A recent Wall Street Journal article commented on the dramatic growth in investments in TIPS funds. These are bond funds that invest in Treasury Inflation-Protected Securities, a type of government bond that has a principal escalator that increases the value of the bond to match inflation. This interest in mutual funds that focus on TIPS is no surprise, given rising interest rates and fears of inflation.
These Treasury Inflation-Protected Securities or TIPS can be accessed directly from the Treasury, through brokers and dealers in the secondary market, or indirectly by investing in a fund that concentrates on TIPS. The unique inflation-protection feature of TIPS suggests that retirees and others concerned about inflation may want to consider these securities for a portion of their portfolio.
The Mechanics of TIPS
TIPS bonds pay a fixed interest rate that is set by auction at issue, with that rate never changing over the life of the bond. The formal maturity can be 5, 10 or 20 years. But the principal of that bond is adjusted every six months for inflation based on the Consumer Price Index (CPI). The interest rate is then applied to that increasing principal balance. The fixed interest rate tends to be low by comparison to other bonds, but the inflation indexing feature compensates.
Example. George acquires a $100,000 TIPS bond currently at a specified interest rate of 2.5%. If the inflation rate per the CPI is 4% annually, the principal is automatically increased at the six month point by half of that amount, or 2%. Accordingly, George’s bond is inflation-indexed to $102,000 of principal, and the 2.5% interest rate is calculated on the increased bond value.
From a tax standpoint, both the direct interest payment and the inflation-indexing of principal are treated as earnings and reported as taxable income to the investor. This tax treatment is harsh in the sense that only the interest payment is received in cash, while the inflation growth is not recognized until the bond matures or is sold. On the positive side, because this interest is from the U.S. government, it is exempt from any state income tax. Overall, taxpayers may wish to concentrate any TIPS investments within tax deferred retirement plans, so that the tax consequences are postponed until the investment is accessed by the taxpayer.
The I Bond Alternative
For those investors who do not care for the annual taxation of the TIPS bonds, or seek an inflation-indexed investment with a smaller increment than the $1,000 TIPS minimum, consider U.S. Savings I bonds. These are also inflation indexed. The I bond actually earns interest using two separate rates: A fixed rate of return that is set at the time the bond is purchased and a variable rate that reflects inflation based on recent changes in the Consumer Price Index. The fixed rate never varies over the 30 year life of the bond, but the inflation rate portion is adjusted every six months.
For I bonds issued from May through October of 2006, the I bond rate is 2.4%, consisting of a 1.4% fixed rate and a 1% annualized rate of inflation. These bonds are issued at face value in denominations as low as $25 and as high as $10,000, with interest on each bond compounded semi-annually. And like TIPS, the interest is exempt from state and local income tax, effectively improving the yield.
Because of the flexibility in denominations, these bonds could be a good alternative for a young child, where the intent is to compound the earnings without taxation until at least age 18, to avoid the reach of the Kiddie Tax.
