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The Short Answer

When I Bonds Beat TIPS

Tax advantages and interest-rate protection can tip the scales.

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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  iShares TIPS Bond (TIP), an ETF that tracks an index of TIPS, is 2.12%. However, one advantage that I Bonds have over TIPS is that their composite interest rate is guaranteed to never fall below 0%, meaning the bondholder is guaranteed to never lose principal. With TIPS, yields can turn negative, potentially leading to losses for the bondholder.

Interest Payments and Tax Advantages
I Bonds continue to earn interest for up to 30 years but can be redeemed as soon as after 12 months. However, a three-month interest penalty applies. They can be redeemed after five years with no penalty. Unlike with TIPS and other bond types, which pay out periodic interest payments, I Bond interest accrues until the bond is redeemed, compounding twice a year while offering no periodic payments.

For those looking for an inflation hedge to be held in a taxable account, I Bonds offer some tax advantages relative to TIPS. The most important of these is that I Bond-holders may defer paying taxes on interest until they redeem the bond. The holder of a TIPS, on the other hand, must pay taxes each year on the interest as well as on any adjustment to the value of its principal (sometimes referred to as "phantom income"). As with TIPS, the interest on I Bonds is taxable at the federal level but is exempt from state and local taxes.

For some college savers, I Bonds also offer a tax advantage in that interest is tax-free if used to pay for college tuition and fees. However, income restrictions do apply. For 2014, the tax break begins phasing out at $113,950 in modified adjusted gross income for married couples filing jointly and phases out completely at incomes of $143,950 and above. (For single filers, the tax break starts to phase out at $76,000 and goes away at modified adjusted gross income above $91,000.)

Are I Bonds for You?
If you are an investor looking to add inflation protection to your portfolio and willing to hold on to a security for the long term, I Bonds may be worth a look. But remember that they serve primarily as a principal-preservation tool rather than a source of periodic income. If you're looking for inflation protection that also pays regular income, you might want to consider TIPS. (Christine Benz, Morningstar's director of personal finance, discusses TIPS' lackluster recent performance and explains why they might still be worth a look here.) On the other hand, because I Bonds are not traded, they are essentially immune to interest-rate risk because changes to prevailing rates have no impact on their value. The same cannot be said of TIPS, which are traded and, therefore, susceptible to prevailing interest-rate movements.

If you are considering I Bonds as a long-term holding, it might be worth waiting until interest rates begin moving higher so that you can lock in a fixed rate that is above 0% in addition to the inflation rate on the bond. The I Bond's fixed rate hasn't reached 1% since 2007, and there's no telling when rates will return to that level. But for an investment you plan to hold for many years, any fixed rate is better than nothing.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.