Financial Tips: Inflation Bonds 101

Traditionally, bonds are the reliable, yet less exiting, cousin of the investment family. Inflation bonds, adjusted to take into consideration the increase in cost of living over time (inflation), are often seen as a safe haven in troubled economic times. That said, past performance is no indicator of future performance. Investing in anything is risky business. If you are considering such an investment, it may be time to take a course in financial tips. Inflation Bonds 101 is in session.

Inflation bonds, aka inflation-linked bonds. Inflation bonds are bonds (debt securities) where the principal investment is linked to inflation as an initial investment protection. These inflation-indexed bonds are primarily government issued with only a small remainder issued privately. The issuer owes the holders a debt and must pay interest in the form of a coupon with a promise to repay the principal at a contractually agreed-upon later date -- known as the maturity date. In the case of inflation-linked bonds, the bondholder is, in effect, a lender to the bond issuer. With most inflation-linked bonds, the issuer would be the government, a municipality, sovereignty, or, in lesser cases, an agency or corporation.

Liquidity in inflation bonds. Treasury inflation-protected securities (TIPS) and treasury bonds are the most liquid and therefore are heavily traded on the secondary market. These inflation-indexed bonds issued by the U.S. Treasury are prime examples of principal that is adjusted to an inflation index -- in this case, the Consumer Price Index (CPI). When the CPI rises, the principal adjusts upward to meet it; the converse is also true. The interest rate remains constant. However, when it is multiplied by the inflation-adjusted principal, you can receive a different coupon amount.

Inflation bonds can be affordable, safe investments. Individual I savings bonds can go for as little as $50. While they have a five-year minimum redemption period, they are redeemable as soon as 12 months after purchase. (The maximum penalty for redeeming before the five-year minimum amounts to the last three months of interest.) With I Savings Bonds, the interest is tax-deferred until redemption, and they can be held as long as 30 years.

Safety, liquidity, and inflation protection -- these are all sought-after factors in turbulent economic times. Visit TreasuryDirect for the current rate of interest and ways to purchase these financial products.

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