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Inflation Adjusted Treasury Bonds
 

Inflation Adjusted Treasury Bonds

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    Inflation Adjusted Treasury Bonds Inflation Adjusted Treasury Bonds Document Transcript

    • Inflation Adjusted Treasury Bonds Majority of the people invest in Treasury bonds to protect their investments. They do so to protect their money. However, one drawback of the treasury bond is tha it loses purchasing power when t inflation takes its toll. To protect the bonds frominflation, the United States Treasurydesigned securities, which adjust with inflation and are therefore referred to as inflation adjusted treasury bonds. The inflation adjusted treasury bonds are provided by the United States government. They are also known as government bonds. Inflation adjusted treasury bonds, adjust themselves as per the CPI-U or the Consumer Price Index (urban consumers). The CPI-U is one of the measuring tools of inflation. The CPI-U is published , for the knowledge of the public every month, by the Bureau Of Labor Statistics.(United States Department Of Labor). Inflation adjusted treasury securities are mainly of four types. All these securities enjoy the benefit of inflation adjustment. They are:  Treasury bonds  Treasury bills  TIPS or treasury inflation protection securities  Treasury notes I) Inflation adjusted treasury bonds: These types of bonds are characterized by having maturity periods, which are the longest. The maturity period of inflation adjusted treasury bonds range between 10 years and 30 years. One can avail of coupon payment at intervals of six months. II) Treasury Bills or T bills: The maturity time of treasury bills is one year or less than a year. In case of treasury bills, the interest is not paid before the bill matures. Treasury bills are considered to be very safe and do not involve much risk. III) Treasury notes: Treasury notes are also known as T notes. The maturity time ranges between 2 years to 10 years.
    • Maturity time of 2 years, 5 years, 10 years, have denominations ranging from USD$1,000- USD$1,000,000. Coupon payment at intervals of 6 months is available. IV) TIPS or Treasury inflation protected securities: TIPS are inflation-indexed bonds. These bonds are issued by the United States treasury. In these types of bonds, adjustment of the principal amount is made according to the CPI or consumer price index. TIPS, usually gives a different interest amount, when it is multiplied by the principal, which is inflation adjusted. However, there is constancy in the coupon rate. Term of the bond ranges between 5years to 20 years. TIPS (Treasury Inflation Protected Securities) These are a lot like other treasury notes and treasury bonds. They're sold with a face value of $1000, and the interest rate is determined in an auction. Individual purchasers can skip the auction process and just buy at the auction price (which guarantees you the samereturn as the investment professionals whose bids won the auction). The interest rate is usually pretty low (currently running around 2.3% to 2.4%), which is not as bad as it sounds, because it is paid on the inflation-adjusted face value of the bond. An adjusted face value is calculated for each day and is announced monthly when the new CPI numbers are released. For example, the face value of the 3% 10-year TIPS that was auctioned in 2002 was 1158.80 on September 1st. As long as inflation continues, the face value will go up--and the interest payments, calculated as a percentage of face value, will go up as well. At maturity you get the final adju sted face value. The face value won't go below $1000, giving you some protection against deflation as well. If you have to sell before maturity, though, you're not guaranteed the face value. The price will depend on current interest rates and current inflationary expectations. I-Bonds These are savings bonds, rather like ordinary savings bonds. They're sold in various denominations, from $25 to $10,000. They also pay a fixed rate plus an inflation adjustment, but the calculation is different. Instead of calculating an adjusted face value and then applying the fixed rate to that, the treasury calculates a quot;composite earnings ratequot; that combines both parts. The composite rate is calculated every six months, based on the inflation rate of the previous six months. The fixed part of the rate is determined by the Treasury twice a year. It applies to all bonds sold for the next six months, and remains in effect for the lifetime of the bond (30 years). You can't cash in an I-Bond in the first 12 months after you buy it, and if you cash it in after less than five years, you lose 3-months of interest.
