TIPS

Low yields from both stocks and bonds have led some income-seeking investors in search of cash-flow-friendly alternatives. TIPS (or Treasury Inflation Protected Securities), which are issued by the federal government, have been popular with income investors since their introduction in 1997 for this very reason. Plus, they offer a safe buffer from the threat of rising prices.

Additionally, some big name corporations are tapping the demand for inflation-protected securities by issuing bonds that are pegged to the consumer price index. These corporate inflation-indexed notes are also proving to be popular with investors. Plus they offer monthly payments that are adjusted immediately to reflect changing prices.
Corporate inflation-indexed notes are suitable for investors looking for immediate cash flow, whereas TIPS are generally suited for people seeking protection from rising prices down the road. That’s because TIPS primarily adjust for inflation by increasing the principal value of the bond. For corporate inflation-indexed notes, however, changes in inflation are applied to the bond’s monthly coupon rate. Therefore, corporate inflation-indexed notes often adjust more quickly to changes in interest rates, which can possibly provide more income over time.
Taxes can be a tricky issue with corporate inflation-indexed notes. Income from these corporate-issued bonds is subject to Federal, state, and local taxes, while income from TIPS are exempt from state and local taxation. Because of this difference, effective after-tax yields for corporate inflation-indexed notes could be lower than those for TIPS (depending upon the investor’s income tax bracket).

On the other hand, corporate inflation-indexed notes avoid a tax trap that often catches TIPS investors. When the TIPS’ principal value is adjusted for inflation, the IRS considers this taxable income. The TIPS holder must pay income taxes on this income when it is realized – in the year that the bond’s value is increased – even though the investor does not actually receive the income until the bond is sold or matures. Because the inflation adjustment for the corporate notes is made on the bond’s coupon rate and the bondholder immediately receives all income that is realized, the “phantom tax” that affects TIPS does not have an impact on holders of the corporate inflation-index notes.

It is important to keep in mind that consumer prices do not always rise but can decrease, as was the case in the United States during the 1930’s and Japan during the 1990’s. Falling prices or “deflation” over a prolonged period would decrease the interest payments received by TIP owners; additionally a TIP investor could experience a loss of principal if the TIP is sold prior to maturity.

Aside from the tax-consequences, keep in mind that corporate notes are subject to higher credit risk than TIPS since they are based on the credit-worthiness of the company issuing the bonds. In contrast, TIPS are backed by the full, faith, and credit of the federal government.