TIPS Versus I Bonds
From: www.morningstar.com
I Bonds boast tax advantages, but purchase limits reduce appeal.
When investors think about adding explicit inflation protection to their portfolios, Treasury Inflation-Protected Securities, or TIPS, are usually top of mind, as it’s easy to obtain exposure to these securities by scooping up a mutual fund or exchange-traded fund. But investors looking to add explicit inflation protection have another option: I Bonds, which have recently made headlines thanks to their lush real yields.
What Are I Bonds?
I Bonds are Treasury bonds that pay a fixed rate of interest as well as another layer of interest that varies with the current inflation rate, as measured by the Consumer Price Index. The inflation adjustment is made twice a year. I Bonds issued May 1, 2022, through Oct. 31, 2022, yield 9.62%, composed of a fixed rate of zero and an inflation adjustment of 9.62%.
I Bonds are available only to individuals—that’s why there are no I Bond funds—and they’re available with face values as low as $25 directly from the U.S. Treasury. I Bonds reach their final maturity 30 years after issuance, but investors can cash them in 12 months after purchase. If you redeem an I Bond within five years of buying it, however, you’ll forfeit three months’ worth of interest.
I Bonds don’t pay you income while you own the bond. Rather, the interest accrues and gets paid out when you sell or the bond matures.
The Pros of I Bonds
High real yields—arguably the safest inflation-adjusted yield available today—are the key attraction to I Bonds. And because I Bonds don’t make regular interest payments, holders aren’t on the hook for any taxes until they sell or the bond matures. So if you plan to buy and hold an I Bond for many years, it’s fine to do so within a taxable account—you won’t owe taxes on the accrued interest until you no longer own the bond. When you do pocket income from I Bonds after they mature or you sell, you’ll owe federal tax but not state or local. And those who use I Bond proceeds to pay for college expenses will be able to skirt federal tax, too, assuming they (and their expenses) meet certain criteria. Because I Bonds already come with an element of tax deferral, you can’t hold them inside an IRA.
The Cons of I Bonds
Purchase constraints are the major drawback. New I Bond purchases are currently restricted to just $10,000 per year per Social Security number, with an additional $5,000 in I Bonds available for purchase through tax refunds. That purchase limit is a major drawback for larger investors looking to build a meaningful bulwark against inflation.
And because I Bonds don’t make regular interest payments but instead pay you your income when you sell, they’re not a good option for those looking to fund any part of their living expenses with the current interest from the bonds. I Bonds are very safe, but they don’t offer daily liquidity as would be available through a money market fund or online savings account, for example.
What Are TIPS?
Like I Bonds, TIPS include an element of inflation protection. An important distinction, however, is that TIPS’ principal values are adjusted to incorporate the current inflation rate, whereas I Bonds receive an adjustment in their interest rates to reflect inflation. TIPS’ interest payments also vary with the CPI, but indirectly; when investors’ principal values are adjusted for inflation, their interest payments will also adjust.
Both individuals and other institutions, such as mutual funds, can buy TIPS—they’re sold in $100 increments, and are only available in electronic form. TIPS carry terms of five, 10, and 30 years. But in contrast with I Bonds, which don’t change hands in the secondary market (your only options are to wait until the bond matures or redeem it at the Treasury), you can sell a TIPS bond to another investor via a broker. You can buy TIPS directly from the government at TreasuryDirect.gov, or you can buy individual TIPS bonds via your brokerage firm. You can also buy a mutual fund or ETF dedicated to TIPS.
The Pros of TIPS
An important advantage of TIPS versus I Bonds is that individual investors face virtually no purchase constraints. (The upper limit on TIPS purchases runs into the millions.) That makes them the only reasonable option for larger investors looking to build a sizable stake in inflation-fighting investments.
Moreover, the fact that TIPS sell on the secondary market, as well as the availability of TIPS mutual funds, gives TIPS investors an element of liquidity that’s not available for I Bond investors, who need to wait at least 12 months after purchase to redeem their bonds. The fact that you can sell TIPS to other investors also allows you to capitalize on price changes in the bonds. That can be a double-edged sword, however, in that TIPS’ prices can fluctuate to the downside.
Another advantage is that TIPS bonds make regular, semiannual interest payments, whereas I Bond investors only receive their accrued income when they sell. That makes TIPS preferable to I Bonds for those seeking current income.
The Cons of TIPS
The tax treatment of TIPS is their major disadvantage. TIPS investors pay tax on their income payments as well as the inflation adjustment made to their principal values, making them a far better choice for tax-sheltered accounts like your IRA or 401(k) than your taxable account. Moreover, investors who invest in TIPS bonds by buying a mutual fund could lose money over their holding periods. TIPS bonds trade on the open market and can be volatile, especially over shorter time periods; a TIPS fund’s daily pricing reflects that volatility. So far in 2022, for example, TIPS funds have lost 4.5%, on average, owing to pressure from higher interest rates.
How to Decide Between I Bonds and TIPS
For many investors, the decision about whether to purchase TIPS or I Bonds isn’t either-or. It’s both. I Bonds are one of the best sources of safe, real yields available today. On the other hand, the purchase limitations on I Bonds are so restrictive that for larger investors, TIPS are the only way for larger investors to build meaningful inflation protection into their portfolios in a short period of time.
