I Bonds vs. TIPS: What’s the best bet for inflation protection?

In the strange world of 2021, I Bonds are the clear winner.

By David Enna, Tipswatch.com

A few years ago I met three college friends for a day of hiking in northern Illinois (yes, you can hike in northern Illinois; just check out Starved Rock State Park.) When we sat down for lunch in the park’s beautiful lodge, we got to talking about things we were doing for fun or profit.

“I’ve been writing about inflation-protected investments,” I said.

Blank stares.

“It’s something I’ve been interested in for a long time, so I began writing about it,” I said. “Trying to build up a following.”

Blank stares.

“You’ve never heard of Treasury Inflation-Protected Securities or I Bonds?”

My friends shook their heads. Then, one of them said: “Is this some sort of scam?”

My friends are college-educated and very intelligent. In that moment, I realized that most people – maybe 95% of Americans – have no idea what inflation-protected investments are or how they could fit into a portfolio.

What are inflation-protected investments?

The only two inflation-protected investments I follow or care about are both issued by the U.S. government: Treasury Inflation-Protected Securities and Series I U.S. Savings Bonds, also called I Bonds. Both can be purchased directly from TreasuryDirect.gov without fees or commissions. Both can be considered among the safest investments on Earth, fully backed by the U.S. government. So, let’s take a deeper look at these two investments.

The case for and against I Bonds

I Bonds are the simplest, no-hassle way to add inflation protection to your portfolio. The minimum purchase is $25, and the I Bond’s value will continue to climb tax deferred with inflation until maturity in 30 years – or until you sell the I Bond. There is no secondary market for I Bonds, so you simply hold them and sell them. The return you receive will closely match or exceed the Consumer Price Index.

An I Bond earns interest based on combining a fixed rate and an inflation rate.

  • The fixed rate will never change. So, if you bought an I Bond in 2014 with a fixed rate of 0.2%, it will continue to have a 0.2% fixed rate for the life of the bond. Purchases through October 31, 2021, will have a fixed rate of 0.0%. This fixed rate is the “real yield” – meaning after inflation – of an I Bond. The fixed rate will reset on November 1, and is highly likely to remain at 0.0%.
  • The inflation-adjusted rate changes each six months to reflect the running rate of inflation. That rate is currently set at 3.54% annualized. It will adjust again on November 1, 2021, for all I Bonds, no matter when they were purchased, and is likely to soar to 6.0% or higher, based on inflation from March to September 2021.

To get the I Bond’s actual rate of interest (the composite rate), the Treasury combines the fixed rate and the inflation rate. The combined rate will never be less than 0.0%, so I Bonds are protected against deflation. The current, inflation-adjusted value of an I Bond can never decrease, even in times of severe deflation.

The Treasury limits purchases of “electronic” I Bonds – purchased at TreasuryDirect – to $10,000 per person in each calendar year. You can also get up to up to $5,000 in paper I Bonds each year bought with your IRS tax refund. Although I Bonds seem mundane, a lot of very wealthy people fret over 0.1% changes in the fixed rate and scheme to get additional I Bonds through tax refunds or trust accounts. Why would they do that? Some reasons:

  • I Bonds allow an investor to push tax-deferred, inflation-protected money into the future, with zero risk. They can be used in combination with nominal Treasuries and bank CDs to preserve capital.
  • 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.)
  • Interest on I Bonds is compounded semiannually and rolls into the I Bond’s balance, so you earn interest on your interest. With a TIPS, the coupon rate is paid out as current interest and doesn’t compound.
  • I Bonds are very simple to track as an investment. I use TreasuryDirect’s Savings Bond Calculator, which can be clunky but does work. See this. This is another huge advantage over TIPS held at Treasury Direct, 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. Treasury Direct is not going to tell you, in any easy-to-find way.

So, what are the negatives for I Bonds? 1) Today’s fixed rate of 0.0% means I Bonds can only match inflation, but not exceed it (except during deflationary periods), and 2) I Bonds cannot be purchased in a tax-deferred account or a Roth IRA. So, eventually, when sold, you will owe federal income taxes on the entire gain above the original purchase. This is a negative but can be offset by timing your I Bond sales to limit taxes.

The case for and against TIPS

Treasury Inflation-Protected Securities are a more complicated investment. The Treasury auctions TIPS – either new issues or reopenings – every month of the year. Investors can participate in these auctions by placing noncompetitive bids (the minimum is $100) at TreasuryDirect, again with zero fees or commissions. TIPS are auctioned with terms of 5, 10, and 30 years.

