CDIPS
(Certificates of Deposit Inflation-Protected)
What are CDIPs?
CDIPs are similar to U.S. Treasury Inflation-Protected Securities (TIPS), where the principal amount is adjusted periodically to reflect changes in inflation. CDIPs use the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI) as a reference to measure inflation. Thus, if prices (as measured by CPI) have risen 3%, the principal amount of the investment will also increase by 3%.
How are interest payments calculated?
Assume you invest $10,000 in a new CDIP paying a stated interest rate of 2%. On the first semiannual coupon payment date, CPI indicates that inflation has been 1% for the 6-month period. The CDIP’s inflation-adjusted base would increase by $100 ($10,000 x 1%) to $10,100. The coupon payment of $101.00 is calculated based on the inflation-adjusted amount ($10,100 x ½ of 2% = $101.00), rather than the original investment amount.
After a full year CPI indicates that inflation was 3%, which brings the inflation-adjusted base to $10,300 and the second semiannual interest payment to $103.00 ($10,300 x ½ of 2%).
What does the investor receive at maturity?
At maturity, the investor will receive their initial investment amount plus any additional interest as a result of inflation adjustments made throughout the holding period. In the example above, if the CD matured at the end of the first year, the investor would receive back their initial investment of $10,000 plus $300, which represents the inflation adjustment, for a total of $10,300. If at maturity the inflation-adjusted base amount is less than the initial investment amount (due to deflation) the initial investment amount will be returned to the investor.
Can CDIPs be sold prior to maturity?
Yes, CDIPs may be traded in the secondary market, if available, which provides an opportunity for investors to sell their CDIPs at the prevailing market levels, which may be more or less than the original amount invested. However, CDIPs are most suitable for purchasing and holding to maturity.
Are CDIPs rated?
While not specifically rated, CDIPs are backed by the full faith and credit of the US Government through FDIC insurance. The FDIC insures deposits up to $100,000 per depositor, per institution. (In addition, federal law provides up to $250,000 in deposit insurance coverage for self-directed retirement accounts, such as Individual Retirement Accounts (IRAs).) (For additional information about FDIC insurance and maximizing insured accounts, please see Insuring Your Deposits on the FDIC’s website.)
Who invests in CDIPs?
CDIPs generally attract investors who are looking to protect the “real” value of their savings from the effects of inflation.
- For Savers – When looking forward to retirement, college or any other future expenditure, the main concern is not the dollar value of your savings, but rather the future real purchasing power of those savings. An investment in CDIPs can ensure that your principal investment will keep pace with inflation.
- For Retirees – Retirees who must live off the income generated by their investments for 20 to 30 years or longer often worry about outliving their savings. Because their portfolio buys a little less each year due to inflation, they may be forced to tap into principal to maintain the same lifestyle. CDIPs pay interest that increases as the price of goods and services you buy increase; and the additional interest paid at maturity preserves the income producing power of your savings throughout retirement.
- For Any Investor – The market values of most fixed-income investments can be influenced by a host of events and don’t always move in step with the general level of prices in the economy. CDIPs are directly linked to CPI, so they provide an effective hedge against inflation, may be more liquid than many real assets, and are available in $1,000 denominations.
What is the estate feature?
CDIPs provide an estate feature also referred to as the survivor’s option, which is designed to protect estate assets. In the event of death or adjudication of incompetence of the beneficial owner of a CDIP, this provision allows for the full withdrawal of the principal (at par) and accrued interest regardless of whether the current market value has fallen.
Additional Benefits of CDIPs:
Ensure a “real” return over inflation
CDIPs lock in a return equal to the inflation rate plus the stated coupon, thereby ensuring that your total return will outpace inflation.
Interest protection from inflation
Inflation chips away at buying power as items purchased every day increase in price. With CDIPs, when prices increase, interest payments increase as well.
Diversify investment risk
CDIPs offer portfolio diversification because they are a distinct and separate asset class from either equities or traditional bonds.
Additional Considerations for CDIPs:
Risks
The fixed coupon on CDIPs will typically be somewhat lower than that available on traditional CDs of comparable maturity. This is because CDIP investors expect to receive additional income in the form of the inflation adjustment paid at maturity. Should actual changes in CPI fall short of expectations, the CDIP investment may underperform traditional CDs that could have been purchased instead. A decrease in the CPI due to deflation will reduce the total amount of interest paid during the holding period. If a CDIP is sold prior to maturity, its value will be subject to full market considerations, including, but not limited to, interest rate changes, which could result in a significant loss from the initial investment amount.
Tax Implications
The interest payments on CDIPs are taxable when received. In addition, the inflation adjustments to the base amount are taxable in the year in which such adjustments occur even though the investor won’t receive the additional interest until the CD matures. For this reason, it may be advantageous to hold CDIPs in a tax-deferred account such as a 401Ik) or an IRA.
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