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.

Above 5% Yield Going Away!

Since Fed started hiking short term interest rate in mid-2005, customers of some online banks and credit unions have been enjoying increasing yield in their savings and money market accounts while taking the benefit of easy access to liquid cash. Banks like EmigrantDirect, HSBCdirect were offering above 5% yield with no minimum balance requirement. In certain intervals, their rate even touched 6% APY.

Some people even made quite a good sum by borrowing money from credit cards offering 0.0% interest rates or some other minimal number and putting that in high yield CD accounts in banks like IndyMac.

But with recent rate cuts in short term interest rates, that honeymoon seems to be drawing an end. Most banks have pulled back their rate to below 5% APY. Three major players in online banking that impose no minimum balance requirement, EmigrantDirect, HSBCdirect and IngDirect are offering 4.75%, 4.5% and 4.3% respectively in their savings accounts. Some money market accounts are still offering high rate. For example, the current rate in PayPal money market is 5.2% APY. The Fed rate cut has also affected CD rates. IndyMac is currently offering 5.4% APY only on its 5-month and 6-month CDs and 5.1% APY on 1-year CD.

If the Fed cuts rate further in their next meeting on October 30th, the yield may go even lower pretty fast. If you have lot of cash lying in money maket or savings accounts, you may start shopping around and put your money in CDs of various time frames depending on your future requirement.

Inflation and IFCD

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.

6.00% APY from HSBC

The HSBC Direct Online (HSBCdirect.com) announced that it would give 6.00% APY interest to new money deposited in any old or newly opened savings account until April 30th, 2007. Currently, this is the highest rate among all savings accounts in USA and it has no minimum deposit or fee requirements. It's even better than 3-month CD rates (highest level is near 5.5% APY) and has extra advantage that you can withdraw your money anytime you want.

So if you have money that you need to invest for a short time, this is a good place to keep. Other banks like EmigrantDirect.com is offering 5.05% APY in savings accounts. Most money market funds (MMF) are offering similar yield rates.

Disclaimer: MyDollar has no connection whatsoever with the sites mentioned above. We give such information only because we think our readers may benefit from it.

Everbank's Foreign Currency CD

Foreign Currency CD? Never heard the name? The Jacksonville, Florida based Everbank introduced such a unique investment vehicle in late 2005. Certificate Deposits or CDs are usually referred to as a safe haven in the ever-changing world of investment and are quite popular with retired people who do not wish to take a chance with their hard-earned money at a late stage of their life.

All you need to do in CD investment is just putting your money in for a fixed term, earning a set rate of interest and knowing exactly how much you'll get back at the end of the term. Everbank CDs do not fall in this stereotype. These CDs could pay you back much more or much less. That's because the Everbank CDs are bets on the value of the dollar. At the time of purchase, you select an investment amount ranging from $2,500 to $20,000 and also pick the currency or a mixed bag of currencies that you want to invest in. Everbank then purchases government bonds issued by the country or countries of your choice. These bonds pay a set rate of interest, but the real return or loss comes from the exchange rate.

At the time of maturity, if the currencies you bought are comparatively stronger than the dollar, you can make much more profit than just the interest. As we may be aware, in recent months, some world currency CDs have paid hefty annual returns because of falling dollar value. On the other hand, if, during the investment period, the value of the dollar rises, you could end up with less than what your initial investment was.

We feel, if you are interested in forex or foreign investment, it's better to do that directly through foreign currency trading or by buying foreign stocks, ETFs or mutual funds. Everbank CDs sound too risky to us. It's just good to know that such a kind of investment exists. Who knows, if at a certain point in time, you are able to make a good guess of the direction of dollar value in future, you may consider having such CD in your portfolio.

FDIC-Insured

'FDIC insured' -- this is an important phrase that we must always check out before we put our cash into any bank in any form. But, as we know, its coverage is upto $100,000. For many of our senior citizens who are already retired or are approaching that soon, this is a problem, if they wish to keep most of their wealth in safe deposits rather than investing in stock market.

Nevertheless, just 60% of our $4.4 trillion in deposits are FDIC- insured today. That's down from 77% of $2.5 trillion in deposits that were insured in 1992. There are a few ways to get more than $100,000 of FDIC insurance coverage on your bank deposits, despite the agency's insurance limits:

(i) Visit http://www.fdic.gov/ or call 1-877-275-3342 to find out how you might obtain more FDIC-coverage by splitting your money into different ownership categories including single accounts, joint accounts, self-directed retirement accounts and revocable trust accounts.

(ii) Visit http://www.cdars.com/. CDARS stands for Central Deposit Account Registry Service, a CD placement service owned by Promontory Interfinancial Network LLC, Arlington, Va. One can get coverage upto $20 million through this program. Through this service, you select a participating bank which arranges to split your deposits among member institutions. You get the rate paid by the bank at which you open the account. Bridge payments are made between that bank and the other participating banks to compensate for any interest-rate discrepancies.

(iii) Some companies -- including The Calvert Group and Merrill Lynch -- automatically provide extra FDIC insurance through specific accounts. The Calvert Group may split-up bank money-market deposit account funds among four participating banks through its"Insured Market Plus" account. This means as much as $400,000 of FDIC insurance per person. Merrill Lynch's "Insured Savings" Account is available through certain types of accounts. Twenty-five banks currently participate in this program.

Everbank's Gold CD

Everbank is an internet bank based in Jacksonville, Florida. Since October the bank is offering another innovative way of investing in gold prices. For a minimum investment of $1,500, Everbank is offering a 5-year certificate of deposit with the yield pegged to gold prices. This offers Gold's upside potential as well as its value as a hedge against inflation and other uncertainties. This financial product is a variant of "principal protected" CDs that are linked to the performance of stock indices such as the Standard and Poor's 500.

The CD's effective yield is equal to the percentage difference between the price of gold at the time of purchase and the average value over the time period that the CD is held. Because the average is used, the yield can potentially increase if the price of gold fluctuates rather than rises steadily. If gold prices reverse course, Everbank limits investors' risk by returning their initial investment if they hold the CD to term. The yield hits zero in that case and investors will have to forfeit a guaranteed 5.25% annual return that they could have earned on a safer traditional 5-year Everbank CD. That's the risk-part of this non-traditional CD investment.

On the other hand this is another investment vehicle for an individual to participate in gold without having to pay storage fees for the commodity, or pay a commission.