Immediately after the originating auction, the Treasury sets the coupon rate, which determines the interest paid twice yearly on the TIPS’ principal balance. But investors at the auction pay a price above or below par value, resulting in the TIPS’ real yield to maturity. The real yield is the amount the investor will earn above inflation (or sometimes below inflation) and is the most important factor in the auction. The principal balance of a TIPS rises (or falls) with monthly U.S. inflation continuously until maturity, and the resulting interest earned on the coupon rate also rises (or falls). At maturity, the investor gets back the original par value plus inflation.

For example, if a buyer was purchasing $1,000 in a 10-year TIPS auction and the real yield ended up being 1.1%, the coupon rate would be set at 1% and the buyer would get the TIPS at a discount, something like $990 for $1,000 in value. But in today’s market, real yields are deeply negative, so the real yield would be more like -1.0% and the coupon rate would be set at 0.125%, the lowest the Treasury will go for a TIPS. The price would be more like $112.50 for $100 of value, a steep premium because the real yield is so far below the coupon rate.

TIPS are considered “deflation protected” because an investor can’t receive less than the original par value at maturity, even in a time of severe deflation. But deflation can erode the inflation-adjusted principal balance of a TIPS. That can’t happen with an I Bond. And if you pay a premium price to purchase a TIPS, that premium over par is not guaranteed at maturity.

TIPS get complicated because once they are auctioned, they can be traded on a secondary market. The market value of a TIPS is constantly changing, and that means the real yield is also changing for new investors.

Investors can buy TIPS on the secondary market through brokerage firms, generally incurring a commission. Many brokerage firms also allow purchases at the Treasury auctions without commissions, which allows investors to put TIPS in tax-deferred accounts.

Phantom taxes are an issue with TIPS, because both the coupon rate (paid twice a year) and inflation adjustments to principal incur federal income taxes in the current year. But the investor receives only the coupon rate in the current year. The inflation adjustment isn’t paid until the TIPS is sold or matures. This is the reason many investment advisors recommend buying TIPS in tax-deferred accounts.

You can also purchase mutual funds that invest in TIPS, such as the TIP ETF (I prefer Schwab’s SCHP) or Vanguard’s short-term TIPS fund, VTIP. These funds are ideal for tax-deferred accounts, but investors need to know that the fund’s Net Asset Value will rise and fall with the value of the underlying TIPS.

My personal investing style is to buy TIPS at auction and then hold them to maturity, building out a ladder with TIPS maturing every year for 10+ years into the future. Ideally, this would be done in a tax-deferred account, making purchases through a brokerage. When a TIPS matures, I buy another one to fill a future ladder spot. I don’t follow the daily price fluctuations of the TIPS I own, because I have no intention of selling them before maturity.

In addition, I combine TIPS and I Bonds with other very safe nominal investments, such as bank CDs. In times of very low inflation or deflation, a bank CD may outperform an I Bond or TIPS.

I Bonds vs. TIPS: It’s not a contest

Historically, TIPS pay a yield premium over I Bonds, which makes sense because I Bonds have a more flexible maturity, better deflation protection, and tax-deferred interest. But that’s not the case right now. An I Bond held for 5 years would have a real yield of 0.0%, a massive 170-basis-point advantage over a 5-year TIPS with a real yield of -1.70%.

I Bonds are clearly the better investment, over a TIPS, through every maturity level. A 30-year TIPS currently has a real yield of -0.28%. Investors interested in inflation protection should buy I Bonds first, up to the $10,000 per person per year limit. Then consider an investment in TIPS.

The fact that I Bonds can’t be purchased in a tax-deferred account makes them unappealing for many retired investors. Why? Because they’d have to raise $10,000 in cash to purchase I Bonds each year. Raising cash incurs a tax liability. However, if an investor has cash sitting around earning 0.05%, I Bonds make a lot of sense. They can be redeemed after a year with the three-month interest rate penalty.

(I Bonds purchased before Oct. 31 are likely to earn an annual rate of 5% interest, before any penalty. But because the next variable rate to be set on November 1 is likely to exceed 6%, it would be smart for investors to wait at least 15 months before redeeming.)

Here’s a strategy many investors use: Buy I Bonds every year, up to the $10,000 per year limit, even if the fixed rate is 0.0%. The idea is to build a large cache of I Bonds to push inflation-protected money into the future. With TIPS, watch the auctions and buy when the yields look favorable, but commit to building a ladder stretching out 10 or more years, with TIPS maturing each year.

Investing in TIPS is a bit of a hassle, mainly because TreasuryDirect isn’t extremely user friendly. You have to download cryptic tax forms each year and fill out a 1099-OID tax form on the inflation adjustments. Tracking the current value of your TIPS requires downloading TIPS Inflation Index Ratios to determine the current inflation-adjusted balance. Good at Excel? It helps.

