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.
- 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.