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

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.
RELATED TOPICS