Rising prices make inflation-protected securities more attractive

High oil and gasoline prices combined with trouble in the Middle East, saber-rattling by North Korea, and a slowing housing market have many investors worried anew about inflation. Inflation is an ugly creature; when it spins out of control, it can quickly erase gains built up over years of careful saving and investing. One way to keep inflation in check and guard your portfolio is to invest in inflation-protected notes and bonds.

Comment. Consumer prices rose again in June 2006 for the sixth consecutive month. Core prices, excluding food and energy, rose 0.30 percent. Overall, inflation is running at about 4.7 percent since the start of 2006 compared to 3.4 percent in 2005.

Many countries issue inflation-protected notes and bonds. At home, you can purchase Treasury Inflation Protected Securities (called "TIPS" for short) and I Bonds. If you're an international investor, France issues inflation-protected bonds denominated in euros. The United Kingdom has long been a leader in inflation-protected investments, having issued its first inflation-protected bonds more than 20 years ago.

TIPS

TIPS work just like traditional Treasury notes and bonds. You lend the government money and the government promises to repay you plus interest. Unlike traditional Treasury bonds and notes, TIPS have an extra feature: inflation protection. The government indexes your principal based on the consumer price index (CPI). When inflation rises, your principal increases. If the opposite occurs and prices fall, TIPS are adjusted for deflation.

Let's look at an example. You invest $10,000 in a 10-year TIPS note. The rate of interest is 2.5 percent. You will earn 2.5 percent interest over the life of the bond.  If you had purchased a traditional Treasury note, you would have earned a higher interest rate but without inflation protection.

TIPS pay interest semi-annually at a fixed rate. The rate is determined at auction. Interest payments will vary, however, because the rate is applied to the adjusted principal. When TIPS mature, the government will pay you either the adjusted principal or the original principal, whichever is greater.

The Treasury Department sells TIPS in increments of $1,000, which is the minimum purchase amount. TIPS are issued in terms of five, 10 and 20 years. If you don't want to hold the note until it matures, you can sell it on a secondary market.

I Bonds

I Bonds are another inflation-protected investment. Unlike TIPS, they do not require a minimum $1,000 investment. You can purchase an I bond with as little as $50 for a paper bond and $25 for an electronic bond.

I Bonds grow in value with inflation-indexed earnings for 30 years. However, you can redeem them anytime after one year. However, if you redeem them within the first five years, you will forfeit the three most recent months' interest.

Tax considerations

While TIPS and I bonds protect you from inflation, they can't keep Uncle Sam at bay when it comes to taxes. You will owe federal income tax on all interest earnings and inflation adjustments. The good news is that you will not pay state or local income tax on TIPS and I Bonds.

Although federal taxes cannot be avoided they can be postponed. You can purchase TIPS for your traditional IRA. Because you purchased them for a tax-deferred account, you will not pay federal income tax on your earnings and the adjustments until you start receiving distributions. Give our office a call to explore this option in more detail.

You also may be able to exclude some or all of the interest from I Bonds if you use them to pay for higher education expenses. Not all expenses qualify but many do. Again, our office can help you determine which educational expenses qualify and if you should take advantage of this tax break.