TIPS and CIPS: inflation-protected securities can help manage risk in your clients' portfolios.EXECUTIVE SUMMARY * TIPS are a relatively new form of bond from the federal government that offer protection against the risk of inflation. They combine a high degree of safety of the principal with a hedge against inflation, * Potential investors in TIPS may bid for them at auction in either a competitive or noncompetitive process: Competitive bidders submit an offer for a specified number of shares and a desired yield. The Treasury determines which bids are accepted based on the amount of securities requested and their desired yields: Noncompetitive bidders, on the other hand, are guaranteed to receive at least some securities, because they agree to accept a predetermined pre·de·ter·mine v. pre·de·ter·mined, pre·de·ter·min·ing, pre·de·ter·mines v.tr. 1. To determine, decide, or establish in advance: yield. * TIPS may be held until maturity or sold at any time in the secondary market. * TIPS generate taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. to their holders through semiannual Semiannual An event that occurs twice in a calendar year. Notes: A bond with semiannual coupons would issue payment once every six months. See also: Annual, Bond, Coupon Bond cash interest payments that are taxed as interest income and inflation adjustments to the bond principal amount. * Corporations have issued similar corporate inflation-protected securities (CIPS CIPS Canadian Information Processing Society CIPS Certified International Property Specialist (National Association of Realtors) CIPS Chartered Institute of Purchasing and Supply CIPS Central Illinois Public Service ). These are issued with a specified rate of interest that is periodically adjusted for inflation. Unlike TIPS, CIPS appreciation is paid out monthly; therefore, CIPS react more quickly to changes in interest rates and provide more income over their term. ********** When we invest in debt securities, we accept different types of risk: credit risk (the risk of default by the issuer of the debt), inflation risk (loss of purchasing power Purchasing Power 1. The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you'd be able to purchase. 2. ), liquidity risk and real or "true" interest rate risk (the risk that future interest rates will rise or fall over the life of the debt being held). Federal government debt securities always have offered a level of protection against some of these risks, as government debt carries extremely low credit risk (because of the government's ability to raise revenue through taxation) and these securities are highly liquid, as there is a ready market for disposing of them before maturity. Since the late 1990s, the federal government has been introducing new forms of debt in an attempt to also protect consumers against inflation risk. The U.S. Treasury U.S. Treasury Created in 1798, the United States Department of the Treasury is the government (Cabinet) department responsible for issuing all Treasury bonds, notes and bills. Some of the government branches operating under the U.S. Treasury umbrella include the IRS, U.S. has made available two types of bonds: I bonds and Treasury inflation-protected securities Treasury Inflation-Protected Security (TIPS) First issued by the U.S. Treasury in 1997, these Treasury bonds attempt to protect investors against fluctuations in inflation by linking the principal amount to the consumer price index. (TIPS). Because they combine the highest degree of safety of principal with a hedge against inflation, TIPS may be very attractive to clients of CPAs. We will provide an overview of TIPS, examine their tax implications, and compare and contrast them with corporate inflation-protected securities (CIPS). (For more on I bonds, see "EE vs. I Bonds: Which Are Better?" J of A, Sep.04, page 31.) How TIPS WORK TIPS are bonds that mature over 5, l0 or 20 years. They provide the holder with a fixed rate of interest applied to an adjusted principal balance. The fixed rate of interest is determined as of the date the securities are auctioned; the principal amount is adjusted for inflation semiannually sem·i·an·nu·al adj. Occurring or issued twice a year. sem  i·an This adjusted principal amount is used to calculate the
interest that will be paid to TIPS holders. As with I bonds, inflation
for TIPS currently is measured using the Consumer Price Index for All
Urban Consumers (CPIU), which is issued monthly by the Bureau of Labor
