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Inflation Indexed Bonds

Perhaps the biggest downside to bonds is that they provide no protection from inflation. If you buy a long-term bond, the semiannual interest rate won't change as inflation erodes the buying power of your investment. With the introduction of Treasury Inflation-Protected Securities (TIPS), you gain the advantage of a government-issued note with inflation protection. Here's the way TIPS work: You purchase a 10-year TIPS note and receive the regular semiannual payment of interest. Your principal amount is adjusted for inflation, so the interest being paid is on the inflation-adjusted amount of the note, not the original amount.

Be Careful

TIPS are inflation adjusted, so that knife can cut both ways. It is very rare for us to have a deflationary economy in the United States, but remember that the Japanese have been in a deflationary economy since 1991. If we did have deflation, your TIPS would continue to pay the stated coupon, but there would be an adjustment made at maturity to compensate for any long-term impact from deflation.



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