Related News

GETTING PERSONAL: How Deflation Would Affect TIPS, I-Bonds

 
   By Ian Salisbury 
   A Dow Jones Newswires Column 
 

NEW YORK (Dow Jones)--With economic woes threatening to push the economy into a rare bout of prolonged deflation, investors in TIPS and I-Bonds may get more than they bargained for.

These bonds issued by the U.S. federal government are designed to give investors protection against rising prices, which can eat away at the purchasing power of interest payments. But with plummeting energy prices dragging down the Consumer Price Index, these investments' special safety mechanisms can actually work against investors.

To be sure, many economists think the chances of prolonged deflation, a condition many associate with the 1930s, are still small. Moreover, while deflation could pinch both products' interest rates, yields are generally attractive right now compared to Treasurys, and both types of bond include separate mechanisms to prevent deflation-related damage from spreading too far.

Investors should also be aware of the many other differences between TIPS, officially called Treasury Inflation Protected Securities, and I Savings Bonds - including tax treatment, purchase limits, and the way bonds are bought and sold.

TIPS resemble other Treasury bonds, but adjust their principal to match changing prices. While interest rates are fixed, payouts, made every six months, fluctuate based on principal levels. If prices ever reached a point where they were lower than they were six months before, payouts to investors would shrink.

Still, even with that risk, some investors think TIPS are a good deal. Typically, because TIPS investors benefit from protection against inflation, TIPS pay lower interest rates than plain-vanilla Treasurys with similar maturity dates.

Right now that isn't the case: five-year TIPS yield 3.6%, well above the 1.61% yield for five-year Treasurys.

This probably doesn't reflect fears of deflation - a more likely scenario is that institutional investors currently prefer Treasurys because they are easier to buy and sell. So TIPS' unusually attractive interest rates could actually offset some of the risks of deflation.

"TIPS are a great deal, if you think there is going to be inflation in the future," said Manchester, N.H., financial planner Jean Fullerton. "I'm not going to say in these odd times [deflation] isn't going to happen, but it's much less likely than inflation on a historical basis."

TIPS have another plus, too. While deflation can reduce the bonds' principal for the purpose of calculating interest payments, TIPS carry a guarantee that at maturity, holders will receive at least the original amount of principal.

I-Bonds, which resemble government savings bonds rather than Treasurys also face some risks from deflation - and include some protections. Unlike TIPS, I-Bonds adjust their interest rates to match inflation, not their principal amounts.

The interest rate investors receive on I-Bonds includes two parts, one fixed at the time of purchase and a second one tied the Consumer Price Index. Usually the combined rate is higher than either of the two components, but if the inflation component ever fell below zero, it would be subtracted from the fixed rate, diminishing investors' returns.

As with TIPS, however, there are some upsides. The inflation component of the interest rate is set just twice a year, most recently on November 1, reflecting the change in the CPI between March and September. October, which saw the largest single-month drop in prices since before World War II, isn't included for now.

Investors who buy bonds today receive an interest rate of 5.64%, reflecting rapid price growth this summer, for six months.

Of course, if prices continue to fall the rate could decline sharply after the next adjustment. The fixed portion of the interest rate is only 0.7%, so it wouldn't take very steep deflation to wipe it out. (The inflation component is slightly more complicated than the annualized six-month rate of inflation.)

One plus, however, is that, unlike TIPS, investors can't see their principal, or the interest they have previously accumulated, shrink.

"The interest rate on I-Bonds can't go below zero," said Tom Adams, author of the book "Savings Bond Advisor." "In a deflationary period they will stop paying interest, but the value will never go down."

(Ian Salisbury is a Getting Personal columnist who writes about personal finance; he covers topics including exchange-traded funds and separately managed accounts. He can be reached at 201-938-5219 or by email at ian.salisbury@dowjones.com.)

TALK BACK: We invite readers to send us comments on this or other financial news topics. Please email us at TalkbackAmericas@dowjones.com. Readers should include their full names, work or home addresses and telephone numbers for verification purposes. We reserve the right to edit and publish your comments along with your name; we reserve the right not to publish reader comments.

Click here to go to Dow Jones NewsPlus, a web front page of today's most important business and market news, analysis and commentary: http://www.djnewsplus.com/al?rnd=CSwu20xok0%2BinROM%2BrVbQA%3D%3D. You can use this link on the day this article is published and the following day.

(END) Dow Jones Newswires

December 10, 2008 11:01 ET (16:01 GMT)


Copyright 2008 Dow Jones & Company, Inc.

The Dow Jones content is the property of Dow Jones or its licensors, and is protected by copyright and other intellectual property laws. If you are an individual, you agree not to store, copy, reproduce, modify, distribute, transmit, display, perform, publish, transfer, create derivative works from, broadcast or circulate any Dow Jones content to anyone, including but not limited to others in the same company or organization, without the express prior written consent of Dow Jones. If you are an entity, you agree not to permit access to the Dow Jones content by anyone other than an employee of you.