Statistics Bureau of Labor Statistics (BLS)A research agency of the U.S. Department of Labor; it compiles statistics on hours of work, average hourly earnings, employment and unemployment, consumer prices and many other variables. . This index may either increase or decrease the bond principal amount. The investor is paid neither the principal amount nor the total interest earned until the bond's maturity date. Example 1. James Bond purchased a 10-year TIPS bond with a face amount of $1,000 on the issue date of July 15, 2006, with no accrued interest Accrued Interest The interest that has accumulated on a bond since the last interest payment up to but not including the settlement date. There are two methods for calculating accrued interest: 1) 360-day year method, used for corporate and municipal bonds. . The TIPS were issued with an annual interest rate of 4%; for the first interest payment period, the CPI-U CPI-U Consumer Price Index for All Urban Consumer measured inflation at 1%. The principal value of the TIPS first would be adjusted to $1,010 (1,000 x 1.01). This adjustment would result in a semiannual interest payment of $20.20 [(4% / 2) x $1,010)]. Thus, Bond's income would be the $20.20 interest payment and the $10 increase in the principal amount. These adjustments fully protect the investor against inflation on a pretax pre·tax adj. Existing before tax deductions: pretax income. pretax adj [profit] → vor (Abzug der) Steuern basis. Not considering taxes, the yield determined on the auction date becomes the real yield for the investor; both the semiannual interest payments and the principal balance that will be paid when the note/bond matures are adjusted for the most recent period of inflation. How TO OBTAIN TIPS Investors can purchase TIPS through the Treasury Direct Program, which is available at regular intervals during the year. Currently, the Treasury auctions new 5-year TIPS in April and October, 10-year TIPS in January, April, July and October, and 20-year TIPS in January and July. The auction date establishes the sales price of the securities and the stated interest rate that will apply to the principal balance over the life of the TIPS. Potential investors in TIPS have two ways to bid for new securities: competitive bidding Competitive bidding A securities offering process in which securities firms submit competing bids to the issuer for the securities the issuer wishes to sell. competitive bidding 1. or noncompetitive bidding. In competitive bidding the potential investor submits a tender form indicating the par amount of securities desired (in multiples of $1,000) and the desired yield percent, stated to three decimal places decimal place n. The position of a digit to the right of a decimal point, usually identified by successive ascending ordinal numbers with the digit immediately to the right of the decimal point being first: (for example, 4.123%). The maximum competitive bid allowed is 35% of the par value of the securities being offered. Once the bidding process is closed, the interest rate yield for all successful bidders is determined based upon the competitive bids received. The Treasury starts with the lowest yield that was bid and the amount of principal bid at that yield. It then works its way up the yields that were bid until it reaches the total competitive amount available for sale. Noncompetitive bidding assures that bidders receive at least some securities, because the bidder agrees to accept a yield determined at the time of the auction. A noncompetitive bidder indicates the face value amount of securities that he or she wishes to purchase on a tender form, in $1,000 increments. The minimum bid is $1,000 and the maximum is $5 million. A noncompetitive bidder cannot also be a competitive bidder in the same TIPS auction. Example 2. There are $11 billion par-value 10-year TIPS being offered for sale: Total amount of securities $11 billion available to all bidders Less: Amount allocated to 1 billion noncompetitive bidders (par value of their bids) Amount available to $10 billion competitive bidders Four competitive bids are received: Bidder Face amount Yield number desired bid 1 $3 billion 3.500% 2 $4 billion 3.200% 3 $4 billion 3.200% 4 $5 billion 3.000% Total $16 billion competitive bids Starting with bidder 4 at the lowest yield (3.000%), the $5 billion face amount would be accepted. To reach the $10 billion total available to competitive bidders, another $5 billion must be accepted. This level will be reached with bidders 2 and 3, each of whom bid 3.200%. Each bidder will receive $2.5 million of bonds (a proportionate pro·por·tion·ate adj. Being in due proportion; proportional. tr.v. pro·por·tion·at·ed, pro·por·tion·at·ing, pro·por·tion·ates To make proportionate. share of the amounts for which they bid) but bidder 1 will not receive any of the bonds. Since the $10 billion available to competitive bidders was reached with bidders 2 and 3, the yield for all bidders will be set at what they bid--3.200%. The determined yield then will be used to set the initial stated rate of interest and the initial price for the TIPS. SELLING TIPS TIPS may be held until maturity or sold at any time through a securities broker or the U.S. Treasury's Sell Direct program. When selling through the Sell Direct program, the seller completes a "Request for Sale" form and sends it to the Federal Reserve Bank of Chicago The Federal Reserve Bank of Chicago is one of twelve regional Reserve Banks that, along with the Board of Governors in Washington, D.C. (FRB See Federal Reserve Board. Chicago). FRB Chicago then obtains quotes from different securities brokers and sells the security for the highest offered price. The proceeds, minus a $34 transaction fee for each security sold, are then deposited into the seller's checking or savings account Savings Account A deposit account intended for funds that are expected to stay in for the short term. A savings account offers lower returns than the market rates. Notes: . Details of each sale are documented for the seller in three ways: (1) a sales confirmation issued after each sale, (2) a statement of account issued periodically (depending on the frequency of activity) and (3) an IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. form 1099 issued at the end of the year. TIPS also qualify for the Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program, under which the principal and interest rights can be sold separately. If held to maturity, the bond will be redeemed at the adjusted principal balance. As an added safety provision, the Treasury will redeem the TIPS bond/note at face value if deflation deflation: see inflation. deflation Contraction in the volume of available money or credit that results in a general decline in prices. A less extreme condition is known as disinflation. should cause the adjusted principal balance to fall below the face value at maturity. THE TAXATION OF TIPS TIPS generate taxable income to their holders in two ways: The semiannual cash interest payments are taxed as ordinary interest income and the inflation adjustments to the bond principal are taxed as original issue discount (OID (1) (Object IDentifier) A permanent number assigned to an object for storage (persistence). It is typically a long integer, such as 128 bits, that can be computed using various methods to create a unique number. ). Holders of TIPS generally receive two form 1099s from the Treasury at the end of the year: one form 1099-INT, showing the amount of interest paid to the bondholder Bondholder A firm often has stockholders and bondholders. In a liquidation, the bondholders have first priority. bondholder An individual or institution that owns bonds in a corporation or other organization. , and one form 1099-OID, showing the amount by which the principal balance of the TIPS increased or decreased during the year because of inflation or deflation. An inflation adjustment is reported as income and increases the taxpayer's basis in the bond; a deflation adjustment generally is reported as an offset to the TIPS interest income on schedule B of form 1040. A deflation adjustment decreases the taxpayer's basis in the TIPS. Any interest income from TIPS is income tax-exempt on the state and local levels. Taxpayers may request that the Treasury Department withhold with·hold v. with·held , with·hold·ing, with·holds v.tr. 1. To keep in check; restrain. 2. To refrain from giving, granting, or permitting. See Synonyms at keep. 3. up to 50% of the interest income to help meet their tax obligations at the end of the year. Example 3. Jane Smith bought TIPS at a par value of $1,000 with a 3% yield. The inflation rate as measured by the CPI-U was 2% during the first six-month holding period. Under these circumstances the interest income for this period is $35.30: Inflation adjustment: $1,000 x 2% $20.00 Interest payment: [(1,000 + 20) x 3%] x 1/2 year 15.30 Total interest for period: $20.00 + $15.30 $35.30 Because federal tax law does not distinguish between real income and nominal income Nominal income Income that has not been adjusted for inflation and decreasing purchasing power. , TIPS are subject to some inflation risk. In example 3, the $20 inflation adjustment is made to keep Ms. Smith's purchasing power intact; however, this $20 will be subject to tax. Therefore, the amount of purchasing power lost (the inflation risk) will be the inflation adjustment multiplied by her marginal tax rate Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. . To further complicate com·pli·cate tr. & intr.v. com·pli·cat·ed, com·pli·cat·ing, com·pli·cates 1. To make or become complex or perplexing. 2. To twist or become twisted together. adj. 1. the matter, it is possible for the taxes owed on TIPS to be greater than the cash interest received. This could be a problem if the taxpayer lacks funds to pay the tax and therefore is forced to sell a portion of the securities to cover the shortfall. This may occur when inflation rates are unusually high. The inflation rate risk and potential lack of funds are illustrated in table 1, page 48. The table assumes that investors expect a 1% inflation rate and are demanding a real rate of return of 3% before tax. Therefore, the nominal rate of interest would be set in the market place at 4%--1% to cover the expected inflation and 3% to cover the true yield. The table assumes a marginal tax rate of 30%. With a non-indexed bond (for instance, one not adjusted for inflation), the unexpected inflation rate reduces both the pretax and post-tax real yields by the same amounts. For example, if the actual rate of inflation turned out to be 5% (rather than the expected 1%), the investor's expected true rate of return before tax would fall from $30 to a negative $10 [(the $40 paid less the inflation component of $50 (5% x 1,000))], a decrease of $40. The aftertax true yield would fall from the expected $18 to a negative $22 (the negative $10 pretax real interest less the $12 tax due). The decrease after taxes is again $40. Table 1 also shows the results for actual inflation rates of 10% and 25%. This illustration further demonstrates that the tax burden does not vary with the inflation rate, because it is based on a percentage of the fixed nominal yield Nominal Yield The interest rate stated on the face of a bond, it represents the