Government bonds are a mainstay of many savers and long-term investors because they carry the full faith and credit of the U.S. government.1 However, government bonds can pay low returns relative to other investments, and risk being outpaced by inflation.
In an attempt to remedy this situation and encourage more people to increase their savings, the Treasury Department issues inflation-indexed bonds in 5-, 10-, and 20-year maturities with a return linked to the inflation rate. These issues are available for purchase in $1,000 increments through financial advisors, banks, and Treasury Direct (www.treasurydirect.gov).
Benefits of inflation-indexed bonds include:
- Rate of return is guaranteed to exceed the rate of inflation.
- Principal is indexed to the Consumer Price Index (CPI).
- Semiannual interest payments are based on the interest rate applied to the inflation-adjusted value of the principal.
- Guaranteed return of the principal even if the rate of inflation drops, so that the indexed value is below the value of the bond when it was issued.
Best Purchased in Periods of High Inflation
Are these bonds a good bet for the average small investor? The answer depends on how you intend to use these bonds and your outlook on inflation.
If you purchased a $1,000 bond and the CPI rose 3%, the principal value would rise a corresponding 3% to $1,030. Assuming the interest rate on the bond was 3%, you would receive interest payments of $30.90 twice a year. If, a year later, the CPI had risen by 4%, the principal of your indexed note would then be adjusted from $1,030 to $1,071.20, and your interest payment would be 4% or $42.85, paid twice a year.
How do these bonds compare with the ordinary variety? Assuming the inflation rate is 3%, and the yield of an unindexed $1,000, 10-year Treasury note is 6.3%, the real yield of this note would be 3.3% (6.3% minus the inflation rate). After a year that ordinary bond would be worth $1,063; but you’d lose $30 of that gain to the effect of inflation, leaving you with a note that’s worth $1,030. Clearly, it makes sense to purchase these bonds only if you expect a major uptick in inflation.
Although the interest that inflation-indexed bonds pay is exempt from state and local taxes, federal income taxes apply. You are required to pay taxes on the interest and any increase in principal on an annual basis.
1Bonds are subject to market and interest rate risk if sold prior to maturity.
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