Why Would Anyone Buy Inflation-Protected Investments?

Summary

• The idea: Push inflation-protected money into the future, when you will need it in retirement.
• Both I Bonds and TIPS are super safe investments that can be purchased with zero commissions and fees.
• The only risk in purchasing 'inflation protection' is that you will receive a slightly lower return than with nominal investments. The cost is very low.

I recently met three college friends for a day of hiking in northern Illinois (yes, you can hike in northern Illinois; just check out Starved Rock State Park.) When we sat down for lunch in the park's beautiful lodge, we got to talking about things we were doing for fun or profit.

"I've been writing about inflation-protected investments for a financial website," I said.

Blank stares.

"It's something I've been interested in for a long time, so I began writing about it," I said. "Trying to build up a following."

Blank stares.

"You've never heard of Treasury Inflation-Protected Securities or I Bonds?"

My friends shook their heads. Then, one of them said: "Is this some sort of scam?"

My friends are college-educated and very intelligent. In that moment, I realized that most people - maybe 95% of Americans - have no idea what inflation-protected investments are or how they could fit into a portfolio.

What are inflation-protected investments?

The only two inflation-protected investments I follow or care about are both issued by the U.S. government: Treasury Inflation-Protected Securities (OTCPK:TIPS) and Series I U.S. Savings Bonds, also called I Bonds. Both can be purchased directly from TreasuryDirect.gov without fees or commissions. Both can be considered among the safest investments on earth, fully backed by the U.S. government. So, let's take a deeper look at these two investments.

The case for and against I Bonds

I Bonds are the simplest, no-hassle way to add inflation protection to your portfolio. The minimum purchase is $25, and the I Bond's value will continue to climb tax deferred with inflation until maturity in 30 years - or until you sell the I Bond. There is no secondary market for I Bonds, so you simply hold them and sell them. The return you receive will closely match or exceed the Consumer Price Index.

An I Bond earns interest based on combining a fixed rate and an inflation rate.

• The fixed rate will never change. So, if you bought an I Bond in 2014 with a fixed rate of 0.2%, it will continue to have a 0.2% fixed rate for the life of the bond. Purchases through October 31, 2017, will have a fixed rate of 0.0%. This fixed rate is the 'real yield' - meaning after inflation - of an I Bond.
• The inflation-adjusted rate changes each six months to reflect the running rate of inflation. That rate is currently set at 1.96% annualized. It will adjust again on November 1, 2017, for all I Bonds, no matter when they were purchased.

To get the actual rate of interest (the composite rate), the Treasury combines the fixed rate and the inflation rate. The combined rate will never be less than 0.0%, so I Bonds are protected against deflation. The current, inflation-adjusted value of an I Bond can never decrease, even in times of severe deflation.

The Treasury limits purchases of 'electronic' I Bonds - purchased at TreasuryDirect - to $10,000 per person in each calendar year. You can also get up to up to $5,000 in paper I Bonds each year bought with your IRS tax refund. Although I Bonds seem mundane, a lot of very wealthy people fret over 0.1% changes in the fixed rate and scheme to get additional I Bonds through tax refunds or trust accounts. Why would they do that? Some reasons:

• I Bonds allow an investor to push tax-deferred, inflation-protected money into the future, with zero risk. They can be used in combination with nominal Treasuries and bank CDS to preserve capital.
• I Bonds allow you fantastic flexibility. You can redeem them after one year, costing you three months of interest. Or redeem them after five years and pay no penalty, or just hold them for 30 years and cash out.
• I Bonds protect you against unexpected inflation. If inflation in the next 30 years suddenly soars to 7%, 10%, 15%, your principal will increase by that amount because of the inflation-adjusted interest rate.
• I Bonds allow you to defer federal income taxes until you redeem them, so you pay zero in taxes until they are sold. This is a big advantage over TIPS, which carry current-year income taxes for both the coupon rate and the inflation adjustment to principal. (Both TIPS and I Bonds are free of state income taxes, an advantage over bank CDs.)
• Interest on I Bonds is compounded semiannually and rolls into the I Bond's balance, so you earn interest on your interest. With a TIPS, the coupon rate is paid out as current interest and doesn't compound.
• I Bonds are very simple to track as an investment. Just download the Savings Bond Wizard, update your information, and check it a couple times a year. This is another huge advantage over TIPS held at Treasury Direct, which is a do-it-yourself proposition, even for downloading yearly tax forms. Want to track current value of your TIPS? Open up Excel and get to work. Treasury Direct is not going to tell you.

So, what are the negatives for I Bonds? The current return is very low, for two reasons: 1) today's fixed rate of 0.0% means I Bonds can only match inflation, but not exceed it, and 2) inflation has been running at ultra-low levels over the last few years.

In addition, I Bonds cannot be purchased in a Roth IRA. So, eventually, when sold, you will owe federal income taxes on the entire gain above the original purchase. This is a negative but can be offset by timing your I Bond sales to limit taxes.

The case for and against TIPS

Treasury Inflation-Protected Securities are a more complicated investment. The Treasury auctions TIPS - either new issues or reopenings - every month of the year. Investors can participate in these auctions by placing noncompetitive bids (the minimum is $100) at TreasuryDirect, again with zero fees or commissions. TIPS are auctioned with terms of 5, 10, and 30 years.

