Treasury Inflation-Protected Securities and I-Bonds have a low correlation with other asset classes. In other words, they don't always behave like most other bonds or stocks. That means they can be used to diversify almost any type of portfolio.
If you are approaching or are in retirement, using these bonds to hedge against inflation may give your portfolio added protection. You can create "ladders" using these bonds that will set up an ongoing income stream that increases as we see prices inflate. (A "ladder" is a strategy where you buy bonds in increasing maturities, like five, six, or seven years. When the next bond matures, you buy another at the long end of your ladder.)
And even if we find ourselves in a deflationary environment some day, at least you will always get back the face value of the bond and the interest can never fall below zero.Treasury Inflation-Protected Securities
TIPS are government-issued bonds that provide a hedge against inflation. While the interest rate doesn't change over the life of the bond, the underlying principal rises and falls with changes in the inflation rate. As it does so, the amount you'll receive as income also changes. At maturity you'll always get at least the par value of the bond.
Interest is paid out semiannually. When the bond matures, your final principal value is adjusted for inflation during the term of the bond.
TIPS are guaranteed by the U.S. government and are exempt from state and local tax. Unlike I-Bonds, you'll have to pay tax on distributions. Uncle Sam is going to tax you at ordinary income rates for the semiannual interest payments you receive, as well as on the "phantom income" you receive as your underlying principal adjusts for inflation. You won't actually get this inflated principal until the bond is redeemed, but you'll be paying tax on the adjustments annually. If that tax is significant, you could find yourself in a negative cash flow situation--more is going out in tax payments than is coming in through interest payments.
For those reasons, TIPS are most often recommended for tax-deferred accounts.
But consider this: If you put TIPS in most tax-deferred accounts (not Roth IRAs), they'll lose their state and local tax-exempt status. That's because when you eventually take securities out of most tax-deferred vehicles, they're taxed at ordinary income-tax rates at federal, state, and local levels. So, for investors in lower tax brackets, especially those who live in a state with high tax rates, TIPS may make sense in a taxable account or Roth IRA.
You can buy TIPS individually or through a few different mutual funds, including Vanguard Inflation-Protected Securities
, Harbor Real Return
, and Fidelity Inflation-Protected Bond
You can buy individual bonds directly from the U.S. Treasury in five-, ten- and twenty-year maturities. You can also buy TIPS in the secondary market. Individual bonds sell for as little as $1,000 and increase in increments of $1,000 up to $5 million. You can avoid transaction fees by buying direct at TreasuryDirect
I-Bonds are U.S. Savings Bonds that are designed to offer protection from inflation. The bonds increase in value until they are sold or mature, but do not pay out annual interest payments.
I-Bonds earn interest in two ways: through a fixed interest rate and a variable interest rate. The fixed-rate portion is set when you buy the bond. Remaining interest payments come from the variable-rate portion, which changes twice a year (May and November) based on inflation, as measured by the Consumer Price Index (CPI). The most recent I-Bond is paying a 1.3% annual fixed interest rate and a 2.42% annualized variable interest rate. That means the composite rate is 3.74%. That may not sound like much, but remember this rate goes up when we see inflation. With other types of bonds, your take-home income is likely to go down as inflation increases.
You can buy up to $30,000 worth of paper I-Bonds each calendar year at your local bank. In addition, you can buy up to $30,000 in electronic I-Bonds through TreasuryDirect
. If you cash out before you've owned the bonds five years, you will lose three months' worth of interest.
You purchase I-Bonds at face value, and you probably won't have to pay brokerage commissions. Each bond features a picture of an outstanding American.
You won't receive interest from your I-Bonds until you cash them in or they mature. So you don't have to pay tax on the interest as it accrues. This can be a significant advantage over a Treasury Inflation-Protected Security in a taxable account.
At maturity or redemption, interest on I-Bonds is subject to federal tax, but not state or local tax. And if you meet certain requirements, interest may also be exempt from federal tax if you use the bonds to pay higher-education expenses.
For all of these reasons, I-Bonds can be attractive candidates for many taxable accounts--but not all. In particular, investors in high tax brackets may lose the inflation-protection advantage of these bonds to taxes in a higher-inflation environment. How? If the money you receive from the fixed portion of the bond's interest is less than what you'd owe in taxes.
Say, for example, you bought a $1,000 bond that paid 3% in fixed interest and 7% in variable interest, reflecting an inflation rate of 7%. You'd earn 10% interest on the bond, or $100. If that $100 is taxed at a 35% rate, you'd owe $35 in taxes. Your aftertax income would be $65. But to keep up with a 7% inflation rate, you'd need to net $70.
To sum up: I-Bonds can play important roles in many taxable accounts. They act as a hedge against inflation, are guaranteed by the U.S. government, and are affordable. And unlike a bond mutual fund, you'll always get at least the face value of your I-Bond back. On the downside, you may be able to earn a higher interest rate with other types of bonds. If you need to sell the bond less than five years after you bought it, you'll lose three months of interest. And unless investors are careful about choosing a bond with a fixed rate that makes more income than is taken away in taxes, these bonds may not offer much protection to those in the highest tax brackets if inflation rises significantly.What If We Have Deflation?
Say we move into a deflationary climate before your inflation-indexed bond matures. What will you receive?
With TIPS, the Treasury will pay you either the face amount or the inflation-adjusted amount when the bond matures, whichever is greater. With I-Bonds, the combined interest rate can never fall below zero. So in a deflationary environment, interest payments may be lower than you anticipated, but you'd still get back at least the full face value of the bond when it matures.A version of this article appeared Dec. 23, 2004.