Effect of Inflation on Bonds Part 2

Effect of Inflation on Bonds

While inflation has hardly taken center stage among our economic woes of late, there are some credible voices in economics who are already warning of its dangers down the road. Since the FED has already locked itself into rock-bottom interest rates for the foreseeable future, if the economy does not surprise us with a great rebound in the next few years the Fed will have to resort to its one remaining tool, i.e. an expansionary monetary policy, adopting more aggressive quantitative easing, debt monetizing, and other stimulating (but also inflationary) measures. In short, the FED will have to print more money.

At that time, the threat of inflation will be real once more. It’s advisable to reacquaint ourselves in advance with the basic effects of inflation so that when it comes, we’re prepared to deal with the consequences. Today we’ll be looking at how this would affect the bond market specifically. The following are some things you should know about the effect of inflation on bonds:

The Problem with Inflation

Effect of Inflation on BondsAs we saw in a previous article Impact of Inflation on Bonds Part 1, the main problem with bonds in an inflationary environment (more so than stocks, which would tend to adapt) is that a discrepancy begins to open up between the rate of return on bonds and the rate of inflation. So for instance, if your bonds are yielding 2% for the year, but prices are inflating at 3.5%, your statements would still show a supposed gain of 2%, but this would represent an actual loss in terms of purchasing power.

Another risk is that if serious inflation were unleashed, the Fed would have no choice but to try to counteract it by raising interest rates, after years of driving them down. The result of this would be rising bond yields in tandem with falling bond prices, the end result of which is a loss of principal value for current bondholders. [Read more...]

Worried About Inflation – Consider Inflation Indexed Bonds

Inflation Indexed Bonds (aka i-Bond)-

Although inflation is currently low it is still a key concern for investors, because with interest rates at record lows and the FED promising to keep them there for the foreseeable future even a small uptick in inflation can prevent an investor from achieving a real return on investment, as returns on investment fail to beat inflation rates.

If a return on investment fails to beat inflation, then in real terms you have not earned any money. You may have a larger figure for your total net worth, but in terms of purchasing power this will earn you less as the costs of living increased at a higher rate.

On target

inflation indexed bondsInflation is currently tracking at around the 2% mark in the U.S., which is pretty spot on with the target set by the Federal Reserve. However there are still concerns about the government’s handling of the economy, as was made clear in the recent Presidential election where Obama held on to his presidency comfortably in the end, but not without some rough moments along the way.

The U.S. is making a steady recovery from the financial crisis of 2008. However for many it isn’t fast enough or convincing enough, and with a huge federal deficit that has not been significantly cut, there are fears the U.S. could slide back into trouble, with investments suffering as a result.

Index to Inflation

With all the uncertainty surrounding the financial climate, more secure investments are being sought out. With worries about inflation, the most secure type of savings bond are inflation indexed bonds. These bonds are normally issued by the government, and their rate of return is linked with inflation.

The bonds pay out an agreed coupon rate which is combined with an inflation rate that is updated every 6 months in May and November, meaning if inflation goes up, the coupon goes up, if inflation goes down, so does the coupon. Other returns are available with an variable interest rate which is determined by inflation, together with a fixed rate agreed upon issue.

How this protects investments

What this does is guarantee that in real terms, the rate of return on the bond will remain essentially the same, guaranteeing a return over the life of the bond. It may include a nominal variable component to the bond, but in real terms it is a fixed bond. Essentially a fixed bond is variable as its value is affected by inflation. By introducing the variable component, it has been insured that these inflation indexed bonds actually give a more guaranteed and fixed real rate of return than a bond with an actual fixed rate.


Editor’s Note: At least that is the theory. Let’s see how it is actually working out in practice.

How Inflation Indexed Savings Bonds are Performing

Since November 2010 the fixed rate component of the Inflation Indexed Savings Bonds has been zero yes 0%.  And the variable component has varied from a low of 0.37% to a high of 2.30% as follows:

DATE

Semi-Annual Inflation Rate

NOV 1, 2012 0.88%
MAY 1, 2012 1.10%
NOV 1, 2011 1.53%
MAY 1, 2011 2.30%
NOV 1, 2010 0.37%

The formula for calculating i-Bond returns is as follows:

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

So the current rate of return is:

Composite rate = [0.0000 + (2 x 0.0088) + (0.0000 x 0.0088)]

or

Composite rate = [0.0000 + 0.0176 + 0.0000000] = 0.0176 = 1.76%

So let’s look at what your rate of return would have been if you had bought an I-Bond a year ago.

November 2011 i-Bond Analysis

Composite rate = [0.0000 + (2 x 0.0153) + (0.0000 x 0.0153)]=3.06%

As of this writing the current official inflation rate is 2.2% (for the year ending in October) and based on the Consumer Price Index calculations by InflationData.com it is more precisely 2.16%.

