The Practical Investor

Risk-free investing for the long term with inflation-indexed bonds — Part I

by Marvin Appel, PhD, and Brian Hufford, CPA, CFP

Most investors think of U.S. government bonds as completely safe investments because they are certain to receive all scheduled interest and principal payments. While this is true, even conventional Treasury bonds expose their investors to the ever-present risk of inflation.

The country last experienced damaging levels of inflation from 1973-1981. Investors who bought bonds in 1973 or before lost half the purchasing power of their principal during these nine years, and were locked into yields that did not even match the rising cost of living, much less provide some real return to meet living expenses.

The United States has enjoyed low inflation for the past 10 years (averaging under 3 percent annually). Although nobody can predict future levels of inflation, there is little room for it to fall further. Meanwhile, increased uncertainty and military activity around the world could drive inflation up, a situation similar to the period following the start of the Vietnam war.

Fortunately, the government now offers bonds that are guaranteed to return more than inflation. Available products may be particularly suited for retirement plans or college savings, as well as for investors who are at or near their retirement goals and want to protect themselves against a loss of purchasing power if the economic climate changes. In this article, we discuss how you should factor inflation into your investment planning and describe inflation-protected savings bonds. In the second article in the series, we will discuss a second type of inflation-protected U.S. government bond (Treasury Inflation-Protected Securities) and present some guidelines to use in deciding whether the time is right to invest.

Inflation-protected bonds report their interest rates in two parts: a fixed rate and a variable rate. The actual interest rate paid to investors is the sum of both components. The variable rate is adjusted every six months based on the consumer price index for urban living (CPI-U). When inflation goes up, the variable rate eventually catches up, and so does the investment return. Conversely, when inflation falls, so will the yield.

The fixed rate tells you how far ahead of inflation your returns will be each year (not including taxes). For most investors saving to finance future needs, a return above inflation is what really counts. The amount of an investment's return above inflation is called the real return. A 10 percent annual investment return sounds attractive, but would not be if inflation were 12 percent. In this case, the real return would be minus 2 percent per year (10 percent annual return minus 12 percent annual inflation). A risk-free return of 5 percent is not that high by historical standards, but it would be great if inflation also were at historically low levels of only 1 percent, for example.

The fixed rate does not change once you buy a bond, so you know in advance how much the value of the bond will gain over inflation each year. If you hold bonds guaranteed to yield 3 percent above inflation, it is very likely that over the life of the investment, you will be able withdraw 3 percent of the assets each year. No other type of investment offers that degree of safety. Money markets have a good record of keeping up with inflation, and they offer safety of principal, but they have not returned enough beyond inflation to produce much current income while preserving purchasing power. (Real money returns have been closer to only 1 percent annually over the long term and are now almost zero.)

On the other hand, stocks have had an excellent return above inflation over the decades, but they do not provide consistent returns. During the high-inflation years of 1973-1982, the S&P 500 did not keep up with inflation (even counting dividends).

I-bonds: Savings bonds with inflation protection
The government offers individual savers tax-deferred savings bonds called I-Bonds, not to be confused with series EE bonds, which are not inflation-indexed. I-bonds have two outstanding features. First, the interest compounds tax-deferred. Second, buyers choose how long to hold the bonds — anywhere from five to 30 years without penalty. (After 30 years, no more interest is paid. Prior to five years, you forfeit three months' interest to redeem the bonds. I-bonds cannot be redeemed for the first six months.)

If you are in a high tax bracket and you hold the bonds for a long time (20 years or more), conventional Treasuries would have to pay about ½ percent per year higher than an I-bond to match the after-tax return.

As with other savings bonds, I-bonds do not pay out any interest income while you hold them. All proceeds are automatically reinvested. The only way to meet current expenses with I-bonds is to redeem part of your holdings. In order to avoid interest penalties, do not invest any money in I-bonds that you expect to spend within five years. If you plan to redeem I-bonds gradually, make sure that you buy smaller denominations. For example, to invest $10,000 now under a plan to spend $1,000 per year in the future, buy ten $,1000-denomination I-bonds rather than one $10,000 bond.

Your choice of when to redeem I-bonds basically transfers much of the interest rate risk to the government. In this regard, you have the same advantages as you do in deciding when or if to refinance your mortgage. If you happen to invest now, and, five years later, real interest rates are higher, you can redeem your bonds and repurchase better-yielding ones. On the other hand, if real yields are even lower in the future than when you bought the bonds, you would continue to collect the better return you originally locked in.

The government provides an additional benefit for parents: Investors below certain income levels may be able to redeem their I-bonds to pay for college without owing tax on some or all of the accrued interest.

You can buy I-bonds at your bank at face value. There are no sales charges to buy or redeem your bonds. (In contrast, when you buy or sell other types of bonds through a broker, the price quoted to you includes transaction costs that the broker has collected.)

You also can buy savings bonds online directly from the government at its Web site: www.publicdebt.treas.gov/td/tdstorefront.htm. Buyers may purchase these bonds with a credit card. Denominations range from $50 to $10,000. An individual may purchase up to $30,000 in I-bonds in any one year.

Should you buy I-bonds now or wait?

The history of real yields and total yields from I-bonds is available on the government's Web site: www.pub licdebt.treas.gov/sav/sbirate2.htm. Since the debut of I-bonds in September 1998, their real yield has gone as high as 3.6 percent but is now only 2 percent. The public debt Web site (www.publicdebt.treas.gov) contains information about all kinds of government debt, including tax treatment. You should review this site before investing.

The government adjusts the interest rates on I-bonds every May 1 and November 1. Because I-bond rates are adjusted only once every six months, they will lag behind changes in real interest rates. You can use this lag to your advantage. If you plan to buy I-bonds and real interest rates have been rising, you should wait until after the May 1 or November 1 adjustments to buy.

On the other hand, if real rates have been falling, you should buy before any upcoming adjustments. In next month's "Practical Investor" column, we will discuss how to find the information you need about real rates in order to make bond investment decisions about I-bonds as well as inflation-protected Treasury Notes.

I-bonds issued from now until April 30, 2002, pay 4.4 percent (2 percent above inflation). You can get an idea of whether or not this is an attractive rate by comparing it with the government's other inflation-protected product (which we will cover in Part 2).

On the open market for Treasury Inflation-Protected Securities (TIPS) maturing in five years, real rates have risen sharply since November 1 and are now 3 percent above inflation (as of Nov. 30, 2001) — 1 percent per year higher than the I-bond yield. This discrepancy between I-bonds and TIPS is now unusually large by historical standards, which augurs against buying I-bonds until at least the May 1, 2002, rates are announced.

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