For years, financial experts have been warning investors, particularly those with long-term goals like retirement planning, that inflation was the single biggest risk to their nest egg.
In response, the U.S. Treasury recently announced that in January, it will start issuing 10-year "inflation protection" bonds. These are bonds whose value is designed to rise with inflation, thus protecting the investors' purchasing power.So far, reaction to the announcement has been mixed.
Some financial planners believe these new bonds, which will be available in denominations as small as $1,000, may be just what some conservative investors want - secure, government-backed bonds with a guarantee that inflation will not erode their value.
Others dismiss the plan as little more than a gimmick pandering to unrealistic fears about inflation. And, they note, it may have some nasty tax implications for investors.
The tax problem arises because both the interest income and the appreciation in principal value are taxable every year - even though a bond-holder doesn't actually get the added principal until the bond is sold or matures. That means when the bonds go up in value, owners will be paying tax on income they haven't actually received.
"There's nothing worse that getting a tax bill when you have no income to show for it," said J. Michael Martin, a certified financial planner with Financial Advantage in Columbia, Md. "I don't think it's a good idea - not for my clients."
One way around that problem is for investors to purchase the new securities for their tax-sheltered retirement accounts.
People who include stocks in their portfolios to protect against inflation may not need the new bonds, a New Jersey analyst said. "But there are many individuals out there who primarily invest in bonds. For those individuals, this could be helpful."
Richard A. Miller, a planner with Straub Financial Solutions Inc. in Denver, said he is "not wildly excited" about the new Treasury security.
"While it will probably be fine for the most conservative of investors, they would be giving up potential yields to minimize a fairly low-risk investment," Miller said. He noted that the interest rate on the new securities is expected to be lower than on traditional bonds because there is no inflation risk to the investor.
"I don't see a crying need for it," he added, particularly since inflation has averaged less than 3 percent over the past five years.
Here's how the new bonds will work. A person invests $1,000 in a 10-year bond in January 1997. The new bonds will be sold at auction, meaning the market will determine the interest rate. Let's assume it is 3 percent, which is locked in for the life of the bond.
The investor will receive interest payments twice a year. Meanwhile, if inflation goes up, the principal value of the bond will increase to reflect that increase.
For example, if inflation was 1 percent during the first six months of the year, then by midyear, the principal of the bond would increase to $1,010 - the original $1,000 plus 1 percent.
In addition, at midyear, the investor receives the first semi-annual interest payment of 3 percent, based on the new higher principal.
That works about to $15.15 - $1,010 multiplied by 3 percent interest, divided by two to make half a year's worth of interest.
Semi-annual interest payments and principal adjustments continue until the bond is sold or reaches maturity.
The first auction of 10-year inflation-protected bonds is scheduled for Jan. 15 and quarterly thereafter. The bonds can be purchased through brokerage firms or directly from the U.S. Treasury.
At a later date, the Treasury may offer inflation-protection bonds of differing maturities and denominations. Several investment companies are investigating ways to package the new securities in mutual funds.
Harold Evensky, a financial planner in Coral Gables, Fla., said he expects the new inflation-protected bonds to be very popular in tax-sheltered retirement accounts.
"There is a real need for a product like this," Evensky added. "More money has been lost in bonds than has ever been lost in stocks," he noted. "This new bond will be a safe investment."