Like their name implies, inflation protected bonds are designed to protect investors from inflation. They do this by adjusting their principal and/or interest payments up and down with some commonly agreed upon measure of inflation.
The two most popular types of inflation protected bonds here in the United States are treasury inflation protected securities (TIPS) and the i series savings bond. Both bonds work in a similar manner, but there are a few nuances which make i bonds the superior choice in the current interest rate environment. To help understand why let’s look at the logistics of each.
To see a list of high yielding CDs go here.
With TIPS the principal value of the bond (the amount you receive back at maturity) adjusts up and down with changes in the consumer price index (CPI). What is the consumer price index? Its a measure of the price changes in a fixed basket of goods and services, which is designed to measure inflation for the average consumer. (you can learn more about the CPI here)
The coupon interest rate that you earn on a TIPS is set when the bond is purchased and remains the same for the life of the bond. The coupon interest rate is set to represent the real yield at the time of purchase. The real yield is the yield on a bond not including the additional yield that investors require to compensate them for expected inflation. (you can learn more about real yields here).
As discussed above, with TIPS investors are compensated for inflation through changes in the principal value of the bond, which moves up and down with inflation as measured by the CPI. Because the dollar amount of interest that you receive on a TIPS is calculated by multiplying the fixed coupon interest rate by the principal value of the bond, the dollar amount of interest you receive fluctuates as well.
We are currently in uncharted territory with TIPS however. As a result of the increased demand for safe assets after the financial crisis, and the Fed’s intervention into the market, the coupon interest rate that you earn on a TIPS is currently zero, and the real yield is negative. This means that when purchasing a TIPS you are actually losing money after accounting for inflation.
Unlike TIPS, the principal value of the i series savings bond does not fluctuate. It compensates investors for inflation through they way it pays interest. The interest rate paid on the i series savings bond is made up of two components. The first is a fixed (stays the same for the life of the bond) rate component, which represents the real interest rate. Unlike TIPS however, it also has a floating rate component. The floating rate component of the interest rate, changes based on fluctuations in the CPI.
In normal market conditions both the TIPS and the i series savings bond protect you from inflation, they just do it in slightly different ways. Because real interest rates are currently negative however, TIPS lose you money after accounting for inflation. The price that you pay for the TIPS is above its principal value, so while you still get the inflation adjustment, the real yield is negative.
Because the principal value of the i series savings bond is fixed for the life of the bond, the real interest rate on the i series savings bond cannot go negative. This means that you are guaranteed not to lose money with the i series savings bond after accounting for inflation as measured by the CPI.
There are several limitations to keep in mind when choosing the i series savings bond for the inflation protected bonds portion of your portfolio.