Dear Dr. Don,Every month I open a two-year CD with my credit union (rated four stars on Bankrate.com) paying above-average interest rates. With this procedure, I believe I benefit from the advantages of laddering and have some protection from inflation and deflation. Am I kidding myself?-- Richard Redux
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Dear Richard,What I like about your approach is that you are not building your initial CD ladder at a single point in time. To my mind, that's a drawback with the typical approach to laddering. A laddered CD portfolio is supposed to get you past trying to time the market, but when you build the ladder at one point in time, some CDs have to mature to get a changing interest rate environment incorporated into your ladder.
That said, I don't see your two-year CD ladder offering you much protection against inflation, or deflation for that matter. In a deflationary environment, your investment horizon is too short to offer much protection. A dollar in the future will buy more than a dollar today, so I would argue that long-term, default-free government bonds would be a way to go for deflation protection.
Expected future inflation rates are baked into the yield of all fixed-income investments. When inflation expectations are low, the premium is small, but it increases as inflationary expectations heat up. Your investment horizon is so short that, at any point in time, you're only capturing the inflationary expectations of the next two years. That's good if you think inflation premiums are too low and long-term interest rates are headed higher.
As inflation heats up, so will the yields on your CD purchases, but you might want to consider an "extension ladder" versus a static two-year horizon. As the implied inflation rates head higher, you would start extending the maximum maturity from two years out to longer maturities.
Treasury inflation-protected securities, or TIPS, or Series I savings bonds guarantee an inflation-adjusted return based on changes in the Consumer Price Index. These securities also offer protection against deflation. From the TreasuryDirect Web page, TIPS In Depth: "At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation." And from the Series I Savings Bond FAQ page on the same site: "I Bonds even protect you from the effects of severe deflation -- the earnings rate can't go below zero and the redemption value of your I Bonds can't decline."
There are tax considerations when investing in TIPS that, for most investors, make them better suited for holding in a tax-advantaged retirement account. Talk to your tax professional if you plan on switching from investing in CDs to TIPS.