Experts at odds on inflation-proof bonds

Investing

February 10, 1997|By Bill Atkinson

THE NEW strain of Treasury bond designed to protect an investor's principal from inflation sounds like a good deal, but you might want to take a closer look before rushing out to buy them, some experts warn.

The bonds, called inflation-indexed bonds, are touted by the U.S. Treasury as a way to save for retirement and college education without worrying that inflation will eat up your capital.

The Treasury Department held its first auction this month, and it sold $7 billion worth of the bonds in a snap. The notes yield 3.449 percent with a coupon of 3.375 percent.

"In my view, it's the best idea to come out of the federal government since the U.S. Treasury created its zero-coupon bond program in 1985," writes James M. Benham, vice chairman of the Kansas City-based mutual fund company, American Century Cos., in a letter to shareholders.

Benham calls the securities a "breakthrough for savers."

The 10-year bonds can be bought in denominations as low as $1,000, and the government is planning to expand the program to Savings Bonds.

By next January, Inflation-Protection Savings Bonds will be available for as little as $50.

Here's how the new Treasury bonds work:

The principal -- the money you have paid out of your pocket for the bond -- is adjusted on a regular basis for changes in inflation as measured by the Consumer Price Index. If the CPI increases by 1 percent, your principal is indexed accordingly -- and the interest paid on the larger, indexed amount.

The idea is to guarantee a rate of return above the inflation rate. When the bond matures, your principal will have the same buying power as when you first bought the bond -- unlike money in certificates of deposit and passbook accounts. And you will have pocketed the interest in the meantime.

Benham says the bonds should reduce the need for hedges against inflation, like gold or stocks in natural resources companies.

But there are drawbacks. One is that you will have to pay tax on the semiannual interest payments each year, like other Treasury securities. And the inflation adjustments to the principal will be taxable in the year that the adjustment occurs, although the increase won't actually be paid until maturity.

It's the taxes that bother Jonathan D. Pond, a financial commentator and author.

He argues that the taxes will eat up most of the profits unless inflation jumps above the 5 percent range.

Say an investor buys a $10,000 inflation-adjusted bond, and the coupon is roughly 3.5 percent and inflation is at 3.5 percent. The coupon pays the holder $350 a year, but if the investor is in the 28 percent tax bracket, he clears just $252 after forking over $98 to the federal government.

"When retirees start realizing this, they are going to say this is a high price to pay," Pond said.

"If you start seeing inflation going to 5, 8 and 10 percent, you could be a winner," he added. "The issue is, there are a lot of people who have gone to the poorhouse trying to bet on interest rates."

Richard O'Brien, head of the fixed-income department with Folger Nolan Fleming Douglas Inc., a Washington-based brokerage and investment banking firm, agrees.

"If you are betting inflation is going to be higher than 3.125 percent, this is the place to be," he said.

"My feeling is there would be other ways to realize your objective, which would result in better tax planning."

Pub Date: 2/10/97

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