Inflation can be something of a wild card. It has a volatility of its own and is not something that any of us can just wish away. It is an economic condition that ultimately affects the purchasing power of everyone’s cash.
You should always be prepared for inflation. For that reason, we think inflation-protecting some of your bond allocation is normally a good idea.
When it comes to inflation protection, there are two types of debt securities that stand out: I Bonds and TIPS. Both are U.S. debt obligations which are adjusted by the Consumer Price Index, but they do so very differently.
An I Bond is a Series I savings bond . Treasury Inflation Protected Securities (TIPS) are Inflation-Indexed U.S. Treasury bonds . For both of these types of bonds, if the CPI goes down, the coupon payments go down, and if the CPI goes up, their coupon payments go up. However, there are several differences between them.
I Bonds are non-marketable.
All savings bonds, I Bonds included, are purchased directly from the government, and they cannot be bought or sold by private parties. This is why they are called “non-marketable.” There is no secondary market for their purchase or sale. When you purchase a savings bond, you purchase it into a specific person’s name and generally the ownership must stay with that person.
Savings bonds always have 30-year maturities, but you are able to cash in early to redeem principal at the loss of any future interest you would have otherwise been due.
I Bonds also have limitations on when you can cash in. Any I Bonds you purchase must be held for at least one year before you can consider cashing it in, and if you redeem them within 5 years of issue, you lose the last 3 months of interest paid. In this way, I Bonds are illiquid in the short-term.
TIPS are more liquid.
In contrast, Treasury bonds can be both purchased from the government and traded on secondary markets. As a result, they have high liquidity and marketability. You need not cash in a Treasury bond in order to recoup principal. Instead, you can sell your Treasury bond to someone else. This is why there exists TIPS bond funds like VTIP or SCHP but do not exist savings bond funds.
New Treasury bonds are issued with 5-, 10-, or 30-year maturities, but in the secondary market you can find a TIPS bond of any number of years left.
Both use the non-seasonally adjusted CPI-U.
Both I Bonds and TIPS use changes in the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy to update to inflation.
TIPS hedge against unexpected inflation.
TIPS pay a fixed coupon rate twice per year, but the principal of the bond is adjusted with inflation daily.
So for example, the CPI-U was 292.296 in May 2022 and rose to 296.311 in June 2022. This is +1.37% increase in CPI-U experienced in June 2022 and released to the public in July 2022. It is then implemented for TIPS adjustments over the course of the month of August 2022 . The TIPS index ratio (amount the principal is multiplied by) is gradually increased so as to have the full 1.37% increase by the start of the new month (ie. October 1, 2022).
When the TIPS finally do mature, you are then entitled to the greater of the adjusted principal or the original principal.
And, because the coupon dollar amount is calculated by the coupon rate (a percentage) multiplied times the principal, this means that the semiannual coupons increase with inflation too.
That being said, the starting coupon rate for TIPS is lower than that of identical maturity, regular U.S. Treasuries. This maturity rate difference is the average annual inflation assumption that has been priced into the TIPS. This difference is called the breakeven spread or breakeven rate.
If the average annual inflation rate through maturity is the breakeven rate, then the TIPS will perform the same as a regular Treasury bond of the same maturity. If the average annual inflation rate is less than the breakeven rate, the regular Treasury bond will outperform the TIPS. If the average annual inflation rate is more than the breakeven rate, the TIPS will outperform the regular Treasury bond.
In this way, a TIPS hedges a portfolio against unexpected inflation. Any expected inflation, the breakeven rate, is already priced into the security.
I Bonds hedge actual inflation.
In contrast, the interest rate on an I Bond is made up of a semiannual fixed rate (currently 0%) and a semiannual variable inflation rate (currently 4.81%). These are often stated as an annual composite rate (the semiannual 4.81% times two, currently 9.62%). However, it is important to keep in mind that the inflation rate is changed every six months so you won’t experience this annual rate.
The inflation rate is set directly based on changes in the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy . Every 6 months, in May and November, the variable rate is updated based on the change in CPI-U over the last six months.
For example, the 3.56% November 1, 2021 I Bond inflation rate was calculated from the CPI-U in March 2021 which was 264.877 and in September 2021 which was 274.310. This is a 9.433 increase or 3.56% increase in CPI-U.
