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Although today's economic downturn doesn't warn of immediate inflation, many economists appear to be concerned about the long-term inflationary effects of the massive government rescue package and immense liquidity currently being injected into financial markets. If inflation does eventually perk up, it could be of particular concern to fixed income investors, because rising price levels could have the potential to erode the relative value of bond investments. Put another way, higher inflation could reduce the future buying power of the interest payments made by bonds. (Remember, many bonds are obligated to pay a fixed interest rate; since the interest rate doesn't climb along with inflation, the purchasing power of this interest income may decrease.)
To account for the dampening effects of inflation, professional investors tend to consider real yields as a part of assessing income-producing investments. Real yield is an investment yield that is adjusted to account for the rate of inflation. The calculation is as follows:
real yield = (nominal yield) - (inflation rate), where:
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The
nominal yield is the stated, official interest rate offered by the particular security.
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Inflation is measured by changes in the Consumer Price Index (CPI), published monthly by the U.S. Department of Labor.
To illustrate the formula above, let's say you own a 10-year Treasury bond yielding 3.4%, while inflation is running at 2.0%. Factoring in inflation, the real yield on your bond is decreased by more than half, to 1.4%.
Inflation compromises the value of your dollars
To illustrate the dilutive power of inflation, it's helpful to look from another angle. Instead of talking about securities, let's talk about the most basic of financial instruments: a personal loan. Let's say you loan an individual $100, at 10% interest, to be repaid after one year. Assuming that inflation accelerates during the period, your $100 will have less purchasing power when it's returned to you at the end of the period. For instance, if inflation tugs along at 5% during the year, you will need $105 to buy what you could have gotten for $100 twelve months earlier. So: although the nominal interest rate owed to you was 10%, inflation shrunk your real interest rate to 5%.
Keeping pace with inflation: Inflation-protected bond funds
Investors have long looked for investments that accommodate the effects of inflation. Industry research indicates that among the options they've turned to are mutual funds similar to Delaware Inflation Protected Bond Fund, which invest in Treasury inflation-protected securities (TIPS). Originally introduced by the U.S. Treasury in 1997, TIPS are Treasury bonds that have their par values adjusted to reflect changes in inflation. (A bond's par value is its face value, representing the amount the bondholder will receive when the bond reaches its maturity date.) The underlying value of the principal typically grows at the same rate that prices grow (as measured by the CPI referenced above). When TIPS reach their maturity dates, they are redeemable at their inflation-adjusted values or their original par values, whichever is greater.
Unfortunately, no one can forecast inflation rates with perfect accuracy. Inflation is a product of many economic forces, the prediction of which is rife with limitations and dilemmas. One of the biggest challenges is that inflation can be evasive and difficult to detect; even when it's not snaring headlines, it may be working quietly behind the scenes.
As an investor, you won't always know when inflation will flare up, but you may want to consider including Delaware Inflation Protected Bond Fund, if suitable to your particular circumstances, to help counteract the effects of inflation. Among the Fund's features:
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Because the principal of the underlying TIPS is indexed to the CPI, it grows along with inflation. Therefore, the real purchasing power of the principal will generally keep pace with the inflation rate.
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The Fund normally pays monthly interest payments, based on the inflation-adjusted principal mentioned above. In this way, the investor is likely to achieve a real yield that stays ahead of inflation.
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TIPS are backed by the full faith and credit of the U.S. government, and are therefore generally considered to be high-quality investments.
Investing in a TIPS mutual fund is by no means a guarantee of market-beating returns; but we believe it's an easy and effective way to focus a portion of your portfolio squarely on the effects of inflation. Click here for more information about Delaware Inflation Protected Bond Fund, including its risks, charges, and expenses.
Want to know more?
Detailed information about the Consumer Price Index is posted online at the Labor Department's Web site, www.bls.gov/cpi.
Important Information
Investing involves risk, including the possible loss of principal.
Carefully consider a Fund’s investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Fund’s prospectus, which may be obtained by clicking here or calling 800 523-1918. Investors should read the prospectus carefully before investing.
Inflation-protected debt securities tend to react to changes in interest rates, that is, the expected impact of inflation on interest rates. In general, the price of an inflation-protected debt security can fall when interest rates rise, and can rise when interest rates fall. Payments on inflation-protected debt securities will vary as the principal and/or interest is adjusted for inflation. The Fund may experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability for investors.
Not FDIC Insured | No Bank Guarantee | May Lose Value
This article is for informational purposes only and is not meant to predict actual results. Information herein should not be construed as financial advice. This article is not a recommendation to buy, sell, or hold any security.
September 2009 (4777)
The Funds are distributed by Delaware Distributors, L.P., an affiliate of DMHI, and MGL.
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