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Your Bank > Education and Advice > CNB University

One Way to Deal with Inflation

The smell of rising inflation is in the wind. Although Alan Greenspan hopes to moderate inflation with interest rate controls, it is likely we will see some inflationary pressures over the next few years.

This may be a good time to dust off and take a look at investments that generally are ignored during low-inflation periods - inflation-adjusted US Government notes and bonds.

Conventional bonds and other fixed-income investments, including CDs, carry with them what is called "inflation risk". Such investments typically have rates of return that are at or just a bit higher than the long-term rate of inflation. The consequence is a flat income and principal, both of which decrease in buying power over time. While safer and less volatile than stocks, most fixed-income investments are not a practical vehicle to use by themselves for inflation protection.

Fortunately, the US Treasury offers two different fixed-income options that deliver increased returns when inflation occurs: Treasury Inflation Protected Securities, commonly called TIPS; and Series I Savings Bonds, commonly called I-Bonds. Each operates a little differently, and each has its own advantages and disadvantages.

TIPS, first offered in 1997, are sold in minimum increments of $1,000. They are now available in 3 terms - 5, 10, and 20 years maturity. TIPS are auctioned every 3 months, and a fixed interest rate, dependent on maturity, is determined at that time. The difference between TIPS and most other fixed-income securities is: 1) the principal is adjusted up or down semi-annually for inflation or deflation, as determined by the CPI; and 2) the interest rate is applied to the adjusted principal, not to the original investment.

The result is that the ongoing income and the principal are both inflation adjusted.

The interest income portion is paid semi-annually and is taxable as ordinary income for federal tax purposes. Upward semi-annual principal adjustments, although not available to owners until maturity, also are taxable each year as ordinary income for federal tax purposes. Alternatively, downward adjustments can be taken as an ordinary loss in the year the adjustment occurs.

At maturity, the adjusted principal is paid to the TIPS’ owner. Assuming inflation occurred over the life of the security, the payment will be greater than the original investment. In the unlikely event of ongoing deflation, a safeguard has been built in - the final payment cannot be less than the original investment. TIPS are not risk-free, however. They, like other bonds, can lose principal if interest rates rise and the TIPS are sold prior to the maturity date.

I-Bonds are savings bonds that offer a two-part interest rate: a fixed rate and an additional inflation-adjusted rate.

The fixed rate is set when the US Treasury issues new bonds. That occurs every 6 months. The fixed rate remains unchanged for the life of the bond - up to 30 years. The additional rate is readjusted every 6 months, based on the CPI for the previous 6 months. This interest rate adjustment is what provides the bondholder with inflation protection.

Like Series E/EE savings bonds, no annual payments are made to the bondholder. Interest income accumulates in the bond’s value, and no tax is owed on the accruing interest until the bond matures or is cashed in. If the proceeds are used for qualified college expenses, there may be no tax. There is no risk of principal loss with I-Bonds.

I-Bonds are offered at face value (principal remains unchanged over the life of the bond) at denominations ranging from $50 to $10,000. Unlike TIPS, there are purchase limits - no more than $30,000 worth of paper I-Bonds and another $30,000 in electronic I-Bonds in a calendar year. You also have to hold the I-Bonds at least 12 months after purchase, and if cashed in within the first 5 years, there is a 3-month interest penalty imposed.

Which is better? Like everything else, it depends.

Both types of securities are exempt from state income tax. Both can be purchased directly from the US Treasury, although TIPS can also be bought through mutual funds. Because of the different interest/principal characteristics, I-Bonds generally are better held in taxable accounts, while TIPS and TIPS mutual funds generally are better held in tax-deferred accounts.

Also, both carry a common risk. The fixed interest rate on both of these securities is less than what is available for comparable non-indexed Treasury bonds. The interest-rate gap reflects the expected rate of inflation over the life of the security. If inflation comes in lower than anticipated, investors may do better with regular bonds.

If interested, you are encouraged to consult with a trusted financial planner and investment/tax professional to determine if either type of security makes sense for you as part of a well-diversified portfolio.

James Terwilliger, Certified Financial Planner™, is Vice President, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext 50630 or by email at jterwilliger@cnbank.com .