percentage of interest to be paid by the issuer on the face value of the bond. Notes: This is sometimes referred to as the coupon rate. . In the case of TIPS, if the inflation rate turned out to be 5% (rather than the expected 1%), the bondholder would be paid more than the nominally expected $40 (to insure a true yield of 3%). The $1,000 par value first would be boosted to $1,050, with a resulting cash payment of $31.50 (1,050 x 3% true yield). The total interest may be viewed in a slightly different way: True interest, if there were no inflation (1,000 x 3%) $30.00 Inflation adjustment (30.00 x 5%) 1.50 Actual cash payment $31.50 Inflation adjustment to original principal (OID) 50.00 Taxable interest $81.50 The real pretax yield pretax yield The rate of return on an investment before taxes have been considered. As with other measures of yield, pretax yield is usually stated on an annual basis. is $30 regardless of the inflation rate, since the bond is adjusted for inflation. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke" put differently , the inflation rate does not affect the pretax yield. However, because the inflation adjustments are subject to tax even though they are not "true" interest, the aftertax true yield is affected by the tax rates. At the 5% level of inflation, the $81.50 of taxable income would result in a tax liability of $24.45, thus giving an aftertax true yield of $5.55 ($30.00--$24.45). If the inflation rate was the expected 1%, the aftertax true yield would be $17.91 ($30.00--the $12.09 tax due on the $40.30 of taxable income). Thus, the unexpected inflation causes a decrease of $12.36 on the effective return. However, this $12.36 decrease is better than the $40 decrease that occurred on the nonindexed bond. Note that for 10% and 25% inflation rates, the taxpayer may experience the "lack of funds" problem, since the cash paid to the bondholder is less than the taxes due. Table 1, below, further highlights the fact that, when taxes are involved, the bondholder cannot completely eliminate the risk of inflation. (For more on the effects inflation may have on an investor's choice of investments, see "Worries About Inflation," page 49.) There is one other cost when TIPS are involved. The Treasury imposes an annual maintenance fee of $25 on accounts of more than $100,000. This fee may be deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). , subject to the investor's limit on miscellaneous itemized deductions Itemized Deduction A deduction from a taxpayer's taxable adjusted gross income that is made up of deductions for money spent on certain goods and services throughout the year. . CORPORATE INFLATION PROTECTED SECURITIES (CIPS) In response to the success of TIPS, a number of companies have begun to offer corporate inflation-protected securities (CIPS) to help investors protect their money against inflation risk. CIPS are new bonds initially offered at par, usually in $1,000 increments. Somewhat like I bonds, the securities are issued with a specified, fixed rate of interest that is periodically adjusted for inflation (or deflation). Like TIPS, the interest payment is adjusted for changes in the CPI-U, thus providing a real rate of return above the inflation rate. Companies have issued both inflation-linked corporate notes and corporate inflation-protected bonds. The bonds normally are issued in 5-, 7- and 10-year maturities and provide for monthly payments that immediately reflect an increase in inflation. Unlike TIPS, though, CIPS pay out appreciation monthly and include it in the inflation-adjusted payment over their 5-, 7-or 10-year lives. At maturity, the CIPS principal payment is at par ($1,000). TIPS payments are made on a semiannual basis and do not pay out the inflation-adjusted principal increase. CIPS, on the other hand, react more quickly to changes in interest rates and provide more income over their terms. Since interest is paid monthly, investors can reinvest re·in·vest tr.v. re·in·vest·ed, re·in·vest·ing, re·in·vests To invest (capital or earnings) again, especially to invest (income from securities or funds) in additional shares. their interest payments more frequently, and therefore interest compounds at a faster rate. And because CIPS holders do not pay a phantom tax on noncash principal adjustments, a greater portion of their monthly interest payments is available for reinvestment Reinvestment Using dividends, interest and capital gains earned in an investment or mutual fund to purchase additional shares or units, rather than receiving the distributions in cash. 1. In terms of stocks, it is the reinvestment of dividends to purchase additional shares. . TIPS OR CIPS TIPS and CIPS offer valuable new investment options that are especially suitable for investors concerned about inflation risk. While similar, each investment alternative offers it own set of advantages. TIPS pose virtually no credit risk because they are issued by the federal government and their inflation rate is minimal. In fact, the inflation rate risk can be eliminated by placing the TIPS in a Roth IRA Roth IRA An individual retirement plan that bears many similarities to the Traditional IRA. Contributions are never deductible, and qualified distributions are tax-free. A qualified distribution is