What it is:
How it works (Example):
One of the most significant economic threats to anyone living on a fixed income or a fixed stock of assets is the eroding effects of inflation. For example, with an inflation rate of 3% per year, a fixed income investment earning 5% per year will yield only 2% earnings in real terms. Retirees receiving Social Security payments are exposed to inflation on their savings or pensions, even when those payments are adjusted for inflation.
The federal government offers several types of inflation-indexed investments: 10-year notes and 30-year bonds and savings bonds, also known as I-Bonds. The 10-year notes and 30-year bonds are non-marketable securities that cannot be traded or sold in the secondary market. I-Bonds offer tax-exempt interest earnings and also cannot be sold. The principal for both of these inflation-indexed bonds is adjusted with the Consumer Price Index (CPI-U) annually and is payable upon redemption.
The Treasury Inflation-Protected Securities (TIPS) offer 10 and 20 year bonds that provide CPI adjustments to the principal and interest payments at a fixed rate on the adjusted principal, payable semi-annually. TIPS bonds are marketable securities and can be bought and sold in the secondary market.
Why it Matters:
Inflation-indexed securities are an important investment alternative for anyone living on fixed incomes or pensions. However, except for TIPS bonds, the market for these securities is comprised mainly of "buy and hold" investors. As a result, the market is fairly illiquid, because there is a lack of buyers and sellers for these securities. In practice, these bonds do not offer premium returns because they do not have many buyers and they do not have to provide an interest premium to compensate for inflation.