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Handy Weapons in an Inflation Fighter's Arsenal


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The Short Answer

Handy Weapons in an Inflation Fighter's

We take a close look at TIPS and I Bonds, investment products that Securities mentioned in this article

can help preserve your long-term purchasing power. Morningstar Morningstar

Ticker Price($) Change(%) Rating Analyst Report
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PRRIX 11.03 -0.09
By Karen Wallace | 03-23-17 | 05:00 AM | Email Article
VTAPX 24.77 -0.04

BPRIX 10.70 -0.09

After laying low for several quarters, inflation is stirring. In fact, the Federal Reserve
explicitly mentioned realized and expected inflation in its decision to raise the target VAIPX 25.74 -0.08

range for the federal funds rate on March 15. With Morningstar Analyst reports you can get our expert Buy/Sell
opinions on over 3,900 Stock and Funds
Not everyone needs an Karen Wallace does not own shares in any of the securities mentioned
above. Find out about Morningstar's editorial policies.
investment that provides
About the Author
explicit inflation protection in
Karen Wallace is a senior editor with Follow her on Twitter their portfolio. As discussed in Video Reports
@KarenW60602. this article, many younger
investors already have
Contact Author | Meet other investing specialists
some built-in protection from
inflation in the form of steadily
increasing wages and a heavy exposure to equities, which have a good chance of
outpacing inflation over long periods.

But investors with a shorter time horizon or those who are already drawing income
from their retirement portfolios might have a growing need to preserve their
long-term purchasing power. Treasury Inflation-Protected Securities and I Bonds are
Handy Weapons in an Inflation Fighter's Arsenal

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two popular inflation-fighting tools. But, although we compare and contrast the two
security types in this article, the decision to use one doesn't necessarily prohibit you
from using the other. If both security types suit your needs for inflation protection, More Videos...
there's no reason you can't use them together in a portfolio. For instance, you could
hold I Bonds in a taxable account and TIPS and equities in a tax-deferred account as
part of a multipronged inflation-protection strategy.
Handy Weapons in an Inflation Fighter's Arsenal

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All About I Bonds

If you work with a broker or advisor, I Bonds might not be on your radar because
they are available for purchase only directly from the Treasury.

I Bonds are not an especially complicated security, and they are extremely low risk
and very liquid. During your holding period, they earn interest and protect you from
inflation. Unlike TIPS, they can't lose money over your holding period, even if you sell
them before maturity. Even if inflation is negative, the combined rate will not go
below 0%, protecting your principal value.

One potential drawback of I Bonds (depending on the size of your portfolio) is that
purchases have annual limits of $10,000 per Social Security number (electronic), or
$5,000 for paper versions (purchased using a tax refund). So, it may take you a
while to amass a suitably sized stake to protect your portfolio against inflation. (This
is also why you won't see any I Bond mutual funds or ETFs).

Earnings Rate
The I Bond earnings rate has two parts: a fixed rate and an inflation rate. The fixed
rate, which is determined by the Treasury, is reset each May and November.
Handy Weapons in an Inflation Fighter's Arsenal

Purchasers of I Bonds today will get a pretty attractive composite rate of 2.76% that
comprises the semiannual inflation rate and the fixed rate. The fixed rate, as its
name implies, is fixed for the life of the bond (30 years).

Knowing this, it can pay to be strategic about when to buy an I Bond. David Enna,
author of the TIPSWatch blog, points out that though the Treasury doesn't say how it
determines the I Bond fixed rate, inflation seems to be on the rise, which should
make I Bonds more attractive. Therefore, it could pay to wait until May 1 to see if the
Treasury raises the fixed rate above 0.0%.

"A higher fixed rate is coveted because it stays with the I Bond until it is sold or
matures," Enna said. Based on his analysis of historical spreads between the I Bond
fixed rate and the 10-year Treasury yield, he thinks it's likely, though certainly not
guaranteed, that the fixed rate will go up a small amount on May 1 (to 0.1%).

Tax Considerations
Another feature of I Bonds, which could be a negative or a positive depending on
your circumstance, is that they don't make regular income payments. They are
designed as a long-term savings product. You pay taxes on the earned income when
you sell. Therefore, they are a good fit for taxable accounts (and in fact, since you
cant buy them through a broker, you can't really own them in an IRA).

On the flip side, though, they would not be a good option for investors who want to
fund any part of their living expenses with the interest payments from the bonds.

One more interesting thing to note: If you redeem I Bonds during the same year that
you pay qualified educational expenses, you would be able to exclude all or part of
the interest paid during that tax year (subject to certain income thresholds). Click
here for more.

Traits of TIPS
TIPS are also inflation-adjusted based on changes in the CPI-U, but the mechanics
work differently. Unlike traditional bonds, TIPS' principal value will change to keep
pace with inflation as measured by CPI-U (with a lag of a few months). The coupon
payments, which are paid twice per year, will also vary, then, because though the
coupon rate is fixed, the inflation-adjusted principal amount is changing.

If an investor holds a TIPS bond to maturity, she receives the adjusted principal or
the original principal, whichever is greater. This provision protects the bond owner
against deflation. (If the TIPS holder sells before maturity, it's possible that she
would experience a loss of principal.)

