Inflation protection

Question: If I am concerned about the possibility of inflation, which alternative to choose; TIPS, I-Bonds, or Floating Rate Notes? I am not an expert and just started reading about this issue. Thank you in advance. John, Philadelphia, PA

Answer: You might want to add Worry Free Investing by Zvi Bodie and Michael J. Clowes to your reading list. They have the best explanation around for the logic of investing in Treasury Inflation Protected Securities (TIPS), I-bonds, and the like over the long haul. You can download it here.

One of the biggest risks faced by savers is that inflation will erode the value of their money over time. Even small rates of inflation, say, in the 1% to 3% range, reduce the purchasing power of savings. Many economists reasonably fear that inflation could go much higher than that following the extraordinary actions the Federal Reserve took to bail out the banking system and avoid a depression.

I'm a fan of TIPS and I-bonds. When it comes to floating rate notes (which covers a large universe of securities) I would stick with short-term Treasury bills. You don't have to worry about default risk and the historic record shows that T-bills perserve the value of your dollar against the ravages of inflation. You don't make much, but you don't lose it either.

TIPS are really the long-term savers' friend. They come in 5, 10 and 20 year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. An additional advantage of TIPS is that they protect against deflation--a decline in the overall price level--by offering a "deflation floor" that protects principal value during deflation.

TIPS have two main drawbacks. The first is that Uncle Sam requires owners of TIPS in a taxable account to pay income taxes on your inflation-adjusted gains before getting any of the inflation-adjusted money at maturity. The easy way to invest in TIPS and avoid the tax problem is to own them in a tax-deferred retirement savings account, such as a 401(k) or IRA. The other problem is that for a variety of legal and regulatory reasons you can't buy TIPS directly from the U.S. Treasury for your retirement savings account. You have to pay a broker to do it for you. It's worth it, however

Taxes aren't an issue with I-bonds, the federal government's other inflation-protected security. These 30-year inflation protected savings bonds allow money to compound tax-deferred until they are cashed in. There are no commission costs when buying or selling them. I-bonds redeemed before the 5 year mark forfeit the 3 most recent months' interest, but after 5 years that there is no penalty at redemption. The only drawback to I bonds is that you can't buy very much at a time. Savers can purchase $10,000 worth a year--$5,000 online from the Treasury and $5,000 in paper bonds bought at a bank.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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