I-Bonds boast tax advantages, but purchase limits damp appeal.
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.
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 any TIPS holdings you might have in your 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.
A version of this article last appeared July 21, 2011.