After the TIPS's originating auction, the Treasury sets the coupon rate, which determines the interest paid twice yearly on the TIPS's principal balance. But investors at the auction pay a price above or below par value, resulting in the TIPS's real yield to maturity. The real yield is the amount the investor will earn 'above' inflation and is the most important factor in the auction. The principal balance of a TIPS rises (or falls) with inflation continuously until maturity, and the resulting interest earned on the coupon rate also rises (or falls). At maturity, the investor gets back the original par value plus inflation.

For example, if a buyer was purchasing $1,000 in a TIPS auction and the real yield ended up being 1.1%, the coupon rate would be set at 1% and the buyer would get the TIPS at a discount, something like $990 for $1,000 in value.

TIPS are considered 'deflation protected' because an investor can't receive less than the original par value at maturity, even in a time of severe deflation. But deflation can erode the inflation-adjusted principal balance of a TIPS. That can't happen with an I Bond.

TIPS get complicated because once they are auctioned, they can be traded on a secondary market. The 'market value' of a TIPS is constantly changing, and that means the real yield is also changing for new investors.

Investors can buy TIPS on the secondary market through brokerage firms, generally incurring a commission. Many brokerage firms also allow purchases at the Treasury auctions, which allows investors to put TIPS in tax-deferred accounts.

Phantom taxes are an issue with TIPS, because both the coupon rate (paid twice a year) and inflation adjustments to principal incur federal income taxes in the current year. But the investor receives only the coupon rate in the current year. The inflation adjustment isn't paid until the TIPS is sold or matures. This is the reason many investment advisors recommend buying TIPS in tax-deferred accounts.

You can also purchase mutual funds that invest in TIPS, such as the TIP ETF or Vanguard's Inflation-Protected Securities Fund (MUTF:VIPSX). These funds are ideal for tax-deferred accounts, but investors need to know that the fund's Net Asset Value will rise and fall with the value of the underlying TIPS.

My personal investing style is to buy TIPS at auction and then hold them to maturity, building out a ladder with TIPS maturing every year for 10+ years into the future. When a TIPS matures, I buy another one to fill a future ladder spot. I don't follow the daily price fluctuations of the TIPS I own, because I have no intention of selling them before maturity.

In addition, I combine TIPS and I Bonds with other very safe nominal investments, such as bank CDs. In times of very low inflation or deflation, a bank CD may outperform an I Bond or TIPS.

TIPS vs. I Bonds

TIPS generally pay a yield premium over I Bonds, which makes sense because I Bonds have a more flexible maturity, better deflation protection, and tax-deferred interest. Right now, for example, an I Bond has a fixed rate of 0.0%, and a five-year TIPS has a real yield of 0.17%. At that yield, I would prefer the I Bond over the TIPS as a five-year investment. When you stretch out the maturity to 10 years, the TIPS is paying 0.47% real versus 0.0% for the I Bond. So, the advantage goes to the TIPS as a 10-year investment.

Here's a strategy many investors use: Buy I Bonds every year, up to the $10,000 per year limit, even if the fixed rate is 0.0%. The idea is to build a large cache of I Bonds to push inflation-protected money into the future. With TIPS, watch the auctions and buy when the yields look favorable, but commit to building a ladder stretching out 10 or more years, with TIPS maturing each year.

Investing in TIPS is a bit of a hassle, mainly because TreasuryDirect isn't extremely user friendly. You have to download cryptic tax forms each year and fill out a 1099-OID tax form on the inflation adjustments. Tracking the current value of your TIPS requires downloading TIPS Inflation Index Ratios to determine the current inflation-adjusted balance. Good at Excel? It helps.

When you place an order for a TIPS at auction, you won't know exactly what real yield you will get - that's determined by the auction, which is also where the 'big boys' play - foreign central banks, hedge funds, insurance companies, maybe even the Federal Reserve.

If all this seems intimidating, I suggest placing a couple of small orders to learn the routine. Remember, the minimum investment is $100 - take that, big boys!

Is inflation even a problem anymore?

And, here is the key question: Is it worth devoting a portion of your asset allocation to inflation protection? I argue - strongly - that it is. Inflation over the last 10 years has averaged 1.6%, the lowest for any 10-year period in more than 50 years. A lot of investors are getting complacent about inflation.

With yields so low on safe investments like Treasuries and bank CDs, there is very little 'cost' to buying inflation protection.

I'll close by quoting an October 2012 article by Michael Ashton, who writes about inflation and is author of the E-piphany blog and a new book, 'What's Wrong with Money?: The Biggest Bubble of All'. In this article, Ashton talks about how investors are being told to 'remain calm, all is well' And then he writes ...

But I think that’s also what they told the people on board the Titanic. At some point, regardless of what the authorities are forecasting, investors need to grab for their life jackets or to head for the stairs anyway (and if I sound frustrated, it’s because we’re trying to hand people life preservers and they keep going back below decks). The worst thing that can happen if you’re wrong is that you’re feeling foolish, standing freezing on the deck of the ship and all really is well. The “Titanic Decision” matrix is below. I can tell you one thing: there is a single box there that I am pretty sure I want to avoid. What about you?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.