So if you had bought an Inflation Indexed Savings Bond in November 2011 it would have been yielding 3.06% and over the year you would have suffered a 2.16% loss of purchasing power thus you would have had a real return of 0.9%

3.06% (return) – 2.16% (inflation) =0.9% (real return)

But based on Bonds bought now you will only receive 1.76% so if inflation stays at 2.16% you will actually lose 0.4%. Also there is a 3 month penalty if you withdraw your money before 5 years so if you only held for one year you would have earned 3.06% * .75 = 2.295% or 0.135% more than the inflation rate of 2.16%.

Would you like to know How Have Inflation Indexed Bonds Really Performed since their creation in 1998? See the inflation adjusted performance of Inflation Indexed Bonds.

See Also:

Author Bio: James McDonnel: When he’s not writing for sites like Inflation Data, he works with Swift Money helping users source short term loans in times of need. Visit Google+ for more detail about SwiftMoney.

US Savings Bonds Are Still A Safe Investment

With interest rates still at record lows, many people are looking for alternatives to savings accounts.  US Savings Bonds are a safe and smart investment choice.  No other investment carries the full weight of the U.S. government. The U.S. Treasury Department guarantees investors will receive their full principle plus interest.  Consider why purchasing savings bonds is an investment that can be made with confidence.

US Savings Bonds: Conservative, but Smart

Although savings bonds do not yield as much return as higher-risk investments, investors can rest easy knowing they will not loose their money.  The financial downturn of the last few years has resulted in many Americans loosing large portions of their retirement.  Even if the rate is not high, investing in a savings bond will never result in the loss of principle.  Despite a down economy, investors will always gain some interest on savings bonds, usually at a rate higher than traditional savings accounts and certificates of deposit.

Savings BondsThe United States government backs savings bonds.  Therefore, as long as the government is in existence, investors will receive their money, unlike millions of dollars lost to investors when corporations fail or go out of business.  Take comfort in Public Debt Commissioner Van Zeck’s own words, “Savings bonds are very much a part of this country’s history and culture, and will remain a part of America’s future.”

Additionally, investors receive tax benefits when opting for bonds.  Savings bonds are exempt from state and local taxes, and buyers can even defer paying federal taxes on the interest until the savings bond is redeemed.  Conversely, interest on savings accounts is considered taxable income and subject to federal, state and local taxation.  Another perk is that investors can receive special tax benefits for using bonds for higher education savings.  All or part of the earned interest can qualify for exclusion from taxation when used for tuition and associated fees. [Read more...]

Should I Invest in Inflation Indexed Bonds?

The question of “Should You Invest in Inflation Indexed Bonds?” depends on your personal situation and the current inflationary environment. If you want to have a low risk investment that will keep up with inflation you might consider investing in inflation indexed bonds.

Inflation Indexed Bonds

When Inflation Rates are High, you might be worried about what’s going to happen to your savings. Inflation series bonds are one option to consider. These unique investments have the ability to fight inflation and protect your savings from total devastation.

Types of Inflation Indexed Bonds

There are two different types of inflation indexed bonds issued by the U.S. Treasury   one is called the Series I Savings Bond and the other is called TIPS or Treasury Inflation Protected Securities.  In this article we will cover only the Series I Savings bonds. See: What are Treasury Inflation Protected Securities (TIPS)? for information about TIPS.

Series I inflation Indexed Bonds-

Should I invest in Inflation Indexed Bonds?Inflation series I bonds are purchased at face value. Unlike zero coupon bonds or T-Bills, you cannot buy inflation series bonds at a discount. Instead interest rates paid are based on a sort of complex formula made up of two components. The first component is a base interest rate and it remains the same for the life of the bond. The second component is an inflation adjustment  that is calculated every May and November. When inflation is high this will boost the return on your i-Series Inflation Indexed bond. Fixed rates and semiannual inflation rates are combined to determine composite earnings rates. An I Bond’s composite earnings rate changes every six months after its issue date. Interest is accrued monthly but not paid until maturity or early redemption. The differential is based on the Consumer Price Index.

[Read more...]

What are T-Bills?

T-Bills Definition:

Treasury bills (aka. T-Bills) are short-term debt obligations that are backed by the US government and which have less than a year’s maturity. They are sold in $1000 denominations and purchases can go up to 5 million. Commonly, T-bills come with 4-week (1 month), 13-week (3 month) or 26-week (six month) maturities.

The issuing of T-bills is done by a competitive bidding process where the bids are placed on “discounts from par” which means that unlike in the case of conventional bonds with fixed interest rates, here, it is the bond appreciation that gives the holder his returns.

What are T-Bills?For example, if you buy a T-bill with a 13-week maturity at $9,950. What happens here essentially is that you give the government the use of your $9,950 and the US government will write you a $10,000 IOU which it agrees to pay you back after the 3-month period. You do not get regular payments as would be the case with coupon bonds. Instead, you get returns for how much the received value ($10,000) differs from the original discounted value paid by you ($9,950). So in this example, the interest rate that the T-bill pays is 0.5% ($50/$9950) over a period of three months. That would be the equivalent of an annual yield of about 2.01%.  The U.S. Treasury publishes the Current T-Bill rate daily. As of this writing the 3 month T-Bill is yielding [Read more...]

What are Treasury Inflation Protected Securities (TIPS)?