Notwithstanding the foregoing, the Dow Jones content may be copied and sent without charge in the ordinary course of business provided all copyright and other proprietary rights notices, the original source attribution, and the phrase "Used with permission from Dow Jones & Company” are included. Dow Jones content may only be used in this way for a non-commercial purpose, meaning such copying:
(i) is made on either an infrequent or irregular basis to a limited number of individuals;
(ii) is incidental to the purpose of your principal business;
(iii) cannot be used as a substitute for any Dow Jones content or any substantial part of it;
(iv) has no independent commercial value;
(v) is not separately charged for; and
(vi) is not made in connection with commercial information broking, information vending, publishing or credit rating, nor for substantial reproduction through the press or media, nor for transmission via any private or public network, cable or satellite system.

You may not post any Dow Jones content to forums, newsgroups, mail lists, electronic bulletin boards, or other services, without the prior written consent of Dow Jones. To request consent for this and other matters, you may contact Dow Jones at djnewswires@dowjones.com .

The Dow Jones content is not intended for trading purposes. The Dow Jones content is not appropriate for the purposes of making a decision to carry out a transaction or trade. Nor does it provide any form of advice (investment, tax, legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments or products. Dow Jones may discontinue or change the Dow Jones content at any time, without notice.

The Dow Jones content includes facts, views, opinions and recommendations of individuals and organizations deemed of interest. Dow Jones does not guarantee or warrant the accuracy, completeness or timeliness of, or otherwise endorse, these views, opinions and recommendations.

DOW JONES IS NOT RESPONSIBLE FOR ANY DELAY IN YOUR RECEIPT OF THE DOW JONES CONTENT RESULTING FROM THE INHERENT LIMITATIONS OF INTERNET TRANSMISSION VIA THE WORLD WIDE WEB. DUE TO THE NUMBER OF SOURCES FROM WHICH THE DOW JONES CONTENT IS OBTAINED, AND THE INHERENT HAZARDS OF ELECTRONIC DISTRIBUTION, THERE MAY BE DELAYS, OMISSIONS OR INACCURACIES IN THE DOW JONES CONTENT. THE DOW JONES CONTENT IS PROVIDED “AS IS”, WITHOUT ANY WARRANTIES. DOW JONES AND ITS AFFILIATES, AGENTS AND LICENSORS CANNOT AND DO NOT WARRANT THE ACCURACY, COMPLETENESS, CURRENTNESS, TIMELINESS, NONINFRINGEMENT, TITLE, MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OF THE DOW JONES CONTENT, AND DOW JONES HEREBY DISCLAIMS ANY SUCH EXPRESS OR IMPLIED WARRANTIES. NEITHER DOW JONES NOR ANY OF ITS AFFILIATES, AGENTS OR LICENSORS SHALL BE LIABLE TO YOU OR ANYONE ELSE FOR ANY LOSS OR INJURY, OTHER THAN DEATH OR PERSONAL INJURY RESULTING DIRECTLY FROM USE OF THE DOW JONES CONTENT, CAUSED IN WHOLE OR PART BY ITS NEGLIGENCE OR CONTINGENCIES BEYOND ITS CONTROL IN PROCURING, COMPILING, INTERPRETING, REPORTING OR DELIVERING THE DOW JONES CONTENT. IN NO EVENT WILL DOW JONES, ITS AFFILIATES, AGENTS OR LICENSORS BE LIABLE TO YOU OR ANYONE ELSE FOR ANY DECISION MADE OR ACTION TAKEN BY YOU IN RELIANCE ON SUCH DOW JONES CONTENT. DOW JONES AND ITS AFFILIATES, AGENTS AND LICENSORS SHALL NOT BE LIABLE TO YOU OR ANYONE ELSE FOR ANY DAMAGES (INCLUDING, WITHOUT LIMITATION, CONSEQUENTIAL, SPECIAL, INCIDENTAL, INDIRECT, OR SIMILAR DAMAGES), OTHER THAN DIRECT DAMAGES, EVEN IF ADVISED OF THE POSSIBILITY OF SUCH DAMAGES. IN NO EVENT SHALL THE LIABILITY OF DOW JONES, ITS AFFILIATES, AGENTS AND LICENSORS ARISING OUT OF ANY CLAIM RELATED TO THIS AGREEMENT EXCEED THE AGGREGATE AMOUNT PAID BY YOU FOR THE DOW JONES CONTENT IN THE 12 MONTHS IMMEDIATELY PRECEDING THE EVENT GIVING RISE TO SUCH CLAIM. BECAUSE SOME STATES OR JURISDICTIONS DO NOT ALLOW THE EXCLUSION OR LIMITATION OF LIABILITY FOR DAMAGES OR THE EXCLUSION OF CERTAIN TYPES OF WARRANTIES, PARTS OR ALL OF THE ABOVE LIMITATION MAY NOT APPLY TO YOU.

These Terms of Use, your rights and obligations, and all actions contemplated by these Terms of Use will be governed by the laws of England and Wales, and You and Dow Jones agree to submit to the exclusive jurisdiction of the English Courts.
If any provision in these Terms of Use is invalid or unenforceable under applicable law, the remaining provisions will continue in full force and effect, and the invalid or unenforceable provision will be deemed superseded by a valid, enforceable provision that most closely matches the intent of the original provision.