When you place an order for a TIPS at auction, you won’t know exactly what real yield you will get – that’s determined by the auction, which is also where the ‘big boys’ play – foreign central banks, hedge funds and insurance companies.

If all this seems intimidating, I suggest placing a couple of small orders to learn the routine. Remember, the minimum investment is $100 – take that, big boys!

Is inflation really a long-term problem?

And here is the key question: Is it worth devoting a portion of your asset allocation to inflation protection? I argue – strongly – that it is. Inflation over the last 10 years has averaged 1.9%, but current U.S. inflation is raging at an annual rate of 5.4%, and it appears this trend will continue through 2021, and possibly well into 2022.

With yields so low on safe investments like Treasuries and bank CDs, there is very little “cost” to buying inflation protection.

I’ll close by quoting an October 2012 article by Michael Ashton, who writes about inflation and is author of the E-piphany blog and a book, ‘What’s Wrong with Money?: The Biggest Bubble of All‘. In this article, Ashton talks about how investors are being told to ‘remain calm, all is well’ And then he writes …

But I think that’s also what they told the people on board the Titanic. At some point, regardless of what the authorities are forecasting, investors need to grab for their life jackets or to head for the stairs anyway (and if I sound frustrated, it’s because we’re trying to hand people life preservers and they keep going back below decks). The worst thing that can happen if you’re wrong is that you’re feeling foolish, standing freezing on the deck of the ship and all really is well. The “Titanic Decision” matrix is below. I can tell you one thing: there is a single box there that I am pretty sure I want to avoid. What about you?

* * *

This article draws on information I first collected for a Seeking Alpha article in 2017.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.


About Tipswatch

Author of Tipswatch.com blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website.
This entry was posted in I Bond, Investing in TIPS. Bookmark the permalink.

23 Responses to I Bonds vs. TIPS: What’s the best bet for inflation protection?

  1. bernie says:

    I have just started my IBOND purchasing, for both my wife and I. And glad of that.
    But i have had 2 TIPS mutual funds, And they are both doing awful. They are both very popular mutual funds. Does anyone know why TIPS funds are doing so poorly when inflation is going up? Is it because the bond portion of the fund is going down, while the interest portion is not compensating? thanks!

    • Tipswatch says:

      TIPS mutual funds — like all bond mutual funds — are subject to interest rate risks. When real yields rise, the value of a TIPS declines. Since January 2022, the 10-year real yield has gone from -0.97% to 0.64%, an increase of 161 basis points. That’s a huge increase in real yields, and that sort of increase should equate to a drop in the net asset value of 11% or 12% in an all-TIPS mutual fund like the TIP ETF. Some of that is balanced off by inflation accruals, which get paid out as dividends. In August, for example, the value of all TIPS will increase 1.37%, based on June inflation.

      Make sure to look at total return of the TIPS funds, not net asset value. The TIP ETF has had a total return of -8.8% in 2022 so far. I’m a fan of shorter-term TIPS funds, which lessen the volatility but still get inflation accruals. VTIP has a total return of -1.81% in 2022. See this for more information: https://tipswatch.com/2022/06/26/are-tips-broken/

  2. Cole says:

    New to the site, thank you for sharing the info and insights. One way I came across in my very new research to see the value of I-Bonds over the months is this site http://eyebonds.info/ibonds/home100.html
    Very new to this, as I’m recognizing my equities are running away I’m glad I found these alternatives to other bond funds.

    • Tipswatch says:

      Hi Cole, yes, I am a fan of eyebonds.info and I have it included in my links in the right column. Excellent information. I use that site often and credit it.

  3. DENNIS says:

    How well do i-bonds actually perform if there is high inflation for years? The inflation adjustment changes every 6 months, but over time, the cumulative inflation would eat away at those gains. For instance, say you bought a $100 i-bond 5 years ago 11/2016, using the treasury calculator, that bond is now worth $111.92. The cumulative inflation over that time period is about 15.81% so to have truly protected the buyer of that bond it would have to be worth at least $115.81. The real “yield” of this bond after 5 years is about -3.3%! If inflation stays high or flat wouldn’t this only get worse over time since it doesn’t adjust for inflation from the purchase date?

    • Tipswatch says:

      Using the BLS inflation calculator, (https://www.bls.gov/data/inflation_calculator.htm) $100 in November 2016 is equal $115.16 today, not $115.92. Second, the inflation-adjusted interest rate reflects inflation for a past six-month period. The current rate of 7.12%, which just went into effect, reflects inflation for the PAST six months, but will pay out for the FUTURE six months. The I Bond’s inflation-adjusted interest rate ends up reflecting official U.S. inflation very accurately, over time.

