IFCD: To Prepare for Inflation

Whenever the economy decides to come back, it would bring with it another malice: inflation! (Don't you see a glimpse of that in the recent hike in oil price?). Remember that even the stimulus money has its origin in debt ... and someone needs to pay that back some day.

Inflation is defined as a sustained rise in the general level of prices of consumer goods and services and is measured by the non-seasonally adjusted Consumer Price Index (CPI) for All Urban Consumers. The CPI is a good measure of inflation as experienced by consumers in their day to day living expenses and is often referred to as the cost-of-living index. For getting additional information about the Consumer Price Index, visit the website of U.S. Department of Labor .

In an inflationary environment, today’s dollar may be worth only a fraction of a dollar next year. Inflation poses a problem for all investors, including holders of fixed-income investments, because the effects of inflation can erode the real value and purchasing power of coupon payments received in the future. To illustrate, it takes about $13000 in 2006 to buy what could be purchased for only $10,000 in 1996. For investors who rely on the stability and predictability of fixed-income investing, finding ways to limit or mitigate the effects of inflation are crucial. It’s clear from the example above that investors who are saving for some future expenditure, be it a major purchase or living expenses in retirement, could benefit from an investment that preserved purchasing power.

One of the newer ways to tackle inflation is inflation-linked CDs, or IFCDs. They've been around for about two years and enjoyed tremendous popularity. IFCDs have a floating rate coupon that changes monthly based on the government's inflation measuring stick, the Consumer Price Index, as compared to the same period a year ago.

For example, there is a two-year inflation-linked CD issued by LaSalle Bank and LaSalle Bank Midwest. The base coupon is 1.85% plus the year-over-year inflation rate. That brings the coupon to 6%, because the year-over-year Consumer Price Index rate is 4.15%. The year-over-year CPI rate adjusts monthly so every month a new rate is determined and that's added to the base rate to get the coupon. A five-year coupon with a base rate of 2% is also available with a combined rate of 6.15%.

IFCDs are FDIC-insured and can be purchased through brokers and financial advisers. One reason for the IFCD's popularity is that consumers like the inflation link being tied to the monthly coupon payment, versus the government's Treasury Inflation-Protected Securities, or TIPS, which adds the inflation premium to the principal, something the consumer doesn't receive until maturity.