one that is taken at least five years after the taxpayer established his/her first , and thus completely eliminating federal taxes on the earnings TIPS already are income tax-exempt on the state and local levels. They also may be viewed as being back-loaded, since investors receive most of the inflation adjustment at maturity, and so may be better suited to investors who do not need current income (another good reason for placing them in a Roth IRA). Because of their safety, TIPS can be a desirable investment for conservative, risk-averse investors. CIPS expose investors to the issuer's general credit risk and are subject to state and local income taxation. They may be viewed as being front-loaded, as investors receive the inflation adjustments throughout the term of the investment, and more desirable than TIPS, because of the monthly payments and faster adjustment to inflation. The yields also tend be higher than that of TIPS, because of the credit risks involved. CIPS also can be placed into retirement accounts to delay or prevent federal taxation; they are, however, subject to state income taxation. Table 2, below, summarizes the similarities and differences of TIPS and CIPS. Inflation-protected securities (IPS (1) (Inches Per Second) The measurement of the speed of tape passing by a read/write head or paper passing through a pen plotter. (2) (IPS) (Intrusion Prevention S ) are among the safest and easiest investments for CPAs and their clients. They are not correlated cor·re·late v. cor·re·lat·ed, cor·re·lat·ing, cor·re·lates v.tr. 1. To put or bring into causal, complementary, parallel, or reciprocal relation. 2. to stocks or bonds, making them a good vehicle to diversify diversify To acquire a variety of assets that do not tend to change in value at the same time. To diversify a securities portfolio is to purchase different types of securities in different companies in unrelated industries. a client's portfolio. Investors should be aware, however, that long-term IPS issues can result in short-term volatility in their rates of return, and their complex structure may be hard to understand. In spite of these risks, CPAs should be aware of these investment alternatives and their features to help their clients balance their portfolios and meet their financial goals. Practical Tips * Because an investor receives most of the inflation adjustment at maturity, suggest TIPS to clients who do not need a current income stream. * Recommend CIPS to clients looking for Looking for In the context of general equities, this describing a buy interest in which a dealer is asked to offer stock, often involving a capital commitment. Antithesis of in touch with. more current income, because of their monthly payments and faster adjustment to inflation. * Eliminate the risk of an increase in the inflation rate by placing TIPS in a Roth IRA. AICPA AICPA See American Institute of Certified Public Accountants (AICPA). RESOURCES * AICPA Personal Financial Planning Financial planning Evaluating the investing and financing options available to a firm. Planning includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in the form of a financial plan, and then comparing future performance against Center, http://pfp.aicpa.org. * "Risk Management" by John J. Kenny Jr., CPCU CPCU Chartered Property Casualty Underwriter CPCU Cardiac Progressive Care Unit CPCU Custody Pending Completion of Use ; John E. McFadden, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , CFE CFE Conventional Forces in Europe (treaty) CFE Cash Flow to Equity (finance/accounting) CFE Comisión Federal de Electricidad (México) CFE Certified Fraud Examiner ; and Joseph A. Wolfe; e-MAP (# MAPXXJA). RELATED ARTICLE: Worries about inflation. The United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. has enjoyed a long period of relatively tame inflation and either steady or declining interest rates. This environment has lent itself well to investing in equities and predictable returns in debt securities for conservative or income-oriented investors. Recently, however, disturbing signs that more aggressive inflation may be on the way have begun to worry the markets. The predictable response of the Federal Reserve has been to tighten the money supply. The global trends that drive the re-emergence of inflation are not so much cyclical cyclical Of or relating to a variable, such as housing starts, car sales, or the price of a certain stock, that is subject to regular or irregular up-and-down movements. as they are eventdriven. This time the threat derives from the obvious insatiable demand for petroleum, along with the persistent weakness of the U.S. dollar and emerging Asian demand for goods and services In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility (unless the "good" is a "bad"). It is often used when referring to a Goods and Services Tax. . Ongoing government spending Government spending or government expenditure consists of government purchases, which can be financed by seigniorage, taxes, or government borrowing. It is considered to be one of the major components of gross domestic product. required by hurricane reconstruction projects and military spending in the Middle East also are major factors. Conventional investing wisdom dictates that high