Investors have a need to plan for inflation since this is what erodes future spending power. TIPS and I Bonds were created to protect against inflation. They respond differently to the threat of deflation.
Usually inflation is the more pressing concern. Investors are well aware of how inflation can erode a portfolio's value. But there are times when deflation threatens. Deflation represents rising value of the currency in which you are investing. Consumers see falling prices of the goods they are purchasing. A portfolio will be able to buy more in the future as long as it is invested in investments that hold steady or grow.
Deflation would seem ideal to the consumer. It has its disadvantages though. One thing that occurs is that dropping prices hurt businesses. In turn, business have to pay less in wages which reduces a consumer's spending power. Consumers spend less because of their reduced wages. Deflation can become a continual downward spiral.
Treasury Inflation Protected Securities (TIPS) and I Bond Savings Bonds were created to provide a way to counter inflation. Their goals are to preserve your spending power. Some may argue that the Consumer Price Index they are tied too does not reflect actual inflation. Whether this is true or not, they do provide a way to offset part to all of inflation.
TIPS have two rates. One is the fixed coupon rate. The other is the inflation rate. The inflation rate adjusts your principal. This rate varies as inflation varies. The fixed coupon rate is calculated based on the adjusted principal. Your semi-annual interest payout will rise as your principal rises, even though your coupon rate remains the same. During deflation, your principal can diminish as the inflation rate drops into negative territory.
An example: you have a bond that pays a fixed 3% on a $10,000 principal. The first few years there is inflation and your bond’s principal grows to $10,600. Your interest payout increases because your principal has increased while the coupon rate remains at 3%. Then you encounter deflation. The first year the inflation rate drops down to 1%. Your principal continues to grow because the inflation rate is in positive territory. The next year the rate drops to -1%. Now your principal is adjusted downwards by 1%. Your semi-annual interest decreases because your principal is less. The coupon rate remains at 3%.
Compare this to I Bonds. I Bonds are calculated differently. I Bonds have two rates: the fixed rate and the inflation rate. Both rates are combined to get the interest rate on the I Bond.
An example: you have a fixed rate of 1% and the inflation rate is 2%. These are calculated together to give you the current rate of 3% on your bond for the next six months. (The 3% rate is a rough example as the calculation process may give you slightly more.) The interest accumulates on the I Bond since the bonds do not payout until you cash them in.
Then deflation hits. In this example, inflation drops to -1% (deflation). Now the fixed rate is cut by the deflation rate. (1% fixed – 1% deflation = zero (roughly based on calculations). Your bond is no longer earning interest. The good news is that the interest rate will never drop below zero. You may have a fixed rate of 1% and deflation is -3% but your bond will hold its accumulated value. It will not lose principal. This applies to whenever you choose to sell as long as it is past the five year hold period. Prior to the five years, you will pay a penalty to withdraw. That applies whether in an inflation or deflation cycle.
TIPS have a failsafe too. TIPS will hold the original principal value if you hold them to maturity. Sell them before maturity and you will receive market value which can cause you to lose principal. Hold them and you will get your original investment back.
TIPS and I Bonds are great investments for inflation. They can lose some value in deflation. They do offer some deflationary protections though. A fixed, standard bond may be better for deflation. Inflation is the bigger concern in most instances. It pays to know all aspects to an investment before you buy though.
Are you interested in a simple portfolio to save for retirement? Please check out my book on building a simple retirement portfolio that is available at Amazon.com:
Investing $10K in 2014 (Sandra's Investing Basics)