(MONEY Magazine) – Every retired investor who values his financial security must be keenly attuned to the creeping threat posed by inflation. Could that be why those new inflation-indexed 10-year Treasury notes sound so appealing? Introduced in January and specifically designed to protect investors from the ravages of rising prices, the notes' principal and interest are adjusted every six months to reflect the going inflation rate.

You're going to be surprised to hear this, but the notes are not necessarily right for you. If you need high current income, inflation-indexed notes won't provide it. Worse, under some circumstances they could leave you with an annual tax bill that exceeds the income they do pay. The notes actually make more sense for an investor still saving for retirement, especially within a tax-deferred plan such as an Individual Retirement Account. "Inflation-indexed securities allow you to diversify your portfolio and hedge against inflation over the long run," explains New York City investment strategist and money manager Peter Bernstein, who has purchased 10-year notes for his own firm's retirement plan. "But you don't want to use them for money you need in the near future."

Inflation-indexed securities are common in Australia, Canada and the United Kingdom, but the U.S. Government issued them for the first time in January. So far this year, the Treasury has sold only $15 billion worth of 10-year notes, vs. $24 billion of conventional 10-year securities. This summer the Treasury will auction off the first batch of five-year inflation-indexed notes, and 30-year bonds are coming sometime in 1998. "We view this as a long-term project," says Roger Anderson, deputy assistant secretary of the Treasury for federal finance. Anderson endorses the official view that the new securities will boost the nation's savings rate by attracting inflation-wary investors and will reduce the government's cost of borrowing by bringing additional buyers into the bond market.

Other issuers are slowly picking up on Washington's lead. Roughly 20 government agencies, municipalities and corporations (including Fannie Mae, the City of Orlando and the Tennessee Valley Authority) have issued their own inflation-indexed securities. Two mutual funds--$4 million American Century-Benham Inflation Adjusted Treasury (800-345-2021) and $50 million PIMCo Real Return Bond (800-227-7337)--have been created to invest solely in these securities; a third, offered by Dreyfus, is in registration.

Here's the way it works: Say you buy a $1,000 Treasury note with a 33/8% interest rate. If the CPI continues to rise at an annual rate of 3%, the face value of your bond would be adjusted twice a year to total $1,030 by year-end--or 3% of $1,000. You'll receive roughly $17 in interest semiannually--or 33/8% of $1,030. Let's say that next year, the CPI grows 5%. The face value of your bond rises to $1,081.50, and your interest payments at 33/8% would average $18 semiannually. Now suppose inflation fell to 1% in the year after that. Then the note's value would increase less, to $1,092, and you'd receive about $18.43 in interest every six months. In the unlikely event that prices actually dropped--what's known as deflation--the government would cut your note's value. But as long as you held the note to maturity, you would never receive less than $1,000 at that time, and the interest payout would always equal 33/8% of the face value. Like all fixed-income securities, indexed notes also fluctuate in price daily with the bond market.

All in all, not a bad deal. And with 10-year inflation-indexed Treasuries recently yielding 3.57%, vs. 6.66% for conventional 10-year notes, fixed-income analysts say you're not giving up much income for the promise that you'll be able to keep your nest egg intact over the long haul. "If you presume there's around 3% inflation in the economy right now, these securities seem as attractive as normal bonds, yet you're protected against inflation," says Dan Bernstein (no relation to Peter), director of research for Bridgewater Associates, a fixed-income money manager.

Whether the new bonds beat the old-fashioned kind depends on how steep inflation gets in the future. If the CPI's growth slows to just 2% annually, for instance, you'll be better off holding conventional Treasuries. (See the chart below.) If consumer prices rise faster than today's 3% level, the indexed notes become clear winners.

So what's the problem? Simply that if you need current income--as many retired investors do--you won't get as much as you could from conventional bonds. True, you earn interest on your inflation adjustment, but you don't get the increased principal until the note matures or you sell it. As long as inflation remains at 3%, you'll never get more than $45 in annual interest payments, when conventional Treasuries are paying in excess of $60. Then there are taxes. Like other Treasury issues, inflation-indexed notes are exempt from both state and local levies, but you must pay federal income tax each year on the interest and--get this!--on the inflation adjustment that you won't get until the bond matures. In other words, you will have to pay taxes on money you won't receive for years.

In fact, if inflation speeds up too much, your tax bill could conceivably exceed your bond's current income--not exactly an ideal situation for retired investors seeking income to meet living expenses. If the CPI exceeds 7.3% (admittedly improbable in the current economy), investors in the 31% tax bracket would be in the hole, according to Barbara J. Moore, managing director of SEI Investments. (That would include married couples with a taxable income from $99,601 to $151,750 and singles from $59,751 to $124,650.) If inflation rose to 8.45%, investors in the 28% bracket would find their income taxed away. That's why Gib Watson, national managing director for investment advisory services at KPMG Peat Marwick, recommends keeping most inflation-indexed securities in an IRA or other account whose earnings aren't taxed annually. "That's where you'll get the biggest bang for your buck," he says.

Finally, because inflation-indexed securities are relatively new, the market for them is fairly small. That means they trade less frequently than conventional securities of the same maturity and at a slightly higher spread between the price that sellers are asking and what buyers are willing to pay. Obviously, you need not worry much about finding willing buyers for your indexed Treasuries, but most bond analysts advise waiting until the market matures before you buy inflation-indexed bonds offered by municipalities, agencies or corporations.

No need to rush into buying mutual funds specializing in inflation-indexed notes either. "It's hard to justify paying a fund's expenses when there's such a limited supply of these bonds and such limited opportunities for managers to add value," says Todd Porter, a fixed-income analyst with Morningstar, the mutual fund rating service in Chicago. The tiny American Century fund, for instance, holds just two 10-year bonds, one issued by the U.S. Treasury and the other by the Tennessee Valley Authority. The fund does offer one advantage over direct ownership, however; unlike the federal government, it pays out the inflation adjustment on a monthly basis.

Even so, you have time to see how these securities work out. The U.S. Government is going to be around for a while--and so is inflation.