By David Braze (TMF Pixy)
June 26, 2000

In recent years, the U.S. Treasury began issuing two new securities that may be of interest to many retirees -- Treasury Inflation Protected Securities (TIPS) and I Bonds. Both are designed for savers and bond investors who wish to protect the purchasing power of their investment while earning a guaranteed rate of return on their principal. Like all public debt instruments issued by the federal government, these vehicles are backed by the full faith and credit of Uncle Sam. Thus, they are among the safest investments in the world. As such, and because they offer both inflation protection and a guaranteed rate of return, they may play a useful role in retiree investment selections. Let's look at both vehicles to see how they work. Knowing that, we can then decide whether either deserves a place in our portfolios.

TIPS are sold at a Treasury auction in multiples of $1,000 during the months of January, July, and October. They may be purchased directly from the Treasury during the auction or later from a broker, and may be sold by the purchaser in the secondary market at any time. The interest rate, called the coupon rate, is set at the initial auction based on the competitive bids for that issue. The coupon rate remains fixed throughout the term of the security.

The term of the security may range from 5 to 30 years. Interest is paid twice each year on the initial face value, as adjusted for inflation. Inflation is determined by the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS). Semiannual interest is computed as one-half the coupon rate times the inflation-adjusted principal of the security.

Although exempt from local and state taxation, interest paid during the year on TIPS held outside of tax-deferred accounts is considered ordinary income for federal income tax purposes. Additionally, although increases to the inflation-adjusted principal will not be paid until the security matures, any increase must also be declared as ordinary income subject to taxation in the year the increase occurs. At maturity, the security is redeemed at the greater of the inflation-adjusted principal or the principal paid at original issue.

The major advantage to TIPS compared to other fixed-income vehicles or bonds is that the principal is protected against inflation as measured by the CPI-U. Interest is also protected in that the semiannual payment is based on an inflation-adjusted principal. That protection ensures the investor will receive a real rate of return that is above the inflation rate.

Potential disadvantages to TIPS include a possible decline in interest income because of deflation instead of inflation, and having to declare "phantom" income due to inflationary increases to the security's principal that won't be realized until the security is redeemed at maturity. Reduced interest income and increased income taxes both have a negative effect on a retiree's cash flow.

Market risk for TIPS includes that normally associated with changes in interest rates. But, it also includes an adjustment factor for any potential changes to the inflation index, which may or may not correspond to changes in interest rates of other securities with similar maturities. Thus, the secondary market for TIPS may be more volatile than that for fixed-income securities not subject to an inflation adjustment.

I Bonds are issued in face-value denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. Their selling price is the face value, and they may be purchased through most local banks and/or credit unions. Up to $500 worth of I Bonds per transaction may also be purchased online at the Bureau of the Public Debt Some employers also offer purchase through payroll deduction. I Bonds increase in value with inflation-indexed earnings for up to 30 years.

The U.S. Treasury announces the fixed rate of return for I Bonds in May and November of each year, and that rate is applied to the life of any bond purchased during May 1 through October 1 and November 1 through April 30, respectively. The semiannual inflation rate is also announced in the same months, and is based on changes in the CPI-U. The two rates are combined to determine the total earnings rate of the I Bond for the following six months. The interest earnings are not paid in cash. Instead, bond values are increased monthly. On redemption, the buyer will receive the principal invested plus all credited monthly earnings.

Monthly earnings are exempt from local and state income taxation, but they are considered ordinary interest income for federal income taxes. Earnings may be declared for income tax purposes in the year earned or in the year the I Bond is redeemed. If deferred, then all accumulated earnings must be declared as income in the year of redemption.

I Bonds may be redeemed for cash at most local financial institutions six months after initial purchase. Redemption proceeds will include the investment cost plus accumulated monthly earnings; however, I Bonds redeemed within the first five years after purchase are penalized three months' worth of earnings. Accordingly, if you redeem an I Bond 24 months after purchase, then you will receive only 21 months of earnings.

Like TIPS, I Bonds enjoy inflation-protected earnings that guarantee a real rate of return over and above the inflation rate. In the case of deflation, wherein the decline in the CPI-U exceeds the fixed rate of return on the I Bonds, the redemption value (i.e., original purchase price plus accumulated monthly earnings) does not decline but remains the same. While TIPS may fluctuate in market value based on interest rate and inflation index changes, the redemption value of I Bonds is always known and readily determinable. Unlike TIPS, which may be purchased for any amount in multiples of $1,000, I Bond purchases are limited to a total of $30,000 in any one calendar year.

So, that's the scoop on TIPS and I Bonds. Want to learn more? Just visit the Bureau of the Public Debt Online. For those seeking an investment outside of stocks, both may make a profitable and secure addition to one's portfolio. Neither is perfect, but both offer purchasing power protection not found in other fixed-income investments. Of the two, I personally like the stability found in the I Bonds versus the TIPS.

The current composite rate for I Bonds purchased between now and October 31, 2000, is 7.49%. As something guaranteed by Uncle Sam and as compared to stock market returns so far this year, that return doesn't look half bad. That's especially true when the ability to avoid state income taxes on that return are thrown into the equation.

See you next week. Until then, post away as usual on the Retired Fools discussion board.

Best to all... Pixy