When I Bonds Beat TIPS

Note: This article has been corrected to reflect the way that inflation adjustments work for TIPS.

Question: I keep hearing about I Bonds as an inflation hedge, but I don't know much about them. How can I tell if they're right for me?

Answer: Most investors looking for a low-risk hedge against inflation automatically think of Treasury Inflation-Protected Securities, or TIPS. But under the right circumstances, I Bonds, which also offer an inflation-adjusted interest rate, may be just as useful--provided you understand how they work and how they differ from TIPS.

One reason you don't hear more about I Bonds is that, unlike many other bond types, they are not traded on a market. Only the person in whose name they are registered may redeem them. As such, you won't find I Bonds in bond funds' portfolios. These are securities you have to invest in directly.

There are two ways to purchase I Bonds. You can buy them in electronic form directly from TreasuryDirect.gov or you can instruct the IRS (using Form 8888) to use some or all of your federal income tax refund to buy paper I Bonds or to send the money to your TreasuryDirect account, which you can then use to purchase them.

One drawback of I Bonds is that annual purchases are limited to $10,000 per Social Security number for electronic versions and $5,000 per year for paper versions. So, investors who hope to make I Bonds a cornerstone of their inflation-protection strategy and who have a large amount of assets may have to build a suitable position over time. Also, electronic I Bonds may be purchased in any amount of $25 or more while paper I Bonds are only issued in denominations of $50, $100, $200, $500, $1,000, and $5,000.

Difference in Inflation-Adjustment Methods Like TIPS, I Bonds are designed to adjust for inflation, although they do so in different ways. For one, TIPS adjust the value of their principal and, thus, the yield, while I Bonds adjust the yield directly with no change to the principal value. Both adjust for inflation semi-annually, and for I Bonds, this happens on the six- and 12-month anniversaries of the date they were issued (the rate of the adjustment is determined every May and November). Both security types use the Consumer Price Index as the basis for their inflation adjustments.

The fact that I Bonds adjust their yields only twice a year and are not tradable means that they can be less sensitive than TIPS to near-term changes in the rate of inflation. For example, if inflation spikes in June of a given year, an investor holding I Bonds would have to wait at least another five months, until November, for the yield on the I Bond to reflect this change (and possibly longer if the anniversary of the I Bond's purchase falls after November). With TIPS, that's not an issue because market prices will adjust to reflect more recent changes to the rate of inflation. Of course, if inflation heads lower, the delay in the adjustment could potentially provide a short-term advantage for I Bonds relative to TIPS.

The interest rate paid by I Bonds includes both a fixed rate that remains constant for the life of the bond plus the inflation adjustment. With interest rates as low as they are right now and inflation relatively low as well, newly issued I Bonds aren't paying much. In fact, the fixed-rate portion of new I Bonds is paying 0%, while the inflation rate for the full year ending with the most recent adjustment last November is 1.48%, for an overall composite rate on the bond of 1.48%. By comparison, the current 30-day SEC yield on

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