Preserve you Buying Power with Bonds - ch 5 Bogleheads Series at Catch a Gideon

November 6th, 2006 by digerati

This is Chapter 5 of the Bogleheads Series. The series goes through the book The Bogleheads Guide to Investing and gives the highlights of each chapter along with my comments and additions.

Preserve Your Buying Power with Inflation-Protected Bonds

Inflation diminishes your returns. If inflation is 2% and your return is 8% then your real return is 6%. Get it? Got it? Good. Basically inflation is that friend you don’t really like but don’t have the heart to stop talking to. It will eat away at you little by little, almost so you don’t notice.

Inflation is the diminishing purchasing power of a dollar. What a dollar bought 50 years ago is about ten times what a dollar will by you now. In part 2 of the Boglehead series we learned that compound interest when saving is our friend. Well with inflation compound interest is not our friend.

The book has lots and lots of table to show you how $1000 dollars will look at various return rates given various rates of inflation and tax brackets. The important point is that because the combined effect of inflation and having to pay taxes on the total return (not the real return of total-inflation) some investments with total gains may actually cause real losses.

But you can get a Guaranteed positive real return! The US Treasury offers two options: I Bonds and Treasury Inflation Indexed Securities (TIPS).

I Bonds

The I is for Inflation. I Bonds return is made up of two parts:

the real rate in effect when you purchase the bond. This is what you will receive over and above inflation. It does not change over the life of the bond.
Variable inflation adjustment rate. This is calculated twice a year (May and November). The rate is determined by estimated the inflation over the previous 6 month period.

The sum of these gives you your total return for the next 6 month period. The only problem is you have to pay taxes on both portions, not just the real rate gains. BUT, the I Bonds are tax deferred for up to 30 years, so you can probably wait to pay the tax until you are in a much lower income bracket than while you are working. To realize the best gains on bonds you need to be in a lower tax bracket when you cash them in than when you purchased them. This is yet another reason why recent graduates should not buy bonds.
TIPS

Buying TIPS from the Treasury auction is the best option to reduce return erosion from fees. Investing in TIPS funds is the best choice for flexibility.

TIPS guaranteed rates are usually higher than I Bond fixed rates. If you have room in your 401(k) or IRA accounts that’s where they should go. If you cannot place them in your tax deferred accounts you may be in the unfortunate situation of paying taxes on some income that you won’t see until the bonds mature. They call this “phantom income.”

If you haven’t done it yet, why not buy The Bogleheads’ Guide to Investing?