Inflation “Protection” Through TIPS and I Bonds
We have all felt the pain of rising prices as we go about our daily lives, whether it’s at the gas pump, the grocery store, or when we travel.
Inflation in the U.S. has left many of us wondering how we can preserve purchasing power in our investment portfolios, particularly in fixed income. Two different forms of inflation-protected bonds have been top-of-mind for some investors: Treasury Inflation Protected Securities (TIPS) and I Bonds. Both are bonds offered by the U.S. Treasury that are designed to help investors during times of inflation. However, there are some key differences between the two, and both have several caveats that are important to consider.
Treasury Inflation Protected Securities (TIPS) are U.S. Treasuries that pay a fixed coupon twice per year. The actual dollar amount, or principal of the bond, fluctuates with inflation. When TIPS mature, the investor receives the adjusted principal or the original principal, whichever is greater.
TIPS have gotten increased attention in the last year because of higher inflation, but unfortunately, TIPS are one of the most misunderstood fixed income instruments in the bond universe. It’s commonly believed that TIPS provide a return that is equal to inflation plus a stated percentage. However, this is not the case.
Interest Rate Risk
TIPS are offered with maturities of five, 10, and 30 years. The longer duration means TIPS can be negatively impacted by fluctuating interest rates. In periods of rising interest rates, the value of the bond can decrease. Even in periods of higher inflation, the decrease in value caused by rising rates may outweigh the inflation (increase in value) component. In fact, TIPS can be priced at negative yields – meaning they are worth less than they were when they were first purchased.
Buying and Selling
TIPS can be purchased directly via auction through treasurydirect.gov. They are also available through the secondary market. TIPS can be sold prior to maturity. Of course, investors would forego any remaining interest payments and the holding would be sold at current market values. If selling before maturity, TIPS may not benefit from an increase in value due to inflation. In addition, TIPS can be harder to sell than typical U.S. Treasuries, especially during times of economic stress or market volatility.
The semiannual interest payments and principal adjustments of TIPS are federally taxable in the year they occur. However, they are exempt from state and local taxes.
TIPS can potentially help provide a hedge against unexpected inflation. Expected inflation is already reflected in the price of the security. Therefore, TIPS only work as an inflation hedge if actual inflation is greater than what is expected or already priced into the market.
The yield spread between TIPS and U.S. Treasuries of the same maturity is referred to as the breakeven spread. This number represents the average inflation rate required throughout the life of the TIPS for it to outperform a U.S. Treasury bond of the same maturity (i.e., length).
For example, a five-year TIPS was recently yielding 0%, and a five-year U.S. Treasury was yielding 3%. The breakeven spread is calculated in this manner: 3% – 0% = 3%. Inflation must exceed 3% over the five-year period for the TIPS to perform better than the U.S. Treasury bond.
As illustrated, the return on TIPS is dependent on more than just an inflation figure. It involves some interest rate complexities, market stress, and calculations.
I Bonds are U.S. savings bonds with adjustable interest rates based on inflation. Interest rates on I Bonds are adjusted every six months (May and November) based on the Consumer Price Index (CPI).
I Bonds made news in 2022 when – between May and October, they earned a composite rate of 9.62%. (During the same period in 2023, the composite rate is 4.30%.) However, there are some other characteristics that need to be considered when thinking about purchasing I Bonds.
The interest earned on I Bonds resets every six months based on inflation. Investors do not receive interest payments until the bond matures. Instead, the interest earned is added to the value of the bond twice per year. This means the principal amount on which you earn interest increases every six months, which amplifies the compounding effect over time.
Maturity and Liquidity
I Bonds have a rather long maturity of 30 years and must be purchased directly through https://www.treasurydirect.gov/. In addition, there is no secondary market for I Bonds. They must be cashed out directly with the U.S. Treasury.
There is a one-year minimum holding period and a penalty of three months’ interest for cashing out the bond in fewer than five years, according to the U.S. Department of the Treasury. For these reasons, investors should make sure they will not need the funds before the five-year time period.
Maximum Holding Size
Investors can purchase up to $10,000 of I Bonds annually per person. They can purchase another $5,000 with a tax refund. Also, I Bonds cannot be held in IRA accounts.
Reporting the interest on your tax return may be deferred until redemption, final maturity, or another scenario involving selling the bond. Investors also have the option to pay taxes annually on the interest earned. I Bonds are exempt from state and local income taxes, but not federal. They may be entirely tax free if used to pay for college tuition at an eligible institution.
We know these times of higher inflation can be unsettling. Although TIPS and I Bonds may provide some help against inflation, it is also important to be aware of price fluctuations, liquidity constraints, and other restrictions.