IFCDs
(Inflation-Linked Certificates of Deposit)
What are IFCDs?
IFCDs pay a monthly coupon that changes periodically, or “floats”, based on the change in the Consumer Price Index for All Urban Consumers (CPI) over the previous year. The inflation component is added to the stated interest rate and paid out as part of each coupon payment. At maturity, the initial investment is returned to the investor. Therefore, a portion of each interest payment is meant to offset inflation, and the remainder is the “real” return.
How are interest payments calculated?
Assume you invest $10,000 in a new five-year IFCD paying a stated interest rate of 1%. Assume that it is issued when the benchmark CPI value at 185 is 3% higher than it was the year before, and that the index increases steadily throughout the holding period. Each month, the current CPI value is compared to what it was one year prior, and the year-over-year percent change in CPI is added to the base coupon rate to determine the interest rate in effect for that month. The first year payments on our hypothetical investment would be as follows:
| |
Reference
CPI |
Prior
Year
CPI |
CPI Percent
Change |
Stated Coupon
Rate |
Effective Coupon
Rate |
Interest
Payment |
| |
|
|
|
|
|
January |
185.0 |
179.6 |
3.00% |
1.00% |
4.00% |
33.33 |
February |
185.2 |
180.1 |
2.83% |
1.00% |
3.83% |
31.91 |
March |
185.9 |
180.5 |
2.99% |
1.00% |
3.99% |
33.25 |
April |
186.1 |
180.9 |
2.87% |
1.00% |
3.87% |
32.25 |
May |
186.6 |
181.4 |
2.86% |
1.00% |
3.86% |
32.16 |
June |
187.0 |
181.8 |
2.86% |
1.00% |
3.86% |
32.16 |
July |
187.7 |
182.3 |
2.96% |
1.00% |
3.96% |
33.00 |
August |
188.5 |
182.7 |
3.17% |
1.00% |
4.17% |
34.75 |
September |
188.7 |
183.2 |
3.00% |
1.00% |
4.00% |
33.33 |
October |
189.2 |
183.6 |
3.05% |
1.00% |
4.05% |
33.75 |
November |
189.6 |
184.1 |
2.98% |
1.00% |
3.98% |
33.16 |
December |
190.1 |
184.5 |
3.03% |
1.00% |
4.03% |
33.58 |
| |
|
|
|
|
|
$396.63 |
What does the investor receive at maturity?
At maturity, the investor would receive their initial investment amount. The chart below illustrates the total annual cash flow over the life of the investment using the same stated coupon of 1%, but assumes a constant inflation rate of 3% over the life of the investment.
| Year |
CPI
Percent Change |
Stated Coupon
Rate |
Effective Coupon
Rate |
Interest
Payment |
Principal
Payment |
Total |
1 |
3.00% |
1.00% |
4.00% |
400
|
|
400
|
2 |
3.00% |
1.00% |
4.00% |
400
|
|
400
|
3 |
3.00% |
1.00% |
4.00% |
400
|
|
400
|
4 |
3.00% |
1.00% |
4.00% |
400
|
|
400
|
5 |
3.00% |
1.00% |
4.00% |
400
|
100,400 |
400
|
| |
|
|
|
|
$102,000 |
Can IFCDs be sold prior to maturity?
Yes, IFCDs may be traded in the secondary market, if available, which provides an opportunity for investors to sell their IFCDs at the prevailing market levels, which may be more or less than the original amount invested. However, IFCDs are most suitable for purchasing and holding to maturity.
Are IFCDs rated?
While not specifically rated, IFCDs are backed by the full faith and credit of the U.S. 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 IFCDs?
Investors with a well thought out asset allocation strategy often seek investments that tend to move with inflation, thereby offsetting the negative effect inflation can have on their other investments. But the market values of these asset classes can be influenced by a host of events, and don't always move in step with the general level of prices in the economy. IFCDs 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, which simplifies portfolio rebalancing over time.
What is the estate feature?
IFCDs provide an estate feature also referred to as a survivor’s option, which is designed to protect estate assets. In the event of death or adjudication of incompetence of the beneficial owner of an IFCD, 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 IFCDs:
Ensure a “real” return over inflation
IFCDs lock in a return equal to the inflation rate plus the stated coupon, thereby ensuring that your total return will outpace inflation.
Diversify investment risk
IFCDs offer portfolio diversification because they are a distinct and separate asset class from either equities or traditional bonds.
Additional Considerations for IFCDs:
Risks
Should actual changes in CPI fall short of expectations, the IFCD investment may under perform 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 an IFCD 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 tax treatment of IFCDs is straightforward; taxes are owed each year on the interest payments received.
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