Inflation Bond Gets Big Rate Increase As Consumer Prices Climb, Yield Jumps To 6.73%; Other Ways to Shield Your Portfolio
By JANE J. KIM and RUTH SIMON
Staff Reporters of THE WALL STREET JOURNAL
November 2, 2005; Page D1
Higher energy prices may be pinching consumers' pocketbooks, but they are also boosting returns for some investors who buy inflation-protected securities.
Yesterday, the Treasury Department sharply increased the yield on its I Bond savings bond to 6.73% from 4.8% previously. The rate adjusts twice a year, based on the consumer-price index, or CPI. The new rate is more than two percentage points above the average yield on other conservative investments, such as short-term certificates of deposit and money-market mutual funds.
The boost in yield comes as higher energy costs, from gasoline to heating oil, pushed consumer prices up 1.2% in September from the previous month -- the fastest acceleration in more than 25 years -- and up 4.7% from a year earlier. Yesterday, the Federal Reserve again hiked short-term interest rates, saying the "cumulative rise in energy and other costs has the potential to add to inflation pressures."
Inflation is the bane of investors because it reduces real returns. The I Bond is part of an ever-expanding category of inflation-linked products ranging from Treasury Inflation-Protected Securities, or TIPS, to foreign bonds whose returns can vary depending on whether consumer prices are rising or falling. Investors can also choose from inflation-linked corporate and municipal bonds and certificates of deposit as well as mutual funds and at least one exchange-traded fund that invest in inflation-protected bonds.
Inflation-linked investments aim to help investors maintain their purchasing power by providing a return above the rate of inflation. But there are big caveats. For one thing, if inflation eases, investors could see their returns fall. Indeed, despite today's high energy costs, the Fed said in its statement yesterday that "core inflation has been relatively low in recent months and longer-term inflation expectations remain contained."
Despite the compelling rate, for investors considering an I Bond, there are some notable restrictions. The bonds generally can't be redeemed in the first year. And an investor who redeems the bond within the first five years must give up three months interest as a penalty. One positive: Interest on I Bonds is exempt from state and local income taxes.
Many experts say that only a small portion of one's portfolio -- typically 5% to 10% -- should be parked in inflation-linked products. That's because the key reason to own these products is to protect oneself against the possibility that the Fed won't be successful at controlling inflation.
Investment professionals caution investors to look beyond the I Bond's current 6.73% yield and focus instead on how that yield is calculated. The rate paid on the I Bond has two parts: a fixed-rate that lasts for the 30-year life of the bond and an inflation adjustment that is tied to the CPI for the preceding six months. The inflation adjustment is made twice a year, on May 1 and Nov. 1.
The new inflation adjustment, announced yesterday, is 5.73%, reflecting the steep increase in the CPI over the last six months. That's the highest inflation adjustment on record since the bonds were first launched by the U.S. government in September 1998. At the same time, the Treasury cut the fixed rate on new issues to 1% from 1.2%. That means investors who buy I Bonds can expect a 1% return after inflation.
"People are going to look at the headline number and talk about how good the I Bond is," said Greg McBride, a senior financial analyst with Bankrate.com. "But the I Bond didn't get better. It got worse." He says the fixed-rate is more important to investors over the long term because it remains constant for the life of the bond; the inflation-adjustment, by contrast, changes every six months.
If inflation moderates, investors could wind up earning higher returns on other low-risk investments, such as high-yield money-market funds, high-yield bank money market accounts and CDs. Rates for one-year CDs can be as high as 4.65%, according to Bankrate.com, while some five-year CDs have yields of as much as 5%.
TIPS, which are bonds issued by the Treasury Department, are also popular among investors worried about inflation. TIPS bear a stated interest rate, and the owner receives semiannual interest payments. If the pace of inflation increases, so does the value of the bond's principal -- as well as the subsequent interest payment. The investor gets an increase in the value of the principal at maturity. One downside: Investors must pay federal taxes each year on the increased value of the principal, even though any increase isn't received until the bond is sold or matures. That's why TIPS are often held in tax-deferred accounts.
TIPS aren't as attractive as they were a couple of years ago. Anton Pil, global head of fixed-income at J.P. Morgan Chase Private Bank, calculated that inflation on average has to be above 2.6% over the next 10 years for TIPS to outperform comparable Treasurys. This figure would have been just 1.6% in mid-2003, he said.
Other inflation-linked products include corporate and municipal bonds whose coupon payments are linked to year-over-year or month-over-month changes in the CPI plus a fixed rate. Corporate bonds generally pay out interest every month, while munis pay out twice a year.
One big difference between these securities and TIPS is that changes in the inflation rate are immediately reflected in their coupon payments, so investors get more of the inflation adjustment up front. Investors in the highest tax brackets tend to benefit most from municipal bonds because of their tax-exempt features. Meanwhile, corporate inflation-linked bonds tend to pay 1.5 or 1.6 times the CPI index. One potential downside is that because these markets are still relatively new, individual investors may have a difficult time buying and selling the bonds.
Write to Jane J. Kim at jane.kim@wsj.com1 and Ruth Simon at ruth.simon@wsj.com2
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