One of the fears that many have with regard to their future finances is inflation. Inflation erodes your buying power, making your money less valuable in the future.
In order to protect against inflation, preserving capital, many investors choose Treasury bonds adjusted to keep pace with inflation. Treasury securities are considered to be low-risk investments, since they are backed by the U.S. government. And, because they keep pace with inflation, your capital can be protected from erosion due to price increases.
How Inflation-Adjusted Treasury Bonds Work
There are two main types of Treasury bonds that are adjusted for inflation:
- TIPS: These bonds actually include changes to the principal. So if the CPI shows an increase, you will see a small amount added to your principal. Then, the interest on the bond applies to the new principal.
- I-Bonds: Instead of seeing an adjustment to the principal, I-Bonds feature a variable rate as part of its formula for gains. The variable component of the rate is adjusted up or down along with the CPI.
There are some arguments that CPI doesn’t accurately measure “true” inflation as it relates to the costs consumers actually face. If this is the case, then your investment won’t completely protect you from the vagaries of inflation. However, TIPS and I-Bonds can provide you with one to at least somewhat preserve your capital, without the same level of risk that comes with stocks and other investments.
Even though these are Treasury investments, you are still required to pay taxes on your earnings. When you invest in I-Bonds, you have the option to defer reporting your interest until you redeem your bonds if you don’t want to report the interest earnings in the year you receive them. However, reporting the accumulated interest can mean a bigger tax bill at maturity. Consider whether or not you are better off paying over time, or all at once.
With TIPS, you don’t have the option. Taxes are paid on earnings as you receive them. So, even though you won’t actually receive your principal earnings until you redeem your bond, if the principal was adjusted upward for inflation, you still have to pay taxes on the gains. The only way to defer your tax payment is to hold TIPS in a tax-advantaged account.
Other Investments to Beat Inflation
There are plenty of other investments that can help you beat inflation. Stocks are among the most popular of investments with the potential to beat inflation. Some investors also like commodities and currencies, as well as real estate. All of these investments have the potential to offer higher returns than bonds over time. However, some of them also come with more risk of loss.
With Treasury bonds, you are almost guaranteed safety (although default and the loss of principal and future interest is always possible), and the return keeps pace with inflation in a way that the yields on even safer cash rarely provide.
There are plenty of ways to beat inflation, from starting your own business to making riskier investments. However, if you want to preserve your capital with a relatively safe investment, TIPS and I-Bonds can be an option.