TIPS versus I Bonds during deflationary times

Reader maynardGkeynes (I call him MGK for short) posted an interesting question yesterday in the comment section, referring to the fact that an I Bond’s fixed interest rate can get wiped out by a negative inflation-adjusted rate:

Then in way, if I understand correctly, I-bonds are arguably worse than TIPS in deflation. Compare a $1000 TIPS with a $1000 I-Bond, both with a 2% coupon. Assume -5% deflation. The TIPS pays a (2% X $950) = $19; The I-Bond pays $0. Of course, you avoid the immediate $50 principal loss with the I-Bond, but the loss on TIPS is (hopefully) temporary, because the principal loss is recovered when inflation picks up again. However, because you never make up the lost coupon on the I-Bond, the loss is permanent. Does that make sense?

I decided to create an example to play this out, keeping things fairly simple. So we will compare a TIPS and I Bond, each with $1,100 in current principal, and each with a 1% coupon rate, and each dealing with 2% deflation the first year and 2% inflation the next year.

I have no confidence I can do this without making an error, but what the heck, here we go.

The TIPS

  • Starting principal value: $1,100.
  • Value after year 1 with 2% deflation: $1,078
  • Interest from 1% coupon: $10.78
  • After year 1, $1,078 principal, plus $10.78 interest paid out = $1,088.78
  • Principal value after year 2 with 2% inflation: $1,099.56
  • Year 2 interest from 1% coupon: $10.99
  • After year 2, $1,099.56 principal, plus $21.77 interest paid out = $1,121.33

The I Bond

  • Starting principal value: $1,100
  • Value after year 1 with 2% deflation: $1,100
  • Fixed rate is wiped out in year 1, so zero additional principal.
  • Value after year 2 with 2% inflation and 1% fixed rate: $1,133

The I Bond ends up outperforming the TIPS by 1%, and its resulting principal balance is 3% higher. That’s pretty impressive. In this example, even if the I Bond had a zero percent fixed rate, it would slightly outperform the TIPS with a resulting principal value of $1,122.

If I made any errors in these calculations, or in my logic, give me a critique and we will fix it together.

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9 Responses to TIPS versus I Bonds during deflationary times

  1. Len says:

    Looks right to me and I’ve been a long time holder of TIPS at that. You may yet create a greater appreciation for the “lowly” savings bond. Need we even bring in the absurdity of bond funds- of any category- into these discussions? Another well done I would say. Len, BSEE

  2. maynardGkeynes says:

    I’m out of my depth here for sure, but I think this is essentially a duration calculation, potentially with different outcomes under various interest rate and inflation scenarios. TIPS durations are notoriously difficult to calculate under the best of circumstances, and there have been several papers exploring the methods/problems/assumptions. One possible reason my calculation and conclusion (TIPS did better in my scenario, assuming my math was correct) differed from yours is that I assumed a higher 2% coupon, and a greater change in the inflation component of the total interest rate (-5% vs -2%). A higher coupon shortens duration makes both bonds less sensitive to interest rate changes, that we know; however, it may affect them to different degrees, given the different ways the coupons are structured. I’m just not sure how. Another tricky thing is that as rates get closer to 0% (you chose 1% vs my 2%), the duration calculation gets very weird, even for nominal bonds, and I imagine doubly so for TIPS, given the Fisher equation. As I say, I am totally out of my depth here. This might be a good one to throw to some of those very smart chaps on Bogleheads.

    • Tom says:

      I think the important point here is that the I bond starts the second year with principle at par, while the TIPS is in the hole by the deflation rate. TIPS need a larger real interest rate if it is to catch up with the I bond.

      • maynardGkeynes says:

        Like I say, I’m outta’ my depth here, but I’m not sure that relationship holds under all scenarios. When the fixed rate is very low, yes, it does, because the I bonds effectively have a continuing put at par, which is something that TIPS have only at maturity, But take the situation where the coupon rate is high (someday in the future), and then there is enough deflation to wipe out the coupon on the I-Bond, perhaps for several years. Then, after a while, there’s enough inflation to get the TIPS back to par again. The TIPS holder gets his par plus he has all the interest payments he got over the years. I believe the I-Bonds holder merely gets par — unless, unless….with I-Bonds, they reset the base CPI index every year, so that the I-Bond holder isn’t in the hole, so to speak. Maybe that’s the point I’ve missed….

  3. tipswatch says:

    I Bonds clearly benefit, versus TIPS at least, from a severe, short-term deflationary period. While the TIPS take the total severe hit to principal, I Bonds suffer no hit to principal and can take a short-term pause with zero interest. If deflation is -5% for six months, then I Bonds have a ‘real’ return of 5% during that period, since they don’t decline, but TIPS have a real return of -5% + yield to maturity (basically, the coupon rate.) I Bonds will ride out a short-term deflationary period a lot better.

  4. Dan M. says:

    Another way to think about I bonds being better than tips is to assume a zero percent fixed rate and just one commodity making up the cpi, say gasoline (gas-cpi). If the price of gasoline goes from $4.00 to $2.00 in a period after purchasing either type of bond, the tip value goes down but the I bond stays the same. but the gas-cpi is set at a new lower level. So if the price of gas goes back up to $4.00 in the next period then the I-bond value goes higher, even though the price if gas is the same price as when you originally bought the I-bond. This cycle could happen repeatedly. But the only way for a tip to increase in value from gasoline would be for it to go above $4.00 per gallon.

  5. Pingback: Deflation strikes hard in January: What does it mean for TIPS and I Bonds? | Treasury Inflation-Protected Securities

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