Two Options to Fight Off Inflation

By Martha M. Hamilton
Sunday, December 16, 2007

I have a faint memory from elementary school of stuffing coins into slots in a piece of cardboard decorated with the likeness of a Revolutionary War soldier. I was saving to buy a $25 U.S. bond, but since I don't remember actually owning a bond, I'm guessing my nickels, dimes and quarters didn't add up.

Since then, despite listening to rock-and-roller Gary U.S. Bonds in the 1960s, I haven't thought much about U.S. Treasury securities. Until now.

Recently I decided I needed to know more about two types of bonds that promise protection from inflation, Treasury Inflation-Protected Securities and I (as in inflation) Bonds.

Inflation can be a killer, as benign as 3 percent annual inflation sounds. Even at 3 percent a year, a nest egg of $100,000 loses nearly half its value in 20 years, shrinking to $54,379.43. It could be worse: In 1979, inflation was 13 percent.

That's one reason investment advisers encourage clients to invest in stocks -- to beat inflation. Over the long run, it's true that the stock market has beaten inflation, but it's not true for everyone. Some people have to sell during a market downturn. Others make bad investment choices.

It makes sense, then, to think about investing a portion of your savings in guaranteed inflation protection.

"My starting point as a consumer, as someone who is working hard to earn money and who wants to save it and not see it decline in value, is to say, 'What is the safest thing I can do with my money?' " said Zvi Bodie, professor of finance at Boston University and a major booster of inflation-protected investing.

Both TIPS and I Bonds pay a fixed rate of return that adjusts to account for trends in inflation. But they do it in different ways. Suppose you invest $1,000 in a TIPS that pays an interest rate of 2 percent annually. If the change in the consumer price index in the first six months is 1.5 percent, the Treasury would increase the principal by that amount, to $1,015. The 2 percent interest would then be paid on the higher principal.

With an I Bond, the principal remains what it was at the time of purchase, but the twice-a-year interest rate is adjusted to reflect inflation. For instance, if the current rate of 1.2 percent is adjusted to reflect 3.06 percent annualized inflation, the rate rises to 4.28 percent.

The I Bond rate compares favorably to those of many money-market funds: For instance, the annual percentage yield for balances less than $5,000 is 0.04 percent at one major bank and 1.66 percent for balances less than $2,500 at my credit union. The I Bond rate is closer to the online money-market rates of 4.25 percent at ING, 4.5 percent at Citibank and 4.75 percent at Emigrant Direct.

Money-market rates, however, are subject to change and may drop if the Fed cuts rates again, whereas TIPS and I Bond rates are fixed for the life of the security. If you bought an I Bond between May 1 and Nov. 1, 2000, when the fixed rate was 3.6 percent, you'd be earning about 6.71 percent on that money for the current six-month period. I Bond rates are set below the prevailing TIPS rate.

Right now, the market for TIPS is going like gangbusters despite the talk of recession. The reason is that the high cost of oil and other commodities, and the weakness of the dollar, which could drive up the price of imported goods, have driven up the prices that investors are paying for inflation protection. "There are global forces out there that we can't control," said Brian Brennan, who helps manage a TIPS fund for T. Rowe Price.

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