Despite the I Bond’s appeal, investors shouldn’t ignore the sizable yield advantage for TIPS.
By David Enna, Tipswatch.com
We’ve just gotten through a year of “I Bond mania,” which has brought a lot of welcome attention to a little-known, rarely discussed, but very safe and sensible investment. Now I have a news alert: I Bonds are no longer the star of the inflation-protected universe. That role has shifted to Treasury Inflation-Protected Securities, with real yields now hitting decade-plus highs.
I like both investments, and I will continue to buy both. But because of this year’s surge in real yields, TIPS have become much more desirable. Combine that with a sense of urgency, because there is no way to know how long this advantage will last. Here are the numbers from Friday’s market close:
- I Bond: Current fixed rate of 0.4%, which equates to a real yield (above inflation) of 0.40%.
- 5-year TIPS: Current real yield of 1.71%, a yield advantage of 131 basis points over the I Bond.
- 10-year TIPS: Current real yield of 1.57%, a 117-basis-point advantage.
- 30-year TIPS: Current real yield of 1.63%, a 123-basis-point advantage.
Here is a chart showing how the advantage has shifted strongly to TIPS in the last half year:
Does this mean you should be rushing to sell your I Bonds to buy TIPS? Absolutely not. I Bonds have a key advantage over TIPS as a short-term investment, because their current interest rate is backwards-looking, based on past six-month inflation. The I Bond’s current inflation-adjusted variable rate is 6.48% annualized, for six months. That is too attractive to ditch.
For more on that, read this analysis: Short-term I Bond investors: Be patient with your exit strategy.
But as an investment you plan to buy and hold for 5 or more years, TIPS have a huge yield advantage over I Bonds. That shouldn’t be ignored. It is “normal” (historically, I mean) for the fixed rate of the I Bond to lag below the TIPS real yield. That’s okay, because I Bonds have a lot of other desirable features.
Advantages of I Bonds vs. TIPS
- Both I Bonds and TIPS 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 for I Bonds or inflation accruals for TIPS.
- I Bonds are a simple investment to buy and track, much simpler than a TIPS with a constantly changing market value and inflation accruals that update daily.
- I Bonds accurately track U.S. inflation but can never go down a cent in value if we hit a period of deflation. This isn’t true for TIPS, which lose some principal value after every month of deflation.
- I Bonds earn tax-deferred interest, while TIPS in a taxable account get hit by current taxes on both the coupon rate and the inflation adjustments in any year, even though the inflation accruals aren’t paid out until the TIPS matures or is sold.
- I Bonds can be used tax-free to pay for educational expenses, under some circumstances.
- I Bonds don’t trade on any secondary market and their value is never at risk if interest rates rise.
- 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.
Disadvantages of I Bonds vs. TIPS
- As I noted above, I Bonds currently have a real yield well below the real yield of TIPS of all maturities.
- I Bonds can’t be purchased in a tax-deferred account. This can make raising money for an I Bond purchase difficult, especially for retired people with no regular income. TIPS can be purchased in a tax-deferred brokerage account, so raising the money can be done without tax consequences.
- I Bonds can’t be sold for a year, and there is a 3-month interest penalty for redemptions before 5 years. TIPS can be sold in the secondary market at any time, possibly at a loss or possibly at a gain.
- In times of very low inflation, your 6-month annualized return for I Bonds can drop to a very low level, even 0.0%. But I Bonds in this case may outperform TIPS, which would lose principal value in that scenario.
- Keep in mind, however, that even during times of deflation, a TIPS will continue to pay out its coupon rate. So a TIPS with a higher coupon rate has some added deflation protection. For example, the new TIPS issued in October has a coupon rate of 1.625%, so that is a buffer against annual deflation of at least 1.625%.
- I Bond purchases are capped at $10,000 per person per year. TIPS purchases are essentially unlimited. It takes a lot of years of investing to build a sizable allocation in I Bonds. With TIPS, you can do that in a day.
- I Bonds can only be purchased in electronic form at TreasuryDirect, a government site that has many critics. TIPS can be purchased at any major brokerage, often with zero commission and fees.
- I Bonds can’t be sold on the secondary market, meaning there is no way to capture a capital gain if interest rates fall substantially. TIPS can be traded for gain or loss.
- You cannot create a joint account at TreasuryDirect, so a couple would need to set up two accounts, one with I Bonds registered as Spouse 1 with Spouse 2, and the other, Spouse 2 with Spouse 1.
Why advantage TIPS?
We’ve gone through a decade-plus of extremely low interest rates, thanks to Federal Reserve interventions in the Treasury market. Real yields — meaning yields above inflation — were negative for much of this time. We have finally come out of this misery with a bang: Real yields for TIPS are now reaching levels we haven’t seen since 2008, in the case of the 5-year TIPS, and 2010 for the 10-year TIPS. At the same time, the market continues to price in fairly low future inflation, just 2.29% over the next 10 years, based on the last 10-year TIPS auction. That makes TIPS appealing versus nominal Treasurys.
I Bonds remain a great investment, in my opinion, and I will definitely be buying them up to the purchase limit in 2023. I Bonds are superior as a short-term investment of 1 to 2 years because of their backward-based interest rate and predictable return.
But TIPS right now are a superior longer-term investment, based solely on these historically attractive real yields. As I noted in a recent article, I was able to nab a 20-year TIPS with a real yield of 2.02% on the secondary market, and also filled 2030 and 2031 slots in my TIPS ladder with real yields just a bit over 1.5%. You can’t do this kind of investing with I Bonds, because of the $10,000 per person per year limit on purchases.
I imagine that a lot of I Bond faithful will disagree with my opinion, and I do understand that I Bonds are very attractive because of their simplicity, safety and rock-solid deflation protection. But TIPS are just a better investment in November 2022. Real yields of 1.5% are now available across the TIPS yield spectrum. Is that attractive? Just take a look at where we were a few months ago:
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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 be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.