and rising inflation requires refocusing Noun 1. refocusing - focusing again focalisation, focalization, focusing - the act of bringing into focus asset classes into value-oriented investments with steady predictable returns and low volatility. The investing strategies applicable to the past decade have left many portfolios with low exposure to inflation-fighting investments; presumably pre·sum·a·ble adj. That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster. a quick review of the traditional techniques is in order. Inflation-protected securities are one available choice but there are other suitable vehicles when the goals are maintaining a positive return above the prevailing inflation rate, low volatility and a risk level approximating long-term Treasury securities. These include the following: Real Estate and REITS REITS Real Estate Investors of the Tri-States (Harrison, TN) Real estate investment trusts (REITs) let investors participate in the real estate market without owning real property outright. There are a variety of REITs that specialize spe·cial·ize v. 1. To limit one's profession to a particular specialty or subject area for study, research, or treatment. 2. To adapt to a particular function or environment. in office, apartment, retail and industrial properties. The rents and net profits they generate generally increase in an inflationary in·fla·tion·ar·y adj. Of, associated with, or tending to cause inflation: inflationary prices; inflationary policies. Adj. 1. period, so their returns keep pace with other prices. Keep in mind, though, that substantial increases in real estate prices over the past several years may make real estate investments a risky gamble at this time if the bubble bursts. Commodity Securities and Precious Metals Precious Metals Valuable metals such as gold, iridium, palladium, platinum, and silver. Notes: Investing in precious metals can be done either by purchasing the physical asset, or by purchasing futures contracts for the particular metal. A commodities index fund can provide broad and diversified diversified (di·verˑ·s exposure to the global commodities market with less risk and complexity. Look for funds that specialize in energy, agriculture and livestock, industrial metals, and mining and raw materials, such as paper and forest products. For efficient investing in gold and other precious metals, consider exchange-traded funds Exchange-traded funds (or ETFs) are Open Ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g. (ETFs). Selected Equities Financial stocks should do well, and most banks should show reasonably good earnings (provided their revenue stream has shifted to service charges and other noninterest income sources). But banks that have not done a good job of matching assets and liabilities for interest rate sensitivity will suffer. Energy stocks should continue to reap benefits from high prices. Consumer and household-oriented stocks, especially companies with a handle on costs, should prevail. Avoid companies that are significantly reliant on debt. The health care industry, a traditional performer, is in a period of volatility and should be scrutinized carefully. Ditto for pharmaceuticals, although generic drug generic drug, a drug sold or prescribed under the nonproprietary name of its active ingredients or under a generally descriptive name rather than under a brand or trade name. producers should reap the rewards of increasingly cost-conscious consumers. Growth stocks (including technology) are vulnerable because higher interest rates make their future earnings much less appealing, and because they typically depend on debt as a source of cheap financing. The monumental mon·u·men·tal adj. 1. Of, resembling, or serving as a monument. 2. Impressively large, sturdy, and enduring. 3. losses created by hurricanes Katrina and Rita remind us that domestic property-casualty stocks are another sector to avoid when low risk is the goal. Choosing a proper portfolio requires extensive consultation and discussion with clients. The question of whether the inflation monster has returned is being debated by economists on both sides of the issue. As always, diversifying a client's portfolio is key. --Raymond Cobos, CPA/PFS, is manager of practice management and Web development in the Financial Planning Specialty Area of the AICPA. Mr. Cobos' views, as expressed in this article, do not necessarily reflect the views of the Institute. Official positions are determined through certain specific committee procedures, due process and deliberation deliberation n. the act of considering, discussing, and, hopefully, reaching a conclusion, such as a jury's discussions, voting and decision-making. DELIBERATION, contracts, crimes. . Richard F. Boes, CPA, PhD, and Franklin J. Plewa, CPA, PhD, are professors of accounting, and Mark Bezik, PhD, is an associate professor of accounting, at Idaho State University Enrollment for fall semester 2006 was 12,676 students, including 8,848 undergraduates.[1] ISU enrolls a large number of older, non-traditional students who live and work off-campus. in Pocatello. Their e-mail addresses See Internet address. e-mail address - electronic mail address are boesrich@cob.isu.edu, plevvfran@cob.isu.edu and bezimark@cob.isu.edu, respectively.
