TreasuryDirect (800-722-2678 or www.treasurydirect.gov).

Features of Inflation-Indexed Bonds

• They are guaranteed to offer a rate of return that is above the inflation rate.
• They protect principal from inflation by indexing principal to the Consumer Price Index (CPI), which is calculated by the U.S. Department of Labor.
• They protect interest from inflation by providing the investor with semiannual interest payments, based on the semiannual interest rate applied to the inflation-adjusted value of the principal.
• They guarantee a return of the principal even if the rate of inflation drops, so that the indexed value is below the value of the bond when it was issued.

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Best Purchased in Periods of High Inflation

Are these bonds a good bet for the average small investor? The answer to that question depends on how you intend to use these bonds, and your outlook on inflation.

If you purchased a $1,000 bond and the CPI rose 3%, the principal value would rise a corresponding 3%, to $1,030. Assuming the interest rate on the bond was 3%, you would receive interest payments of $30.90 twice a year.

If, a year later, the CPI had risen by 4%, the principal of your indexed note would then be adjusted from $1,030 to $1,071.20, and your interest payment would be 4% or $42.85, paid twice a year.

How do these bonds compare to the ordinary variety? Assuming the inflation rate is 3%, and the yield of an unindexed $1,000, 10-year Treasury note is 6.3%, the real yield of this note would be 3.3% — 6.3% minus the inflation rate. After a year that ordinary bond would be worth $1,063; but you'd lose $30 of that gain to the effect of inflation, leaving you with a note that's worth $1,030. Clearly, it makes sense to purchase these bonds only if you expect a major uptick in inflation.

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Inflation-Indexed Performance

Benefits

• Guaranteed to outpace the inflation rate
• Guarantee a return of principal
• Provide semiannual interest payments

Drawbacks

• May not keep pace with expenses (e.g., college tuition) that increase faster than the inflation rate
• Could generate poor returns when inflation rate dips
• Subject to federal taxes, which lower interest payments may not cover

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Inflation and Yields on Long-Term Treasuries

This chart shows how inflation sometimes outpaces the earning potential of fixed-rate investments. Inflation-indexed bonds will compensate for this by guaranteeing a percentage spread between inflation and the bonds' yields. Rates given are for 10-year Treasuries. Past performance does not guarantee future results.

Source: The Federal Reserve. The inflation rate is based on the 12-month change of the Consumer Price Index. Yields are based on the annual rate on 10-year Treasuries. (CS000149)

Although the Treasury has touted inflation-indexed bonds bonds as a way of saving for college, that notion may be impractical. College costs continue to rise faster than the inflation rate: Public college fees, tuition, and room and board increased an average 5.8% in the 2008-2009 academic year — substantially more than the increase in the CPI.¹

While it's true that the interest these bonds pay is exempt from state and local taxes, federal income taxes do apply. It's also important to remember that you will be required to pay taxes on the interest and any increase in principal on an annual basis; however, the increase in principal will be paid to you only when the bond matures. Therefore, you may find that your bond may not pay enough in a given year to cover your tax bill. For this reason, it may be wise to invest in these bonds through a tax-deferred retirement account..

Inflation indexing is an attractive feature for those in or near retirement. After all, during periods of high inflation, inflation indexing offers protection that may help make a difference.

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Points to Remember

1. Inflation-indexed bonds offer inflation protection, unlike other Treasury bonds.
2. They provide the investor with semiannual interest payments, based on the semiannual interest rate applied to the inflation-adjusted value of the principal.
3. While these bonds are exempt from state and local taxes, federal taxes do apply.
4. While investors must pay taxes on interest and increases in the value of the bond's principal in any given year, the increase in principal will be paid to the investor only when the bond matures.
5. Because of the tax consequences, it may be wise to invest in these bonds in a tax-deferred retirement account.
6. While the inflation protection offered by these bonds is attractive, they make the most sense in periods of high inflation.

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¹Sources: The College Board; the Federal Reserve. Inflation is measured by the change in the Consumer Price Index between January 1, 2006, to December 31, 2007.

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