Similarly, the current 4.81% May 1, 2022 I Bond inflation rate was calculated from the CPI-U in September 2021 which was 274.310 and in March 2022 which was 287.504. This is a 13.194 increase or 4.81% increase in CPI-U.
The next November 2022 rate will be set based on whatever growth is experienced between March 2022 and September 2022. This next 6 month period could have a lower or higher rate depending on the rate of inflation when the November update comes around.
TIPS provide income now. I Bonds don’t.
The interest from I Bonds are automatically reinvested into the principal. This means that the principal amount increases. While no cash is available for the investor until you cash in the bond, a higher principal does mean higher interest payments as the interest dollar amount is calculated based on the composite rate times the current principal value.
In contrast, TIPS pay out their interest semi-annually, granting a liquid income stream.
Both are exempt from most state’s taxation.
While taxed at the federal level, interest received from U.S. federal Debt Obligations are generally exempt from taxation at the state level. This includes both U.S. Treasury bonds and U.S. savings bonds.
I Bonds can defer taxation.
With I Bonds, you are given the choice of paying taxes on the interest when you cash in the bond or paying taxes yearly on the interest as it accrues. Regardless of which you pick the first year, you must continue that method and cannot change your mind later. However, regardless of which you pick, you do not receive the interest payments on the I Bond until you cash in the bond.
If you use the proceeds of the I Bond for qualified education expenses, then it can also be exempt from federal tax.
TIPS have some phantom income, though TIPS ETFs typically don’t.
TIPS pay out interest and also increase the principal due to the investor later. The increase in principal is phantom income taxed at ordinary rates for that year, but the tax basis of the TIPS also adjusts upward, reducing capital gains owed if you sell it. The interest is taxed as it is accrued and paid out to the investor.
If you own a TIPS exchange-traded fund (ETF), the increase of principal, which is normally phantom income if you held the TIPS individually, is usually distributed from the fund and thus regular income. As iShares describes:
For tax purposes, the principal adjustment is classified as Treasury income and is distributed by the fund even though it is not distributed to individual TIPS security holders (known as phantom income). If there is deflation, the TIP ETF might omit or not pay a monthly distribution.
You can buy more TIPS.
An individual can only purchase up to $10,000 in I Bonds per year for themselves, plus up to another $5,000 if you choose to receive your tax refund as I Bonds.
There is no limit to the amount of TIPS an investor can buy.
Why have a bond allocation?
There is an optimum allocation between stocks and bonds for a given withdrawal rate.
Having too much stability means that you might not have enough growth. When subjected to a withdrawal, many of the sequences of an all-bond portfolio end up running out of money. If the portfolio experiences poor bond returns early in the sequence, monthly withdrawals comprise a greater percentage of the portfolio and can spend it down quickly. If the portfolio experiences high inflation compared to the bond returns, then the portfolio falls behind on its purchasing power. Having everything in bonds risks not having enough appreciation to overcome poor bond returns early in the sequence.
There is a similar effect for the all-stock portfolio or a portfolio that is too aggressive. When the portfolio is burdened with withdrawals, some sequences of returns run out of money during the 30 years. Having everything in stocks risks having to take a large percentage of money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover.
This is why portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds).
A stability allocation helps you have enough money to meet your withdrawal needs by dampening the volatility of stock returns. An appreciation allocation helps you have enough growth in your portfolio to compound your savings into your financial goals.
TIPS or I Bonds?
If you are not anticipating withdrawing from any of your investment accounts over the next 7 years, then you do not need a bond allocation. If you are anticipating withdrawing from your investment accounts, then staging the next 7 years of spending in bonds helps stabilize your portfolio when you need to withdraw during poor market returns.
However, if you are anticipating withdrawing from your investment accounts over the next 7 years, then purchasing an I Bond locks your money up for too long. You cannot redeem your interest without cashing in the bond and if you cash in within the next 5 years you are penalized. In contrast, TIPS pay their interest semi-annually in cash, and there is a secondary market where you can recoup your money.
Furthermore, because I Bonds increase dollar for dollar with the inflation rate, at best an I Bond will have a return matching the rate of inflation – a real return of 0%. If you consider the taxes paid on the interest received though, I Bonds will actually have a slightly negative real return. TIPS, on the other hand, can have a positive real return if future inflation surpasses expected inflation.
For these reasons, if you are looking to inflation-index your bonds, we would generally recommend TIPS.
Photo by Ksenia Makagonova on Unsplash