Traditional fixed-income investments benefit from declining interest rates and comparatively low inflation over an extended period of time. Conversely, a rising interest rate environment and inflation is likely to erode the purchasing power and value of fixed income investments.
How is Inflation Problematic for Bondholders?
Inflation makes the costs and prices of goods and services rise. This presents a problem for some bondholders since the majority of bonds pay just a fixed rate of interest. Rising inflation lowers the future buying power of the fixed interest payments that bondholders would receive.
Inflation-Indexed Securities
Inflation-Indexed Securities offer one alternative to the dilemma of rising inflation and interest rates. They safeguard the future value of fixed-income investments.
Introduced in 1997 by the U.S. Treasury, this form of notes and bonds helps protect investors against inflation risk. Called Treasury Inflation-Indexed Securities (TIIS) or Treasury Inflation Protected Securities (TIPS), they allow for the principal amount to be periodically adjusted. Utilizing the Consumer Price Index (CPI) which measures inflation, the principal on TIPS is adjusted to keep up with inflation:
- Fixed interest rates are paid on a semi-annual basis on adjusted amounts
- The value of the principal is adjusted to combat inflation. So when your bonds mature, if their value has increased because of any automatic adjustments for inflation, then that increased amount is what you will receive
- If deflation has come into play and reduced the value of the principal, you will still receive the original face amount of the security
- Unlike conventional Treasury bonds, TIPS will earn more interest on the adjusted principal when inflation rises; however if deflation is an issue, the value of the securities will not rise as fast or will not rise at all
Advantage of Treasury Inflation Protected Securities (TIPS)
- Good Credit Quality: Securities are backed by the U.S. government.
- Inflation Protection—Principal: When inflation rises, your principal grows so you can rest assured that the purchasing power of the principal will stay in line with inflation.
- Inflation Protection—Interest: You are certain to get returns above inflation. Semi-annual interest payouts are based on a preset semi-annual interest rate applied to the inflation-adjusted principal.
Treasury Inflation Protected Securities (TIPS) and Taxes
While federal income taxes are imposed on TIPS, they remain exempt from state and local income taxes. Any interest payouts on TIPS are taxable when you receive them along with inflation adjustments to the principal.
Other Inflation - Indexed Securities
The U.S. Treasury issues another kind of inflation-indexed security. These are Series I savings bonds, which are sold at face value. Denominations run from $50 to $10,000 and interest is paid based on an earning rate that is a combination of fixed returns and inflation adjustments.
You can earn interest for up to 30 years which is exempt from state and local income taxes and might qualify for some federal tax exemptions if proceeds are used for education expenses (post-secondary). Once you purchase Series I bonds, you receive registered certificates that cannot be given away or resold.
Fixed Income Best Practices