A Primer on Inflation-Linked Bonds

As recently as the 1970s, inflation was one of the biggest concerns for investors around the globe. Inflation then became a back-burner issue during the period of the "Great Moderation." However, many investors have begun to worry again about the impact that possible inflation will have on their investment portfolio. 

Luckily, you have options to prep your portfolio to battle inflation. One easy way for both institutional and individual investors to offset the impact of inflation is with the use of inflation-linked bonds. This type of bond is directly linked to an inflation index such as the Consumer Price Index(CPI) here in the U.S. Therefore, as inflation rises, so does the value of these bonds. 

The idea of the inflation-linked bond originated in the 1780s with bonds issued by the Massachusetts Bay Company. These bonds were linked to the prices of consumer items such as meat, eggs, and clothing. The idea then lay dormant until the 1950s when the nation of Iceland issued such bonds. 

The modern inflation-linked bond market began in earnest in the 1980s. The first inflation-linked bonds in the modern era were issued by Great Britain. Other governments such as Japan, Australia, Canada and many European countries soon followed. The United States government did not issue such bonds until 1997.

Today the U.S. government offers two types of inflation-linked bonds, and depending on your investment horizon, either could be a smart way to battle the ravages of inflation.

I-Bonds

The first inflation-linked bond issued by the U.S. Treasury is called an I-Bond and it is basically a regular U.S. savings bond with inflation protection pegged to the CPI index. The I-Bond has a fixed rate of return plus an inflation premium. The inflation premium is adjusted every May and November by the Treasury Department. The fixed rate assigned when the bond is purchased is good for as long as the bond is held. 

An I-Bond is similar to a savings bond in that they are payable only to the person to whom they are registered. In other words, you can't resell them on the open market, but you can cash them in. The bonds can be cashed in after a minimum of a one-year holding period. However, if you redeem a bond before five years, there will be a three-month interest penalty. Upon redemption, you are paid all accrued interest. The bonds earn interest for up to 30 years. 

I-Bonds can be bought and redeemed through many financial institutions or directly from the Treasury at their website www.treasurydirect.gov. Investors may purchase I-Bonds in denominations from $25 to $5,000. The maximum purchase per year by an individual is $5,000. 

Tax reporting of interest on I-Bonds can be claimed annually or it can be deferred until redemption, final maturity, or other taxable disposition. The interest is subject to federal income tax, but is exempt from state and local taxes. 

TIPS (Treasury Inflation-Protected Securities)

TIPS are basically Treasury notes with the addition of inflation protection tied to the CPI index. Unlike I-Bonds, they are marketable securities and can be bought and sold at any time in the secondary market. The principal on TIPS is adjusted monthly by changes in the Consumer Price Index, and TIPS pay interest every six months. When the bond matures, you are paid the adjusted principal or original principal, whichever is greater. 

#-ad_banner_2-#TIPS are issued with maturities of five, 10, and 30 years. They can be bought directly at auction with denominations as low as $100 and in increments of $100. TIPS can be bought through many banks and brokers and through the U.S. Treasury at www.treasurydirect.gov for no fee. 

Interest on TIPS is subject to federal income tax but is exempt from state and local taxes. In addition to paying federal income tax annually on the interest, you will also have to pay tax each year on any increases to the principal, even though you won't receive the inflation-adjusted principal until the bond matures. Because of the tax implications, it may be best for individuals to hold TIPS in a tax-deferred account or a Roth IRA. 

The Rewards and Risks of Inflation-Linked Bonds

The major benefit of inflation-linked bonds, such as TIPS, is that the outstanding principal of the bond rises with inflation. So when inflation rises, so does the face value of the bond. This is in sharp contrast to most other types of securities. In addition, once the face value of the bond is adjusted upwards due to inflation, the interest paid will increase based on the adjusted face value. 

The major downside to inflation-indexed bonds occurs during a period of deflation. The U.S. Treasury, however, does put a floor under the prices of their inflation-linked bonds. A bond which was originally issued with a face value of $1,000 will be redeemed for no lower than the original $1,000 face value. An investor buying an already-issued TIPS bond, which may trading above the $1,000 face value, could lose money if the bond fell back to the $1,000 face value in a deflationary period. 

Since inflation is much more assured over very lengthy time frames, inflation-indexed bonds remain a safe and popular investment for long-term investors planning for their child's college education or for their own retirement. With the purchase of inflation-linked bonds, longer-term investors can rest assured that their investments can overcome inflation's corrosive effects and retain their long-term purchasing power.

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