There’s an auction of a new 10-year Treasury Inflation-Protected Security on Thursday, and it looks like it will generate a yield to maturity of about 0.25% (plus inflation), well below the 0.661% buyers of the last new TIPS got six months ago, in January.
I’ve already noted that this won’t be an attractive auction for CUSIP 912828WU0, and that potential buyers will have a chance to snag it in two reopening auctions later this year, in September and November, when conditions might be more attractive.
There is another alternative: Forget buying this TIPS and buy an I Bond instead, up to the limit.
The way I Bonds work. An I Bond is a security that earns interest based on combining a fixed rate and an inflation rate.
The fixed rate – now 0.10% for as long as you hold the bond, up to 30 years – will never change. So if you bought an I Bond in 2012 with a zero fixed rate, it will continue to have a zero fixed rate. Purchases through Oct. 31, 2014, will have a fixed rate of 0.10%. I Bonds I bought back in 2000 still carry a fixed rate of 3.4% and will continue to do so through 2030.
The inflation-adjusted rate changes each six months to reflect the running rate of inflation. That rate is currently set at 1.84% annualized (for a combined rate of 1.94%). The inflation adjusted rate will change again on Nov. 1, 2014, for all I Bonds, no matter when they were purchased. (However, the effective start date of the new interest rate can vary depending on the month you bought the I Bond, a Treasury oddity. Learn more on my Tracking Inflation and I Bonds page.)
Why they are a great investment.
- First, I Bonds are the most conservative and most safe of all investments. Your principal is 99.9999999% safe and it will never decline, ever. If inflation falls to below zero, the inflation-adjusted rate will fall to zero, but not below zero. This is not true of TIPS, where accrued principal declines when deflation strikes. This means I Bonds are a superior investment to TIPS in times of deflation.
- I Bonds allow you fantastic flexibility. You can redeem them after one year, costing you three months of interest. Or redeem them after five years and pay no penalty, or just hold them for 30 years and cash out.
- I Bonds protect you against unexpected inflation. If inflation in the next 30 years suddenly soars to 7%, 10%, 15%, your principal will increase by that amount because of the inflation-adjusted interest rate.
- I Bonds allow you to defer federal income taxes until you redeem them, so you pay zero in taxes until they are sold. This is a big advantage over TIPS, which carry current-year income taxes for both the coupon rate and the inflation adjustment to principal. (Both TIPS and I Bonds are free of state income taxes, an advantage over bank CDs.)
- I Bonds are very simple to track as an investment. Just download the Savings Bond Wizard, update your information, and check it a couple times a year. This is another huge advantage over TIPS held at TreasuryDirect, which is a do-it-yourself proposition, even for downloading yearly tax forms. Want to track current value of your TIPS? Open up Excel and get to work. TreasuryDirect is not going to tell you.
The big negative? You can buy only $10,000 per person per year, in a Treasury Direct account, plus an additional $5,000 a year in paper I Bonds through an income tax refund.
Because of these advantages, I Bonds ‘typically’ carried a fixed rate about 1.0% less than the yield-to-maturity of a 10-year TIPS. Today, that spread has dwindled to about 0.15%, and that is the reason that I consider an I Bond more attractive than a 10-year TIPS yielding 0.25%.
A 10-year TIPS is a locked-in investment. You can sell it on the secondary market, but you might face a loss in principal, possibly a dramatic loss. And if held in a taxable account, you will pay ‘phantom’ income taxes on the principal appreciation until maturity.
I Bonds, by contrast, can be sold after one year with a minimal penalty, or after five years with no penalty, or at any other time in future, up to 30 years. All interest is tax deferred. You decide when to cash them in, so you can spread the tax burden across many years.
Or should you wait? The I Bond fixed rate will be re-set on Nov. 1, and it is impossible to predict what the Treasury will do. The fixed rate dropped from 0.2% to 0.1% on May 1, and given current trends in interest rates, it could drop to 0.0% on November 1. But we don’t know, and won’t know.
Unless interest rates begin rising dramatically, though, I can’t see the Treasury raising the I Bond rate above 0.1%.
Les, yes, the return after taxes won’t keep up with inflation. But if inflation really rises, an I Bond holder will come a lot closer to matching inflation than a holder of a money market fund, or bank CDs, or nominal 10- or 30-year Treasurys. Anyone locking in today’s ultra-low rates will get hit hard by rising inflation. With an I Bond, at least you can sell out and reinvest if more attractive opportunities arise.
Very true, very true. But some folks enthusiasm seems rather naïve. We could wait ’til after November at least and certainly not lose much in the interim.
Yes, a sound analysis of the situation. I feel compelled to note, again, that at such a low coupon on the I bond you will probably recive a negative real return, after taxes and inflation. And it matters not whether you hold it one year or thirty. Assuming even just 1% inflation and a marginal income tax rate of 15% your wealth is decreasing. But then what are the alternatives?
Yes, great post, thank you very much. Is anyone mounting a campaign to get the annual maximum Iboond contribution limit raised? to say $25,000 or $50,000? This would help out retirees like myself very much.
Two other reasons to buy an I Bond over TIPS: 1.) you can buy “to the penny” when you purchase through Treasury Direct, i.e.$51.25, $26.20, etc. (http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm), and 2.) it’s a MUCH simpler product than a TIPS. I’ve started using I Bonds (and, to a lesser extent, EE Bonds) as part of my investment/savings efforts.
Great post. Great explanation.