    • After-inflation return Back when inflation-adjusted bonds were new, they paid a pretty good rate. If you'd bought one in 2000, you could have gotten a 10-year TIPS that paid 4.25% over inflation. Until about 2003, you could generally get 3% over inflation. Since then, the rates have dropped, mostly because interest rates in generally are lower now. One way to think about the rate on a TIPS is that it should be exactly the same as the rate on an ordinary treasury security of thesame maturity minus the expected inflation between now and then. So the rate on a TIPS goes down anytime the expected inflation rate goes up, plus it goes down anytime other interest rates go down. The rates on I-Bonds used to be reasonably competitive with the rates on TIPS (from 1998 until 2001 they were 3% or higher). Since then, though, they've fallen quite low. The current fixed rate on an I-Bond is just 1.3% over inflation. Tax Considerations One reason to consider I-Bonds, despite the very low rate, is that they've got the same tax advantages of other savings bonds. You can choose to pay taxes on the interest every year (if, for example, you're a child with almost no income who will owe no tax) or you can chose to wait and pay taxes on the income only when you cash in the bond. Further,if you use the money to pay for certain kinds of education expenses, you don't need to pay taxes on it at all. TIPS, on the other hand, have a unique tax problem: you not on owe taxes each year on the ly interest that you get, you also owe taxes on the increase in face value due to inflation (even though you don't actually get that money until the bond matures). Some people consider this a big deal, and don't recommend that you buy such bonds except in a tax-sheltered plan such as an IRA or a 401(k). Personally, I don't see how it's much worse than the tax treatment of a mutual fund where you're reinvesting the dividends, where you still owe taxes on the dividends and the capital gains, even though the money has been reinvested in the fund. The interest on TIPS and I-Bonds, like all US Treasury interest, is exempt from state and local income taxes. Benefits of Treasuries
    • In any financial climate, U.S. Treasury securities offer investors many benefits, including: Safety Backed by the full faith and credit ofthe U.S. government, Treasuries are considered ideal for safeguarding and preserving your princi al.1 p Guaranteed return of principal If held to maturity, Treasuries are guaranteed to repay your original investment. So no matter how volatile the market may be, as a Treasury investor, you never risk your principal if you hold the security until maturity. Guaranteed with fixed rate income With Fixed Rate Treasuries, you'll know exactly what your income will be and when you will receive interest payments.You'll receive a steady income of semi-annual interest payments when you purchase Treasury notes or bonds. Tax advantages Although federally taxable, the interest on Treasuries is exemptfrom both state and local taxes. Thus, your after-tax return may be higher than the same yields on fully taxable investments like FDIC-insured, fixed-rate CDs, especially if you live in a high-tax state. Flexibility Want a short-term investment for your funds while you decide among alternative investments? Or, are you saving for the long term, like college or retirement? You can choose from the many Treasury issues and maturities available to meet your investing goals. Liquidity Looking for a ready source of cash? The active secondary market for Treasuries enables you to sell your Treasury securities before maturity. Of course, you'll receive full face value if you hold a Treasury until maturity. Choose from Treasury bills, notes, bonds, Treasury inflation-indexed securities and STRIPS Minimum investment2 Treasury bills $10,000 face value investment plus $1,000 increments. Treasury notes and bonds $1,000 face value investment plus $1,000 increments. Treasury inflation-indexed securities The treasury inflation-indexed security is a new security with an inflation adjusted principal amount. Interest payments will be calculated from the adjusted amount (which could be more or less than the original value at issuance depending on changes in the Consumer Price Index (CPI- U)). If you are looking for investment growth over time, consider STRIPS
    • STRIPS are Treasury bonds that have been stripped of their interest and principal payments. If held to maturity, they guarantee the return of your principal, plus all accrued interest. Because they're direct obligations of the U.S. Treasury, they're considered among the safest types of inves tments. Because STRIPS are sold at deep discount, they usually cost less than their face value. Your return is the difference between what you pay and what you receive at maturity. The interest on STRIPS accrues over the life of the bond and is automatical y reinvested. With this compounding of l interest, even a small initial investment can achieve growth over time. STRIPS do not pay interest until maturity, so their prices tend to bemore volatile than bonds which pay interest at regular intervals. And although interest isn't paid until your STRIPS mature, it is taxable the year it's credited to you, which is why STRIPS are favored for tax-deferred accounts such as Keoghs and IRAs. How Much Does a $5,000 Zero-Coupon Treasury Actually Cost? Years to Maturity Maturity Yield 30 25 20 15 10 5 Value 4% $1,540 $1,880 $2,280 $2,780 $3,380 $4,110 $5,000 5% 1,160 1,480 1,880 2,400 3,070 3,920 5,000 6% 870 1,170 1,556 2,090 2,790 3,740 5,000 7% 660 920 1,290 1,810 2,540 3,570 5,000 8% 500 730 1,070 1,580 2,320 3,400 5,000 Numbers are approximations for example purposes only. Contact your Schwab office for current market values.