Inflation-Linked
Investing
Traditional
bonds pay a fixed rate of interest over the life of the investment.
Inflation-linked investments pay interest based upon changes in
the Consumer Price Index (CPI) for all Urban Consumers1,
in addition to a fixed coupon rate, and therefore, provide a consistent
and predictable real return. There are several types of inflation-linked
structures that provide protection from the negative effects of
inflation:
“Adjusted
Principal” Structure
Inflation-linked investments with an “adjusted principal”
structure provide inflation-linked returns by increasing the
base amount of the investment to keep pace with changes in
CPI, while also paying semiannual coupon interest as a percentage
of that adjusted base. At maturity, the inflation adjustment amount
that has been accumulating during the holding period is paid out
along with the original investment amount. This ensures that the
money you get back at maturity will have the same “buying
power” that your initial investment did when you bought it.
With the effects of inflation neatly taken care of in this manner,
it's easy to see that the coupon payments received represent the
real return on the investment. Certificates of Deposit: Inflation-Protected
(CDIPs) and the U.S. Treasury’s TIPS product are issued using
the adjusted principal structure.
“Floating Coupon” Structure
Inflation-linked investments with a "floating coupon"
structure pay a monthly coupon that changes, or “floats”
periodically, based on the change in CPI over the previous year.
Instead of adding the inflation component of the return to the principal
balance, this type of investment simply pays it out as part of each
coupon payment. At maturity, the initial investment is returned
to the investor without any inflation adjustment. Therefore, a portion
of each interest payment is meant to offset inflation, and the remainder
is the real return. Inflation-Floater Certificates of Deposit (IFCDs)
and inflation-linked corporate notes are issued using the floating
coupon structure.
Which Inflation-linked Investment to Choose?
| |
Adjusted
Principal Structure |
Floating
coupon Structure |
| Saver |
Automatic
principal adjustment reduces reinvestment risk but taxation
may be a problem if tax-advantaged funds are not available.
|
Monthly
payments are more trouble to reinvest, but tax benefits may
outweigh the inconvenience and risk. |
| Retiree |
Payment
structure ideally suited to preserve long-term income producing
power of savings while providing inflation-indexed income.
|
Real
value of savings will diminish if a portion of each interest
payment is not reinvested. Requires discipline to manage this
effectively. |
| Diversified
Investor |
Either
structure provides diversification benefits. Tax consequences
should be the main consideration. |
1 Additional
information about the Consumer Price Index can be found at www.bls.gov.
|
