TIPS Versus I-Bonds: How to Choose

Although inflation was a hot topic just a year ago, these days it barely elicits a yawn. Consumer prices actually dropped a touch in the months of May and April, stoking newfound worries that deflation could be a greater threat than inflation.

Yet retirees and preretirees who don't have pensions but do have a large share of their portfolios in fixed-rate assets ignore inflation at their peril. Although Social Security includes an annual inflation adjustment, and pensions usually do, too, payouts from fixed-income investments are just that--fixed. So when there are increasing prices on things that we all need to live--and historically consumer goods prices have increased at a rate of roughly 3% per year--the standard of living for someone on a fixed income is apt to go down.

So that's the reason behind adding inflation protection to your portfolio. I tackled how much to hold in inflation-protecting assets in a previous column, and the timing questions in this one.

Those articles focused mainly on Treasury Inflation-Protected Securities, or TIPS. But investors looking to add explicit inflation protection have another option: I-Bonds.

I-Bond Basics
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 CPI. The inflation adjustment is made twice a year, in May and November. I-Bonds issued this past May yield of 1.74%, composed of a fixed rate of 0.20% and an inflation adjustment of 1.54%.

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. 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. You can buy I-Bonds either as paper securities or electronically.

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.

Pros: 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.

Cons: Although I-Bond buyers could scoop up $30,000 in I-Bonds a few years ago, new I-Bond purchases are currently restricted to just $10,000 per year ($5,000 paper, $5,000 electronic) per Social Security number. 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.

TIPS Basics
Like I-Bonds, Treasury Inflation-Protected Securities 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 Consumer Price Index, 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, but 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 exchange-traded funds dedicated to TIPS.

Pros: 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.

For example, if inflation goes down but your TIPS bond is baking in higher inflation expectations, you can sell the bond at a higher price than you paid for it. You have no such option with your I-Bond; when you redeem, you receive your principal plus any accrued interest payments. The fact that TIPS are available in mutual fund form allows professional investors (and, in turn, individuals) to benefit by selling certain TIPS when they're dear and buying others when they're inexpensive.

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.

Cons: 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.

How to Decide
Whereas the decision about whether to invest in TIPS or I-Bonds was a more arduous one just a few years ago, these days the purchase limitations on I-Bonds are so restrictive that TIPS are the only way for larger investors to build meaningful inflation protection into their portfolios in a short period of time. TIPS are also easy to recommend over I-Bonds for those seeking current income. For example, they can be a fine choice for those taking distributions from their IRAs.

That's not to say that investors shouldn't bother with I-Bonds, however. Because of their tax advantages, they're worth considering for investors' taxable accounts and can be held in conjunction with TIPS holdings in tax-deferred accounts. Moreover, the fact that investors have to dribble their money into I-Bonds could have the salutary effect of enabling them to purchase bonds with a variety of interest rates that reflect varying expectations for inflation.  

See More Articles by Christine Benz

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