Inflation bonds 101

When an investor, financial institution, mutual fund or foreign Government seeks inflation protection, it is a good idea enter into one or more of several financial vehicles designed to protect financial interests and worth. One such financial instrument is the inflation bond.

• What is an Inflation Bond: An inflation bond protects against inflation by offering an interest over and above a periodically adjusted inflation rate.

• Where you can find Inflation Bonds: U.S. Government inflation bonds can be bought directly from the department of the treasury, bureau of public debt. (http://www.publicdebt.treas.gov/) and foreign inflation bonds such as the Canadian Real Return Bond can be purchased through brokerage firms.

• Benefits of Inflation Bonds: Inflation bonds can do more than protect against inflation. Inflation bonds can also help one diversify an investment portfolio against adverse economic and market conditions. Additionally, since interest is not paid until maturity or redemption, inflation bonds can be utilized as an untaxed retirement savings vehicle. When they expire and/or are redeemed the owner may benefit from being in a lower tax bracket than at the time of purchase.

• Costs of Inflation Bonds: Government Inflation Bonds come in a number of different denominations and generally the amount one pays for them is the face value of that denomination. Corporate inflation bonds can be purchased either through a broker or directly form a company.

Tips on buying inflation bonds

When buying inflation bonds there are several things worth thinking about as in many forms of investing. Essentially those things revolve around finding the best deal with the least amount of risk. Some of the factors to consider are as follows:

• Bond Grade: Investment grade is an important indicator of the financial credibility of the institution(s) issuing the bond. The closer the rating is to AAA, the more accountable the issuer is.

• Secured Versus Unsecured: Collateralized bonds may not always be what they are cracked up to be. For example, secured AAA bonds backed by mortgage securities can decline in credibility if the housing market experiences a downturn. Unsecured bonds or 'debentures' rely on credit alone making the grade even more important.

• Real Rate of Return: The real rate of return is the actual amount of interest after inflation is deducted. Not all inflation bonds offer the same real rate of return. Shopping around can assist in finding the best rate.

• Rate Adjustments: Government I-bonds typically readjust interest rates every 6 months. It is a good idea to investigate how corporations readjust for inflation before purchasing their bonds.

• Foreign Inflation Hedge: If one lives in a country where inflation is high, investing in U.S. I-Bonds, Treasury Inflation Protected Securities (TIPS) and/or Corporate Inflation bonds may be a wise choice to protect ones income from losing value. Additionally, such investments can earn money in lieu of a less secure foreign savings vehicle.

Inflation Bonds are an attractive choice for both individuals and institutions wishing to protect, secure, diversify and stabilize investment capital and/or investment portfolios. While the returns on these types of bonds are not always as high as some other possible choices of investment, they do provide a consistent source of capital growth. Such capital growth can also be tax deferred in the case of I-Bonds, and interest gained from TIPS is both state and locally tax free.

Best funds for inflation protection

In the World of investing the practice of hedging is used to combat inflationary pressures. This is done in order to protect one's investments from adverse circumstances arising in particular industries and sectors, economic down turns and inflation. In the case of inflation, hedging involves investing in funds that traditionally perform well and/or better than most other funds during periods of high inflation.

To illustrate the affect of inflation on wealth, in the United States a period of high inflation was the 1970's during the first oil crisis period. During these times the value of the dollar declined against stronger foreign currencies and the spending power of one's income declines. This can often go hand in hand with rising cost of goods such as gasoline, and consumer staples further deteriorating one's spending power.

Financial institutions and Governments are well aware of inflation and take great measures to avoid it because of its negative affect on economic performance. For investors this is good news because it allows them to utilize these financial vehicles to hedge their own investments against inflation. A few of these investment vehicles are the following:

• U.S. Treasury Inflation Protected Securities (TIPS)
• British Inflation-linked Gilts (ILG's)
• Canadian Real Return Bonds (RRB's)
• Australian Capital Indexed Bonds
• Gold and other Metal Exchange Traded Funds (ETF's)
• High Grade Inflation Protected Corporate Bonds (IPI's)
• High Yield Domestic and International Certificates of Deposit

U.S. Treasury Inflation Protected Securities (TIPS)

TIPS are a U.S. Government backed financial instrument first instituted in 1997 and that is periodically adjusted for inflation. For example, if inflation in time period A is 2% the TIPS return on investment will incorporate this into the total yield. If however, in period B the inflation rises to 3% the yield in the TIPS will also rise. In addition to this inflation protected yield is a 'real yield' of around 3.3%. So no matter what inflation is, the TIPS 'real yield' on top of inflation should be steady. A similar method is used in ILG's and RRB's.

High grade inflation protected corporate bonds (IPIs)

Corporations like the Government, issue Bonds to raise money for their project capitalization operations. These Bonds are rated as high as AAA and as low as D. Most bonds in the A range are considered secure investments and since the return is fixed, volatility during times of inflation can be a hedge against one's more risky investments. IPI's are corporate bonds that are inflation adjusted allowing for a fixed yield when inflation rises. IPI's are very similar to TIPS except for the fact they are corporate rather than Government backed.

Gold and metal exchange traded funds

Gold and Metals have traditionally held their value well during periods of high inflation and in some case deflation. This is due to the international confidence in Gold as an alternate form of exchange. Unlike money the supply of Gold cannot be drastically reduced or increased allowing its value to remain more fixed.

During periods of high inflation, confidence in this more secure form of exchange rises, sometimes leading to a steady an/or rising price. The same is true for some other precious metals such as platinum. Gold can be purchased through mutual funds and other securities specializing in this type of commodity.

High yield certificates of deposit

Since investors can lock into a fixed interest rate on Certificates of Deposit this can be advantageous if timed correctly. That is to say, the yield on CD's changes periodically and since one locks into a yield that is the yield one is stuck with if the CD yield rises. Nevertheless, CD's are a stable and fixed form of interest that can be a stabilizing factor in a turbulent economic cycle. Moreover, some countries offer attractive fixed and variable rates on bonds, New Zealand and Australia being two current examples with CD rates in excess of 5%.

Australian inflation protected bonds (RBAs)

In seeking to diversify and protect an investment portfolio, and ideal decision may be to invest in an international financial instrument priced in a currency with low inflation , that yields high interest and offers inflation protection. Australian inflation protected bonds may be suitable for this purpose with a 2009 inflation rate of 2.5% and yields above inflation.

Protecting against inflation is a realistic concern in the investment World and among financial institutions. While there are more financial vehicles for protecting against inflation than listed above some of these other methods like SWAPS are more designed for financial institutions and not the individual investor. One can become increasingly sophisticated with how one protects against inflation but the key principle behind Hedge investing is balancing higher volatility and even outperforming those investments during inflation with more stable and secure returns such as those provided in this article.

Sources:

1. http://money.cnn.com/2007/01/16/commentary/sivy/sivy.moneymag/index.htm
2. http://tinyurl.com/6ybljpl
3. http://www.finpipe.com/tips.htm
4. http://personal.fidelity.com/products/fixedincome/bondratings.shtml
5. http://www.bankrate.com/brm/news/investing/20031021a2.asp