Tax Considerations
Unlike I Bonds, TIPS pay out income twice per year (every six months). And holders
of individual TIPS bonds should be aware of a phenomenon called "phantom
income"--essentially, investors have to pay taxes on the principal adjustments in the
tax year they occur, even though they won't receive the full value of those
adjustments until the bond matures. For that reason, owners of individual TIPS bonds
Handy Weapons in an Inflation Fighter's Arsenal

may want to house them in a tax-deferred account.

Owning mutual funds or ETFs helps circumvent this problem a bit, because the
distributions from funds attempt to match up both forms of payment--they
periodically pay out both the income and the realized inflation. (Investors are still on
the hook for paying the taxes on these distributions.) Because the principal values
fluctuate, however, the size of the fund's distributions can rise and fall.

Individual Bonds or Funds?

There are several advantages to owning TIPS through a mutual fund or ETF wrapper
rather than owning the individual securities, including:

The distributions can be easily reinvested.

The mutual fund or ETF shares have better liquidity in the event that investors
would want to sell all or part of their TIPS allocation.
A mutual fund facilitates a laddered approach to TIPS exposure, investing in TIPS
securities of varying maturities.
A TIPS fund portfolio manager can look across the TIPS yield curve to find relatively
undervalued TIPS, and can swap out lower yielding TIPS for higher-yielding issues.

There is a drawback, however--market risk. TIPS' principal protection feature only

applies if an individual TIP security is held to maturity. In the meantime, TIPS' prices
can be extremely volatile: When yields rise, TIPS' prices come under pressure--the
longer the bond, the more pressure--even if inflation is pushing up their principal
value at the same time.

This is important to note because although TIPS mutual funds and ETFs hold bonds
whose principal values adjust along with inflation, the funds themselves don't have a
maturity date. Therefore, there is no explicit guarantee of principal protection; it's
possible that you could lose money in a TIPS mutual fund over the course of your
holding period.

Some of our favorite TIPS funds include:

Vanguard Inflation-Protected Securities (VAIPX) (Gold rating)

Vanguard Short-Term Inflation-Protected Securities Index (VTAPX) (Gold rating)
PIMCO Real Return (PRRIX) (Silver rating)
BlackRock Inflation Protected Bond Instl (BPRIX) (Bronze rating)

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Handy Weapons in an Inflation Fighter's Arsenal

mrpcid One more point on I-bonds is that they're subject to federal tax, but
Mar 23 2017, 6:21 AM exempt from state.

Like 0

rforno As with government policies governing IRA contributions, I-bonds

23 hours, 36 minutes ago would be more useful if they didn't have such a moronishly-low
Flag annual purchase limit. Let people buy up to, say, $50K or 100K per
year if they want. Heck, do an income or networth check even to
Like 0 ensure it's not being abused by funds, companies, or
uber-uber-HNW individuals.

Darwinian One point to keep in mind is that TIPS mutual funds usually have
21 hours, 40 minutes ago long durations, because the fund managers maximize liquidity by
Flag matching their portfolio's maturity to that of the bonds issued. This
means a 7-8 year duration, which makes them strongly affected by
Like 0 interest rate risk. In the Taper Tantrum of 2013, a rate rise of about
1% caused Vanguard's VAIPX to drop about ten percent in just a
few months; and even now, it still has not recovered this loss.

bogaziti Fighter's. Weapons. Arsenals. Im feeling very uncomfortable.

21 hours, 21 minutes ago


Like 1

Bruzer "'Fighters. Weapons. Arsenals.' Im feeling very uncomfortable."

20 hours, 37 minutes ago

Flag Sounds like an NFL game . . .

Like 0

retiredgary At present TIPS promise a return of a little less than 50 basis points
16 hours, 40 minutes ago over price inflation. That's not bad in comparison to what some
Flag other fixed income products offer, but it is far from good. Bonds of
all sorts are just very expensive.
Like 0

mlott1 I'm glad to see I-Bonds being mentioned again. I think it's good to
14 hours, 9 minutes ago bring them up from time to time, as some have forgotten about
Flag them, or just think that they are the same old Series EE that you
used to buy at the bank, or are just plain ol' unaware of them. Will
Like 0 you get rich with them? No. But they seem to be doing the job they
were designed to do, which is to preserve your purchasing power (I
Handy Weapons in an Inflation Fighter's Arsenal

standing for inflation, in the I-Bond). Yes, they do have annual

limitations on how much you can purchase, which may be an issue
for those burdened with excess amounts of lucre. For the smaller
investor that would like to put a little money into a safe,
government issued, inflation indexed bond, it's hard to go wrong
with I-Bonds. And, at least with I-Bonds, buying and selling them
through TreasuryDirect is very easy, I have had absolutely no
problems, and I'm pretty much hopeless when it comes to

Fundsmaster Please confirm: In terms of using I-Bonds to pay for 'qualified

9 hours, 33 minutes ago educational expenses', these expenses apply only to 1) I-bond
Flag owner, 2) spouse of #1, or 3) dependent of #1. In other words, all
others (ie, grandchildren, nieces, or nephews) would not qualify for
Like 0 tax break to owner.

Oldest First | Newest First 1-8 of 8 Comments