Treasury issues a more consumer-friendly TIPS
By Laura Bruce • Bankrate.com

Treasury Inflation Protected Securities are a great way for investors to receive income while also protecting their principal from the ravages of inflation. But the current 10-year maturity can be a bit risky for most consumers. To counteract that, the U.S. Treasury has announced it will begin offering a five-year maturity starting in October 2004.

The Treasury also will begin offering 20-year TIPS at auction in July 2004. For information on how to purchase government bonds, visit www.TreasuryDirect.gov.

Barry Vosler, a certified financial planner with LPL Financial Wealth Management Group in DeWitt, Iowa, says the new five-year maturity is great news for consumers.

"What's problematic with the current structure is that the longer maturity has a negative impact when rates start to rise. Shortening it to a five-year will reduce the immediate impact of a rate increase. The concept of an inflation-adjusted bond is a very attractive feature, especially to a retiree who might be looking for some income, but more importantly is looking for inflation protection."

Tom Grzymala, CFP, founder and principal at Alexandria Financial Associates in Alexandria, Va., says that as with any investment, consumers will need to weigh the pros and cons.

"Whether to buy the five-year depends on your risk tolerance and your time horizon -- when will you need the money? Look at the yield of the five-year, the real return, and weigh it against other options that may not be as risk-free."

The yield on the five-year TIPS will be determined at auction in October.

The Treasury calls TIPS the "safest of the safest" investments. That's because you can't lose your initial investment. TIPS are pegged to the Consumer Price Index and the principal is periodically adjusted to increases or decreases in the CPI. Semiannual fixed-interest payments are based on the updated principal.

If you have the misfortune of holding TIPS during a lengthy period of deflation, the Treasury guarantees that you'll still receive your initial investment at maturity.

Some consumers may want to compare the return on the five-year TIPS to what they can get with an I bond, another Treasury-issued inflation-protected investment, says Greg McBride, senior financial analyst at Bankrate.com.

"It will be interesting to size up the yields relative to the 1-percent fixed-return component of the I bond, which must be held five years to avoid any interest earnings penalty."

Tom Grzymala points out that the I bond does not have a periodic payout. Interest is added to the principal and paid when the bond is cashed, so someone looking for a bond that pays income would find TIPS preferable over an I bond.

The I bond has a 30-year maturity and must be held one year before it can be cashed. In addition to the fixed rate, the I bond has an inflation-adjusted premium currently at 2.38 percent for an annual compounded rate of 3.39 percent.

As with I bonds, TIPS are not subject to state or local taxes, but you will have to pay federal tax on the semiannual interest payments. In addition, you'll pay tax on the periodic increases in principal even though you don't receive those increases until maturity. Having to pay tax on so-called "phantom income" can be a problem for people who rely heavily on fixed-income payments.

Both Vosler and Grzymala say they don't recommend the 20-year TIPS for consumers because of the length of the bonds.