Table 1
Cases assume a $1,000 bond (sold at par)
with an expected true yield of 3%
The market is expecting a 1% inflation rate
Expected true yield (that
is, post-inflation) 3.0%
Expected inflation 1.0%
Nominal rate 4.0%
Assumed tax rate 30.0%
CASE I:
Nonindexed Pretax
bond Pretax Pretax loss from
inflation nominal "true" unexpected
rate interest interest inflation
Expected 1% 40.00 30.00 0.00
If Actual is 5% 40.00 (10.00) (40.00)
If Actual is 10% 40.00 (60.00) (90.00)
If Actual is 25% 40.00 (210.00) (240.00)
Nonindexed
bond Principal Inflation- Cash Total
inflation inflation adjusted interest taxable
rate adjustment rate base paid interest
Expected 0.00 1,000.00 40.00 40.00
If Actual is 0.00 1,000.00 40.00 40.00
If Actual is 0.00 1,000.00 40.00 40.00
If Actual is 0.00 1,000.00 40.00 40.00
Nonindexed Post-tax
bond Total Post-tax loss from
inflation tax "true" unexpected
rate due interest inflation
Expected 12.00 18.00 0.00
If Actual is 12.00 (22.00) (40.00)
If Actual is 12.00 (72.00) (90.00)
If Actual is 12.00 (222.00) (240.00)
CASE II:
Nonindexed Pretax
bond Pretax Pretax loss from
inflation nominal "true" unexpected
rate Interest interest inflation
Expected 1% 40.00 30.00 0.00
If Actual is 5% 80.00 30.00 0.00
If Actual is 10% 130.00 30.00 0.00
If Actual is 25% 280.00 30.00 0.00
Nonindexed
bond Principal Inflation- Cash Total
inflation inflation adjusted interest taxable
rate adjustment rate base paid interest
Expected 10.00 1,010.00 30.30 40.30
If Actual is 50.00 1,050.00 31.50 81.50
If Actual is 100.00 1,100.00 33.00 133.00
If Actual is 250.00 1,250.00 37.50 287.50
Nonindexed Post-tax
bond Total Post-tax loss from
inflation tax "true" unexpected
rate due interest inflation
Expected 12.09 17.91 0.00
If Actual is 24.45 5.55 (12.36)
If Actual is 39.90 (9.90) (27.81)
If Actual is 86.25 (56.25) (74.16)
* $1,000 par value x inflation rate.
Table 2
TIPS CIPS
Issued by Treasury Corporations
Department
Initial price Set by auction Based on
a spread to
Treasury bills
Interest rate Fixed Variable
Principal Variable Fixed
Payment periods Semiannual Monthly
Inflation CPI-U CPI-U
measurement
Levels of Federal Federal,
taxation state and local
Phantom taxes Yes No
Maturity value Adjusted value Adjusted value
(but not (but not below Par)
below par)
Risk Virtually no Liquidity and
credit risk credit risk associated
with the issuing
company.
Secondary Yes Yes
markets
available
Demand for TIPS by Investment Sector
Competitive bids 2000-present
Dealers 57%
Pensions and insurers 1%
Investment funds 28%
Foreign and international 7%
Other 7%
Source: www.treasurydirect.gov/instit/marketables/tips/tips.htm.
Note: Table made from pie chart.
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