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range for the federal funds rate on March 15. With Morningstar Analyst reports you can get our expert Buy/Sell
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investment that provides
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explicit inflation protection in
Karen Wallace is a senior editor with
Morningstar.com. Follow her on Twitter their portfolio. As discussed in Video Reports
@KarenW60602. this article, many younger
investors already have
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some built-in protection from
inflation in the form of steadily
increasing wages and a heavy exposure to equities, which have a good chance of
outpacing inflation over long periods.
But investors with a shorter time horizon or those who are already drawing income
from their retirement portfolios might have a growing need to preserve their
long-term purchasing power. Treasury Inflation-Protected Securities and I Bonds are
Handy Weapons in an Inflation Fighter's Arsenal http://news.morningstar.com/articlenet/article.aspx?id=799308
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two popular inflation-fighting tools. But, although we compare and contrast the two
security types in this article, the decision to use one doesn't necessarily prohibit you
from using the other. If both security types suit your needs for inflation protection, More Videos...
there's no reason you can't use them together in a portfolio. For instance, you could
hold I Bonds in a taxable account and TIPS and equities in a tax-deferred account as
part of a multipronged inflation-protection strategy.
Handy Weapons in an Inflation Fighter's Arsenal http://news.morningstar.com/articlenet/article.aspx?id=799308
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I Bonds are not an especially complicated security, and they are extremely low risk
and very liquid. During your holding period, they earn interest and protect you from
inflation. Unlike TIPS, they can't lose money over your holding period, even if you sell
them before maturity. Even if inflation is negative, the combined rate will not go
below 0%, protecting your principal value.
One potential drawback of I Bonds (depending on the size of your portfolio) is that
purchases have annual limits of $10,000 per Social Security number (electronic), or
$5,000 for paper versions (purchased using a tax refund). So, it may take you a
while to amass a suitably sized stake to protect your portfolio against inflation. (This
is also why you won't see any I Bond mutual funds or ETFs).
Earnings Rate
The I Bond earnings rate has two parts: a fixed rate and an inflation rate. The fixed
rate, which is determined by the Treasury, is reset each May and November.
Handy Weapons in an Inflation Fighter's Arsenal http://news.morningstar.com/articlenet/article.aspx?id=799308
Purchasers of I Bonds today will get a pretty attractive composite rate of 2.76% that
comprises the semiannual inflation rate and the fixed rate. The fixed rate, as its
name implies, is fixed for the life of the bond (30 years).
Knowing this, it can pay to be strategic about when to buy an I Bond. David Enna,
author of the TIPSWatch blog, points out that though the Treasury doesn't say how it
determines the I Bond fixed rate, inflation seems to be on the rise, which should
make I Bonds more attractive. Therefore, it could pay to wait until May 1 to see if the
Treasury raises the fixed rate above 0.0%.
"A higher fixed rate is coveted because it stays with the I Bond until it is sold or
matures," Enna said. Based on his analysis of historical spreads between the I Bond
fixed rate and the 10-year Treasury yield, he thinks it's likely, though certainly not
guaranteed, that the fixed rate will go up a small amount on May 1 (to 0.1%).
Tax Considerations
Another feature of I Bonds, which could be a negative or a positive depending on
your circumstance, is that they don't make regular income payments. They are
designed as a long-term savings product. You pay taxes on the earned income when
you sell. Therefore, they are a good fit for taxable accounts (and in fact, since you
cant buy them through a broker, you can't really own them in an IRA).
On the flip side, though, they would not be a good option for investors who want to
fund any part of their living expenses with the interest payments from the bonds.
One more interesting thing to note: If you redeem I Bonds during the same year that
you pay qualified educational expenses, you would be able to exclude all or part of
the interest paid during that tax year (subject to certain income thresholds). Click
here for more.
Traits of TIPS
TIPS are also inflation-adjusted based on changes in the CPI-U, but the mechanics
work differently. Unlike traditional bonds, TIPS' principal value will change to keep
pace with inflation as measured by CPI-U (with a lag of a few months). The coupon
payments, which are paid twice per year, will also vary, then, because though the
coupon rate is fixed, the inflation-adjusted principal amount is changing.
If an investor holds a TIPS bond to maturity, she receives the adjusted principal or
the original principal, whichever is greater. This provision protects the bond owner
against deflation. (If the TIPS holder sells before maturity, it's possible that she
would experience a loss of principal.)
Tax Considerations
Unlike I Bonds, TIPS pay out income twice per year (every six months). And holders
of individual TIPS bonds should be aware of a phenomenon called "phantom
income"--essentially, investors have to pay taxes on the principal adjustments in the
tax year they occur, even though they won't receive the full value of those
adjustments until the bond matures. For that reason, owners of individual TIPS bonds
Handy Weapons in an Inflation Fighter's Arsenal http://news.morningstar.com/articlenet/article.aspx?id=799308
Owning mutual funds or ETFs helps circumvent this problem a bit, because the
distributions from funds attempt to match up both forms of payment--they
periodically pay out both the income and the realized inflation. (Investors are still on
the hook for paying the taxes on these distributions.) Because the principal values
fluctuate, however, the size of the fund's distributions can rise and fall.
This is important to note because although TIPS mutual funds and ETFs hold bonds
whose principal values adjust along with inflation, the funds themselves don't have a
maturity date. Therefore, there is no explicit guarantee of principal protection; it's
possible that you could lose money in a TIPS mutual fund over the course of your
holding period.
Add a Comment
mrpcid One more point on I-bonds is that they're subject to federal tax, but
Mar 23 2017, 6:21 AM exempt from state.
Flag
Like 0
Darwinian One point to keep in mind is that TIPS mutual funds usually have
21 hours, 40 minutes ago long durations, because the fund managers maximize liquidity by
Flag matching their portfolio's maturity to that of the bonds issued. This
means a 7-8 year duration, which makes them strongly affected by
Like 0 interest rate risk. In the Taper Tantrum of 2013, a rate rise of about
1% caused Vanguard's VAIPX to drop about ten percent in just a
few months; and even now, it still has not recovered this loss.
Flag
Like 1
Like 0
retiredgary At present TIPS promise a return of a little less than 50 basis points
16 hours, 40 minutes ago over price inflation. That's not bad in comparison to what some
Flag other fixed income products offer, but it is far from good. Bonds of
all sorts are just very expensive.
Like 0
mlott1 I'm glad to see I-Bonds being mentioned again. I think it's good to
14 hours, 9 minutes ago bring them up from time to time, as some have forgotten about
Flag them, or just think that they are the same old Series EE that you
used to buy at the bank, or are just plain ol' unaware of them. Will
Like 0 you get rich with them? No. But they seem to be doing the job they
were designed to do, which is to preserve your purchasing power (I
Handy Weapons in an Inflation Fighter's Arsenal http://news.morningstar.com/articlenet/article.aspx?id=799308