  4. I did always love that Titanic grid. Thanks for the h/t Dave.

    • Rob says:

      Except that most of the people who grabbed life jackets froze to death anyway. Well the ship’s baker got drunk and grabbed a life jacket and survived.

  5. Cyril Hudak says:

    Keep up the great work, I really enjoy the articles and the insight. I built a 10 yr TIPS ladder starting back in 2006 in a ROTH account. As they have matured, I have been rolling them over into a Fidelity TIPS fund. As long as TIPS and I Bonds have been around, it is odd that very few people have heard of them.

  6. Big Ben says:

    Great post. I didn’t follow this though: “(I Bonds purchased before Oct. 31 are likely to earn an annual rate of 5% interest, before any penalty. But because the next variable rate to be set on November 1 is likely to exceed 6%, it would be smart for investors to wait at least 15 months before redeeming.)” Please explain further?

    • Tipswatch says:

      You have to hold an I Bond for a year (but you can cut that to about 11 months by buying late in the month). So, if you buy an I Bond before Oct. 31, you will earn the current 3.54% annualized for six months, and then the new possibly 6+% for the next six months. That works out to be at least 4.75% for 12 months. However, if you redeem after 12 months, you lose 3 months interest at that 6+% level. You probably will want to avoid that by waiting 3 more months, assuming the next inflation-adjusted rate is lower, and take the penalty on the lower interest rate.

  7. Nelson says:

    As always, I really appreciate the update on I Bonds. I purchased half in January and will be making up the remainder in October with the new rate change. Nice to know you visited the “Land of Lincoln”. Starved Rock State Park is one of my favorite spots and of course it’s free! Cheers!

    • Tipswatch says:

      And very close by is another magical place, Matthiessen State Park, with some of the most unusual cross-creek trails I’ve ever seen. Need to hit it when the water is just right, I guess. I love both parks.

  8. David Michael says:

    Thanks once again for your clear and easy explanations. I’ve had my IBonds since 2001.
    A very happy camper. Curious why Treasury started limiting them to $10,000 a person per year way back when?

    • Tipswatch says:

      Obviously, the Treasury wants to limit the appeal of I Bonds (and EE Bonds) to small-scale investors. It states the policy here: https://www.treasurydirect.gov/indiv/research/faq/annualpurchaselimitchangeqa.htm …. Before 2008, an individual could purchase $30,000 a year in each type of savings bond, but the Treasury then dropped the limit to $5,000 a year. And then in 2012, the limit was increased to $10,000.

    • Len says:

      There was an article in the Wall Street Journal back in 2000 detailing how the very wealthy were amassing I bonds by buying $30,000 in each spouse’s name, plus children’s names. Perhaps they sensed the stock market was due for a crash at 40X earnings? (Higher valuation than 1929.)

      • Tipswatch says:

        Oh, the good old days. Keep in mind that on May 1, 2000, the I Bond’s permanent fixed rate rose from 3.4% to 3.6%. And those I Bonds still have nearly 9 years to go before maturity. At the next reset, they could be earning an annual rate of nearly 10%. Those were the glory days of I Bonds.

  9. Ron says:

    Another way to track I-Bonds is to log on to one’s T.D account, where the current value of each is listed. Also, TIPS held in a brokerage account typically list the current value. Many of us don’t subscribe to the Journal.

    • Tipswatch says:

      Yes, with a few clicks you can find the current value of your electronic I bonds on TreasuryDirect, but if you have a combination of electronic and paper I Bonds, you’ll need to use the Savings Bond Calculator to get the full total. In a brokerage account, a TIPS will be listed as “market value” instead of simple accrued inflation. That’s fine, but I don’t track the market value of my TIPS.

      • Cole says:

        Not sure if you all had seen this site for tracking value of I-Bonds at this site, http://eyebonds.info/ibonds/home100.html
        I’m just getting started in I-Bonds, etc and came across your site – thanks for sharing. I had intend to hold to maturity, what do you think about EE Bonds? I see I & EE as essentially hedges, one will certainly be ‘more optimal’ than the other in 20-30 years but I can’t know that now. Curious about your thoughts

        • Tipswatch says:

          I like EE Bonds for the investor who can absolutely be sure to hold for 20 years, because the doubling factor then provides a 3.5% compounded return. That return could very well be better than the return for I Bonds over the next 20 years. But … you have to know you can hold for 20 years, then redeem.

  10. Len says:

    Current value of TIPS. To get a handle on this I simply look up the accrued value in the Wall Street Journal and multiply by the number of bonds I hold. I hold to maturity so interim valuations due to interest rate fluctuations are of little concern. Eventually the value of the bond will converge on the accrued value. (A professional would say this is a foolish way to manage a bond portfolio. One should ‘ harvest’ capital gains and losses. Too much like work.)

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