Inflation Protected Bonds

Inflation bonds are a unique investment tool that is offered by the federal government. One of the biggest enemies of investors is inflation. You always have to stay ahead of inflation, otherwise your money will be worth less than it was when you purchased something. This is why no one wants to just keep their money in a savings account. Some kind of return is necessary to make sure that you don't go backwards. With this in mind, the government came up with the idea to offer series savings bonds. Here are a few things about government bonds and how they can benefit you as an investor. 

How Inflation Bonds Work

Government inflation bonds have the unique ability to grow at different rates, depending on what the inflation is for a particular time period. One period, you might make one rate of return and during another period, a completely different rate. This makes them very different from the normal savings bonds that are issued by the Treasury. These bonds use the Consumer Price Index to determine exactly how much inflation has occurred over a given time period. They currently look at the index every six months, and adjust the payout rate accordingly. 

For example, if there was 4% inflation over that time period, they are going to pay you a 4% return on your bond. They give you a base percentage at the beginning, which is about 1%. Then they add the inflation percentage onto that. This allows you to stay in tune with the rate of inflation, no matter how bad it gets. The amount of return that you get does not depend on a certain company's performance or how diversified your portfolio is. It is only influenced by inflation.

Drawbacks to Consider

Even though you can hedge against inflation with your investments, this strategy is not foolproof. Sometimes, inflation is not as bad as others. Therefore, the rate of inflation might slow down quite a bit and so will your rate of return. During those periods, you could have done a lot better in a more traditional investment. Even a low-risk mutual fund would outperform an inflation bond in that instance. 

Besides the possible low rate of return, you will also be forced to deal with tax issues on the bonds. With inflation bonds, you have to pay income tax on the gains in the year in which they occur. This means that you will have to be paying taxes on money that you never actually got your hands on. The bond is still growing until you decide to cash it in. Therefore, you do not actually get any money out of it until that point. However, you do have to count the gains on your income taxes, which will add to your tax burden overall. 

How to Use

With these factors in mind, use these bonds as a small part of your portfolio. They should be combined with several other investment methods to ensure a well-diversified portfolio. Keep in mind that stocks, bonds, mutual funds and other investment tools are also available to help you balance everything out.

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