As the Government continues to flood the economy with new money via QE1, QE2, Operation Twist and now Twist2, many investors are fearing a massive inflation may be just around the corner. And so they are looking for a sfe haven to protect their investments from the deluge they see coming. Therefore they are turning to Treasury Inflation Protected Securities, or “TIPS”. TIPS are considered an extremely low-risk investment as they have Government backing, are protected from the ravages of inflation and are less volatile than bonds and safer than stocks.

How Treasury Inflation Protected Securities (TIPS)  Protect Against inflation

Treasury Inflation Protected Securities (TIPS)Over time even small levels of inflation can make a big difference in the purchasing power of your investment. So for long-term savers and investors, inflation can be a major enemy of your retirement fund. If  your rate of return isn’t greater than the rate of inflation, then the real value of your investment (the inflation adjusted value)  drops and, with it, your spending power.  So even though it looks like you have more money, you can actually buy less with it.

Treasury Inflation Protected Securities (TIPS) adjust your investment value according to changes in the Consumer Price Index (CPI), i.e the inflation rate. So, when there is inflation, or a rise in the index, the principal increases and, with deflation, the principal decreases. But you are protected against long term deflation as well since, when a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

TIPS are sold at auction several times a year with five, ten or 30 year maturities. The minimum purchase allowed under the scheme is $100. [Read more...]

What are I bonds?

I- Bonds: A brief overview:

In the current shaky economy, everyone is looking for safe and secure investments. Investors might have a chance at high rewards with stocks and corporate bonds, but there’s also a huge risk to putting money in either. The snowballing crises in Europe aren’t making foreign investments look any more tempting. Where can investors trust their finances if they want a solid risk free return on their investment?

Well, for those of you who want to play it cool and safe with your investments, you might consider: I bonds.

What are I-Bonds?

US Treasury I-Bond

US Treasury Bond—DonkeyHotey (Flickr.com)

First of all, I-Bonds are officially called Series I Savings Bonds. According to the U.S. Department of Treasury, I bonds are “a low-risk, liquid savings product.” I bonds are government-issued and therefore carry very little risk as a long term investment. The value and interest of I bonds are adjusted every six months according to the current inflation numbers, which saves the investor from ever losing out on their initial investment upon issue of the bond. In theory, I bonds should never lose out on their initial value since they’re constantly corrected by the inflation (or deflation) rate. They’re low risk (but also low reward) investments meant to protect investors from market volatility. However, in a low inflation environment the return can be lower than other government bonds. Plus due to early withdrawal penalties it can be a less than optimal investment.

Early Withdrawal Penalty on I-Bonds:

An I-Bond is issued with a maximum 30 year maturity. Someone who wants to cash in their I bond early isn’t allowed to do so for the first year. After a year, you can redeem your I-Bonds at their current value, but the value will suffer a three month interest penalty for early withdrawal. After five years the I bonds can be redeemed without suffering a penalty for early withdrawal. [Read more...]

Impact of Inflation on Bonds Part 1

Impact of Inflation on Bonds

Impact of Inflation on BondsBonds are often considered a risk-free (or nearly risk-free) investment suitable for “widows and orphans”. While they are generally safe, they have several weaknesses in the modern marketplace, inflation, rising interest rates and default risk. Before buying a bond, make sure you understand how bonds work and how inflation can have an effect on bonds.

 The Nature of Inflation

Inflation is often described as the general rise of prices in the economy. However, the increase in prices is merely the effect, called “price inflation.” Monetary inflation, which is the expansion of credit in the financial markets, is what often (but not always) drives price inflation. As credit expands, and more money becomes available to the marketplace, the price of goods and services generally rise in response. This is because the inflation increases the supply of money in circulation while simultaneously decreasing the value of money as a result. Like a domino effect, this decrease in the value of money pushes prices of goods and services higher.  The money supply is, tracked using a series of M’s (M1, M2, and M3) quantify the amount of money in circulation. For example, M1 is the most restrictive measure of  money, ie. it is just money in circulation but does not measure bank reserves. M2 is regarded as a broader classification than M1. M2 represents money and “close substitutes.” M2 includes all of M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds. M3 included all of  M2 (which includes M1) plus large-denomination ($100,000 or more) time deposits, balances in institutional money funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks and at all banks in the United Kingdom and Canada. But for some reason the FED stopped tracking M3. See Good-Bye M3.  Looking back it is possible that because of all of the derivatives and Mortgage Backed securities even the FED couldn’t tell how much money was really in circulation.

[Read more...]

Inflation Adjusted Gold vs Stocks vs Bonds

Recently our good friends at Casey research published the following chart comparing the inflation adjusted Gold returns to stocks and bonds for the period 1971 through the present.  From this chart we can see that as bonds fell during the late 1970′s gold rose equivalently and stocks were basically flat. During the 1980′s bonds rose and gold fell while while stocks rose slightly. During the 1990′s stocks rose sharply gold fell and Bonds were volatile but basically flat to slightly up. During the 2000′s gold was up sharply, stocks were volatile and bonds were pretty flat. [Read more...]