Inflation Rate Stays Above CD Rates

The growing gap between CD yields and inflation, which edged past CD rates in February for the second time in a decade, is prompting investors to take steps to “inflation-proof” their portfolios.

The inflation rate climbed to 3.16 percent in April, while the highest paying five-year CD yield stood at 2.4 percent, according to the latest National Pricing Indicator from Market Rate Insights. The gap has continued to widen as the latest Consumer Price Index, a common measure of inflation, show prices, including food and energy, increased by 3.6 percent in May. At the same time, the average five-year CD yield continues to drop and reached 1.7 percent in June, according to Bankrate.com.

The trend is bad news for investors who have money locked into long-term savings products. As the cost of living increases, the purchasing power of their savings decreases. As a result, investors who hold deposit accounts yielding less than the rate of inflation are losing money even as they save it. This phenomenon is known as “inflation risk.”

“While CDs are very safe in that you won’t lose your principal, they are not with risk and today’s environment highlights that,” said Bankrate columnist Sheyna Steiner.

Several financial products attempt to counter inflation risk, yet still provide security. Treasury Inflation Protected Securities, unlike regular Treasury bonds, bills or notes, offer inflation-adjusted yields. The rate adjusts every six months according to the direction of the Consumer Price Index, and the original principal invested is returned at maturity.

Financial firms, such as Fidelity and Vanguard, offer mutual funds invested in inflation-protected securities, but unlike individually held securities, the value of the investment can go up and down, and there is no maturity date.  Income from both individually held securities and inflation-protected bond funds is subject to federal income tax. Some investors shelter these investments in tax-deferred funds such as IRAs and 401(k)s.

Series I bonds are an inflation-adjusted version of the savings bond, says Bankrate. Rates are adjusted each May 1 and November 1, and will stay at a semi-annual rate of 2.3 percent through October 2011, according to the U.S. Treasury. Interest is added to the principal, accruing monthly and compounding semiannually, so the I-bond serves as a tax-deferred investment. Penalties are due on I-bonds cashed within the first five years. Information on purchasing I bonds can be found at www.treasurydirect.gov.