Government bonds are the most popular type of bond that many investors and savers use because they carry the full faith and credit of the U.S. government. Being relatively safe, the are appropriate for investors that can't tolerate much risk and are seeking to preserve their principal. The problem is that they generally pay low returns relative to other investments and face significant inflation risks. Therefore, investors who predominantly use bonds in their portfolios as part of a retirement planning strategy or funding a child's education may be hurting themselves due to the detrimental affects of inflation.

In order to remedy this situation and still keep U.S. government bonds attractive to investors, the U.S. Treasury issued inflation-protected bonds with a return that is indexed to the inflation rate. There are three maturities for these types of bonds issued at 5, 10, and 20 years. These issues are avaiable for purchase in $1,000 increments through financial advisors, banks, and TreasuryDirect (www.treasurydirect.gov).

Features of Inflation-Indexed Bonds

•They are guaranteed a rate of return that is above the inflation rate.

•They protect the investor's principal from inflation by indexing the principal to the Consumer Price Index (CPI).

•They protect interest from inflation by providing the investor with semiannual interest payments based on the semiannual interest rate applied to the new inflation-indexed principal value.

•They guarantee a return of principal even if inflation drops.

The Time to Buy is During Periods of High Inflation

Inflation-protected bonds are a good decision when an investor's outlook of inflation is that inflation will be going up in the coming years. For example, if you purchase a $1,000 bond and the Consumer Price Index rose by 3%, the value of your initial princiap will also increase by 3% to $1,030. Assuming the coupon rate on the bond was 3%, you will receive interest payments based on the new principal amount. If the following year the CPI rises to 4%, the principal will be adjusted from $1,030 to $1,071.20, and your interest payment would increase from 3% to 4%, paid twice a year.

How does this structure compare to the ordinary type bond - one that is not inflation protected? Well, assuming the inflation rate is 3% and the yield of the unprotected $1,000 10-year Treasury note is 6.3%, the real yield of this security would be the 3.3% which is derived by subtracting the inflation rate from the security's note. After a year, that note would be valued at $1,063, but you would lose $30 of that gain because of the erosive nature of inflation, leaving you with a bond that is worth $1,030. Hence, it makes sense to purchase inflation-indexed securities if you believe that inflation will pick up.

Inflation-Protected Securities Benefits and Drawbacks

Benefits

•Guaranteed to outpace the inflation rate.

•Guarantee a return of principal.

Drawbacks

•Some expenses may grow at rates greater than the inflation rate.

•Could generate poor results when there is deflation.

•Subject to federal taxes, which may not justify the lower interest rates.

Be careful when purchasing inflation-protected bonds for expenses such as college education, because that strategy is impractical. College tuition costs outpace the rate of inflation. For the 2008-2009 academic year, college costs including tuition, fees and room and board increased at an average of 5.8% which was substantially more then the increase in the Consumer Price Index (CPI).

Even though it is a fact that these inflation-indexed bonds are exempt from state and local taxes, federal income taxes still apply. It is also important to understand that you will have to be pay taxes on any increases in principal on a yearly basis; however, the increase in principal will be paid to you only once the bond matures. Hence, if you find that your bonds do not pay enough interest income to cover the tax bill on the increase in principal in any given year, they may not be appropriate investments for you unless you invest in these bonds through a tax-deferred account such as a retirement account.

Inflation indexing is especially appealing to investors that are in or near retirement. After all, during periods of inflation, inflation protection can make the difference to protect the retiree's principal.

Things to take away

•Inflation-indexed bonds offer inflation protection.

•Semiannual interest payments are based on the interest rate applied to the inflation-indexed value of the principal.

•These bonds are exempt from state and local taxes, but federal taxes apply.

•Investors must pay taxes on the increases in the value of the bond's principal in any given year, while the increase in principal will be paid to the investor only when the bond matures.

•It may be sensible to invest in inflation-indexed bonds in a tax-deferred retirement account.

•Inflation-protected bonds make the most sense in periods of high inflation.