Inflation Bonds: Not Such a Great Idea

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They seemed like a good deal when Uncle Sam introduced them. But enthusiasm has waned.

 

When inflation-indexed bonds first appeared in the 1990s, they were hailed as a smart way to protect your nest egg. The bonds are pegged to the consumer price index (CPI), which means that as inflation rises so does the principal value of the bonds. But Treasury Inflation-Protected Securities (TIPS) have been disappointing.

 

Like any bond, their value drops when interest rates rise. And if inflation is low, inflation bonds will be worth less than ordinary Treasuries. Does that mean you should avoid inflation bonds altogether? Not necessarily. Cautious savers may want to hold a few TIPS to protect against a disastrous CPI surge, but all investors should tread carefully.

 

TIPS provide two sources of income. First the securities pay a fixed income stream. In addition, the bond principal rises with inflation. Say you have a $1,000 bond, and the CPI climbs 3% this year. At the end of the year, your principal will increase to $1,030. While the interest rate remains the same throughout the life of the bond, the total yield is based on the growing principal.

 

To calculate the total annual payout of an inflation security, you must add the fixed yield and the increase in principal value. The fixed yield on a 10-year TIPS is currently 2.3%. The CPI has been rising at an annual rate of 2.4%. If you add the two figures together, you get a total payout of 4.7%. That's a modest result and about equal to the recent yield of the conventional 10-year Treasury, which does not adjust for inflation.

 

Should you buy the TIPS or the 10-year Treasury? That depends on your outlook. If you think that the CPI will increase by more than 2.4% annually during the next ten years, buy TIPS, which would outperform conventional Treasuries. But if you think that inflation will remain flat or decline, stick with conventional bonds.

 

While predicting inflation is notoriously difficult, many analysts see few signs of rising prices on the horizon. “TIPS are not a big bargain right now,” says Marilyn Cohen, president of Envision Capital Management, a bond specialist in Los Angeles.

 

Those who do buy TIPS should keep in mind that they can suffer sudden losses. When interest rates pop—or signs of inflation recede—investors may dump TIPS, causing the prices to drop. Price declines occurred several times last year. Vanguard Inflation-Protected Securities, a mutual fund that holds TIPS, lost 2.14% in March 2006. In December 2006, the fund dipped again, losing 2.32%. In other years, the fund has declined more than 4% in a single month. That's a sizable loss for an investment that is supposed to serve as an insurance policy.

 

Besides posting losses, TIPS can become tax traps for the unwary. At the end of the year, a TIPS holder owes taxes on the principal appreciation. You must pay income taxes on the appreciation, even if you continue to hold the bond.

 

The owner of a 10-year security may pay annually for a decade—and not see any cash rewards from the appreciation until the bond matures and the principal is repaid. Because of the strange tax treatment, it is best to hold TIPS in an IRA or other tax shelter. But considering all the problems, many investors should decide to forgo the tax-indexed bonds altogether.

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