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Why Use I Bonds Instead of TIPS?

A reader writes in, asking:

“I don’t understand i-bonds. They supposedly protect against inflation, but isn’t that what TIPS do? What’s the point of using treasury direct’s god awful website to buy i-bonds when I can just buy a TIPS fund in my normal Vanguard account?”

It’s true that, like TIPS, I Bonds are debt instruments issued by the federal government that offer a certain after-inflation return — as opposed to most bonds (i.e., “nominal” bonds), which offer a certain before-inflation return.

But there are meaningful differences as well.

No Interest Rate Risk

TIPS work like traditional bonds in that they pay interest every 6 months and their prices fluctuate in response to changes in market interest rates (which is relevant given that, if you want to get rid of TIPS prior to maturity, you have to sell them to a willing buyer).

In contrast, I Bonds are more akin to CDs in that they don’t actually send you interest checks at any point. Instead, the value of the I Bond grows over time until it matures or you redeem it.

While all I Bonds have a 30-year maturity, you can redeem an I Bond with the Treasury at any time, as long as you have held it for at least one year. (Note: If you redeem an I Bond prior to having held it for 5 years, there is an early redemption penalty equal to the last 3 months of interest.)

In other words, even if interest rates go up dramatically, you can still cash out your I Bond without taking a big hit on the price.

Higher Yields (right now)

The yield on an I Bond is made up of two components:

  • A “fixed rate,” which is set for the life of the bond, and
  • An “inflation rate,” which changes every 6 months based on inflation over the last 6 months.

As of right now, the fixed rate on I Bonds is 0%. In other words, I Bonds purchased right now should (before taxes) precisely keep up with inflation. Normally that wouldn’t sound particularly appealing, but with the real yield on TIPS being negative on maturities almost all the way out to 20 years, a 0% inflation-adjusted yield is relatively attractive.

Tax Advantages

Like interest on other Treasury debt instruments, interest on I Bonds is exempt from state and local income taxes.

What’s different about I Bond interest is the fact that it can be tax-deferred for federal income tax purposes. That is, you have the choice of reporting the interest each year as it accrues, or reporting all of the interest earned in the year in which you redeem the bond. For some investors, this creates an opportunity for income shifting in which you purchase I Bonds while in a high tax bracket, yet pay no taxes until you redeem them once you’re retired and in a lower tax bracket.

In addition, if you meet certain requirements, the interest on I Bonds can be entirely tax-free if you use the money to pay for qualified higher education expenses.

Drawback: Limited Availability

In periods in which I Bonds have a yield equal to or greater than that of TIPS, the primary drawback of I Bonds is simply that there are some restrictions on their purchase.

First, they must be purchased directly from the Treasury — either electronically via the Treasury Direct website or by electing (on Form 8888) to have your tax refund paid to you in the form of paper I Bonds. In addition to meaning that you cannot purchase I Bonds at your favorite brokerage firm, this means you cannot buy I Bonds in an IRA.

Also, there’s an annual limit of $10,000 per Social Security number (meaning a $20,000 annual limit for married couples) for I Bonds purchased via Treasury Direct and a $5,000 annual limit for tax-refund-purchased paper I Bonds. While this limit is plenty-big for most people in the accumulation stage making purchases each year, it can be an impediment for people wanting to move a larger portion of an existing portfolio into inflation-protected assets.

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Comments

  1. garland whizzer says:

    Mike, your comments on the bond market are completely on target in my opinion. The bond market’s past performance over the last 30+ years, the greatest uninterrupted bull market in bonds in US history, will definitely not be a replay going forward. Still, bonds role in a portfolio remains unchanged, diversification of stock volatility and capital preservation. Capital appreciation in real dollars going forward seems very unlikely for a considerable period of time. Personally, I have already reduced my asset allocation to bonds and decreased the average duration anticipating these changes but I’m keeping some bonds as an anchor for stormy weather in equity markets.

    Garland Whizzer

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