TIPS and I-Bonds
There are risks in any investment. The market might go down--or the market might go up, but your investment might go down anyway. The company that issued your stock or bond might go bankrupt. Even cash has the (virtually certain) risk that it'll be worth a bit less next month due to inflation. There are a couple of investments that eliminate almost all these risks: TIPS and I-Bonds.
Having just talked about gold as an investment, I thought this might be a good time to talk about these other inflation hedges.
In some ways these securities are pretty similar. They're both issued by the US government and they're both indexed to the Consumer Price Index. Although the details of inflation adjustment are quite different, the results are pretty similar.
They don't eliminate all risks, of course. The calculation of the CPI could understate inflation (it probably does, although not by a lot). The inflation rate that matters to you--the rise in costs of the goods and services that you buy--could be higher (or lower) than the government's calculation, even if the goverment's number fairly represents the average inflation faced by the average person. The US government could collapse. Overall, though, these investments are about as safe as cash and offer a higher return.
TIPS (Treasury Inflation Protected Securities)
These are a lot like other treasury notes and treasury bonds. They're sold with a face value of $1000, and the interest rate is determined in an auction. Individual purchasers can skip the auction process and just buy at the auction price (which guarantees you the same return as the investment professionals whose bids won the auction).
The interest rate is usually pretty low (currently running around 2.3% to 2.4%), which is not as bad as it sounds, because it is paid on the inflation-adjusted face value of the bond. An adjusted face value is calculated for each day and is announced monthly when the new CPI numbers are released. For example, the face value of the 3% 10-year TIPS that was auctioned in 2002 was 1158.80 on September 1st. As long as inflation continues, the face value will go up--and the interest payments, calculated as a percentage of face value, will go up as well.
At maturity you get the final adjusted face value. The face value won't go below $1000, giving you some protection against deflation as well.
If you have to sell before maturity, though, you're not guaranteed the face value. The price will depend on current interest rates and current inflationary expectations.
These are savings bonds, rather like ordinary savings bonds. They're sold in various denominations, from $25 to $10,000. They also pay a fixed rate plus an inflation adjustment, but the calculation is different. Instead of calculating an adjusted face value and then applying the fixed rate to that, the treasury calculates a "composite earnings rate" that combines both parts. The composite rate is calculated every six months, based on the inflation rate of the previous six months.
The fixed part of the rate is determined by the Treasury twice a year. It applies to all bonds sold for the next six months, and remains in effect for the lifetime of the bond (30 years).
You can't cash in an I-Bond in the first 12 months after you buy it, and if you cash it in after less than five years, you lose 3-months of interest.
Back when inflation-adjusted bonds were new, they paid a pretty good rate. If you'd bought one in 2000, you could have gotten a 10-year TIPS that paid 4.25% over inflation. Until about 2003, you could generally get 3% over inflation. Since then, the rates have dropped, mostly because interest rates in generally are lower now.
One way to think about the rate on a TIPS is that it should be exactly the same as the rate on an ordinary treasury security of the same maturity minus the expected inflation between now and then. So the rate on a TIPS goes down anytime the expected inflation rate goes up, plus it goes down anytime other interest rates go down.
The rates on I-Bonds used to be reasonably competitive with the rates on TIPS (from 1998 until 2001 they were 3% or higher). Since then, though, they've fallen quite low. The current fixed rate on an I-Bond is just 1.3% over inflation.
One reason to consider I-Bonds, despite the very low rate, is that they've got the same tax advantages of other savings bonds. You can choose to pay taxes on the interest every year (if, for example, you're a child with almost no income who will owe no tax) or you can chose to wait and pay taxes on the income only when you cash in the bond. Further, if you use the money to pay for certain kinds of education expenses, you don't need to pay taxes on it at all.
TIPS, on the other hand, have a unique tax problem: you not only owe taxes each year on the interest that you get, you also owe taxes on the increase in face value due to inflation (even though you don't actually get that money until the bond matures). Some people consider this a big deal, and don't recommend that you buy such bonds except in a tax-sheltered plan such as an IRA or a 401(k). Personally, I don't see how it's much worse than the tax treatment of a mutual fund where you're reinvesting the dividends, where you still owe taxes on the dividends and the capital gains, even though the money has been reinvested in the fund.
The interest on TIPS and I-Bonds, like all US Treasury interest, is exempt from state and local income taxes.