If you're concerned about inflation -- and you should be! -- there are two kinds of fixed-income products you can use to protect yourself. But in the current environment, one may hold greater value than the other.
Inflation clearly is growing. According to the consumer price index readings released this week, the country had a 3.8% annual rate of inflation for the 12 months through May. Some forecasters now see a 4.4% or higher rate of inflation for 2006.
Rising inflation portends higher interest rates, which are no doubt coming. As inflationary pressures build, so does the pressure to increase interest rates, curb consumer spending and cut the country's massive debt.
There are two kinds of fixed-income investments with built-in inflation protection: Treasury Inflation Protection Securities, or TIPS, and Series I bonds. Should you buy them?
Here's the short answer: TIPS are currently a losing proposition, so I bonds might be your best choice for now. Allow me to explain.
TIPS are U.S. Treasury bills that are sold in denominations of $1,000 and come in 5-year, 10-year and 20-year maturities. You can buy them directly from the government, from your broker or via traditional or exchange-traded funds. And TIPS pay you semiannual interest payments that are exempt from state and local taxes. At maturity, you're paid your principal plus any inflation adjustments.
Depending on the tenor, TIPS are currently paying fixed rates of interest in the range of 2.32% to 2.44% per annum. On top of that, they will offset the impact of inflation -- at least as measured by the CPI.
Not surprisingly, millions of investors have flocked into TIPS investments in recent years. But there are several important facts you should know about these kinds of investments.
- Huge demand for inflation protection has driven up the prices of these bonds and consequently, reduced yields. Here are the performance results of several TIPS funds and ETFs as of Thursday. (For the record, I own VIPSX.) Most TIPS funds have sustained losses in recent months. They may help protect you from inflation, but do not, after all, keep your nest egg intact.
- In a rising interest rate environment, TIPS will also be vulnerable to "opportunity" and valuation loss. Suppose you hold a 20-year TIPS bond paying 2.44% and the Federal Reserve subsequently increases the interest rate, issuing new 20-year TIPS that pay 3%. The market is going to value your "old" bond at a discount. And you will lose the opportunity of earning higher interest over the next years.
- All TIPS funds do not have similar content or risks and, hence, perform differently. Many so-called TIPS funds actually contain a mix of different kinds of Treasury, federal government and sometimes corporate bonds. Some funds use forward contracts to purchase large blocks of bonds with small amounts of cash to magnify results. And that can represent additional risk. If you're contemplating investing in a TIPS fund, be sure to read the fund's prospectus and use online research before you buy to ascertain the fund's content and risks.
- If you buy TIPS or a TIPS fund, you should only do so in a tax-exempt or tax-deferred account such as a 401(k) or IRA. TIPS are exempt from state and municipal taxes, but the federal government recognizes any inflation offset that may be accrued each year as taxable income, even if it is only paid at the bond's maturity.
In other words, you could find yourself with a surprise tax obligation unless you hold your TIPS investment in a tax-sheltered account.
I would normally encourage you to hold a part of your portfolio in TIPS.
But high demand has reduced yields to unattractive levels. Now is simply not a good time to buy or hold these securities.
There is a second inflation-protection alternative with the Series I bonds.
I bonds come in eight denominations from $50 to $10,000. You buy them at face value, meaning that you pay $1,000 for a $1,000 bond.
But you can only purchase up to $30,000 of these bonds a year (plus an additional amount if you buy electronic instead of paper versions).
These bonds pay you two income streams: a fixed-interest rate and semiannual inflation adjustments, which together currently total 2.41%.
You can earn interest on these bonds for up to 30 years. In fact, the redemption mechanics are jury-rigged to encourage holding them long-term.
You can redeem these bonds after 12 months, but if you redeem them within the first 5 years of purchase, you pay a three-month penalty.
This means that if you redeem an I bond after, say, 18 months, you would get back your principal plus 15
not 18 months of earnings.
Series I bonds are exempt from state and local taxes, and federal taxes are deferred until you redeem. So these bonds do not have the same tax-surprise potential that TIPS do.
Buying a small amount of Series I bonds every year and holding them for at least five years may be helpful to hedge against inflation.
If rates go up, you will give up income opportunity. But you will still enjoy positive returns and an offset to inflation along the way.
That's just not the case with TIPS funds right now. Hold off on these funds until you can get better returns.
At the time of publication, Schlagheck was long VIPSX.
Jim Schlagheck is a wealth management professional who has counseled ultra-high-net-worth families, endowments and pension funds in the U.S., Europe, and the Middle East. He is a former senior executive of American Express Bank, UBS AG, Bank Julius Baer, and TAIB Bank. During his career, Schlagheck launched a family of mutual funds (now holding $4 billion), led teams of financial planners and investment advisers based in New York, Bahrain, and Geneva, Switzerland, and helped many high-profile clients to protect and enlarge their wealth. Jim has a blog on investment topics
www.invest-blog.com and is the author of "Show Me The Money!", a soon-to-be-published book that synthesizes his novel views about investing for retirement.