Investing, Economy, Stocks, Real estate, Apple, Google, Inflation, Retirement, China, Housing, Oil, Interest rates, Recession, Banks, Iphone, Housing bubble, Personal finance, Countrywide, Stock market, Credit crunch, Credit, Federal reserve, Bank of america, Dividend, Microsoft.
The United States
Treasury currently offers a special kind of security,
called a Treasury Inflation-Protected Security (TIPS),
whose principal amount is adjusted for inflation. The
Treasury Department regularly auctions TIPS with 5-year,
10-year and 20-year maturity. The Treasury introduced
these instruments in 1997, based on the premise that
the issuance of TIPS would reduce interest costs to
the Treasury over the long term and would increase the
different types of investors that buy their debt instruments.
Although TIPS do bear a significant risk of loss and
are therefore no a cash equivalent, they have been very
popular among certain classes of investors looking to
hedge their interest rate and inflation exposure.
TIPS can be purchased by individual investors directly
from the U.S.
Treasury at auction or through primary brokers.
They offer a number of potential benefits for investors.
Like ordinary US Treasuries, they are backed by the
full faith and credit of the government. Unlike ordinary
US Treasuries, the principal is protected against inflation.
Since the principal is linked to inflation, investors
are guaranteed that the real purchasing power of the
principal will keep pace with the rate of inflation.
For example, if you were to buy a $1,000 TIPS bond and
inflation were to rise at a 2% annual rate, the bonds
would have an adjusted face value of $1,020 after one
year. As inflation fluctuates, the bond's value and
interest payments would too. The inflation adjustment
becomes payable by the US Treasury at maturity when
the securities will be redeemed at their inflation-adjusted
principal amount, but at a price no less than the par
issue price.
Interest is also protected from inflation as investors
receive semiannual interest payments, based on a fixed
semiannual interest rate applied to the inflation-adjusted
principal, and are therefore guaranteed a real rate
of return above inflation.
The index for measuring the inflation rate is the nonseasonally
adjusted Consumer Price Index for
Urban Consumers (CPI-U). CPI-U was selected by Treasury
because it is the best known and most widely accepted
measure of inflation.
The semiannual interest payments on TIPS are taxable
to a holder of securities when received (consistent
with the tax treatment of other Treasury securities).
However, investors will also be taxed on inflation adjustments
to the principal in the year in which the adjustments
occur, even though the principal adjustments would not
actually be received from Treasury until maturity (a
situation that is sometimes described as taxing "phantom
income").
Currently, the 10-year TIPS is yielding approximately
2.10%, or about 2.60% below the 10-year Treasury. Assuming
that your intention is to hold the bond to maturity,
a general rule of thumb is that the 10-year TIPS will
outperform over the life of the bond if inflation over
that period is greater than the discount to which it
trades to the corresponding fixed Treasury (in this
case 2.60%).
What
to Look for:
If you are
concerned about inflationary pressures, these securities
would tend to offer better protection than ordinary
Treasuries. With oil prices holding at a historically
high level, many are afraid that the impact will soon
be felt in the prices of goods and services. Recent
CPI-U indicators, however, indicate that inflation remains
under control.
Avoiding Pitfalls:
Like Treasuries
or any longer term fixed income investment, these securities
bear certain risks. An investment in securities with
principal or interest determined by reference to an
inflation index involves factors not associated with
an investment in a fixed-principal security. Such factors
may include the possibility that the inflation index
may be subject to significant changes, that changes
in the index may or may not correlate to changes in
interest rates generally or with changes in other indexes,
that the resulting interest may be greater or less than
that payable on other securities of similar maturities
and that, in the event of sustained deflation, the amount
of the semiannual interest payments and the inflation-adjusted
principal amount of the security will decrease. However,
if at maturity the inflation-adjusted principal amount
is less than a security's par amount, an additional
amount will be paid at maturity so that the additional
amount plus the inflation-adjusted principal amount
equals the original par amount.
