The one constant that appears to remain constant in our lives is inflation. However, many investors aren’t aware that there are investments that can act as a hedge against inflation.
Welcome to the world of Series I Savings Bonds (I Bonds) and Treasury Inflation-Protected Securities (TIPS). These securities are issued by the US Treasury, and both are inflation-adjusted.
How do they differ from one another, and what are the advantages of each? Let’s take a look.
What are TIPS?
TIPS, also known as Treasury Inflation-Protected Securities, are a special type of bond issued by the U.S. Treasury that is indexed to inflation. When you buy TIPS, you lend money to the US government for a certain period of time, typically 5, 10, or 30 years. In return, the government pays you interest semi-annually at a fixed rate.
TIPS differs from nominal treasury bonds because its principal and interest are tied to the consumer price index (CPI). That means the value of TIPS rises and falls relative to rising or falling inflation.
What are I Bonds?
An I Bond, also known as a Series I Savings Bond, is a type of U.S. savings bond issued by the U.S. Department of the Treasury. These bonds are considered low-risk investments and are backed by the full faith and credit of the US government.
I Bonds are non-marketable, interest-bearing US government savings bonds designed to provide investors with a return on their investment while protecting against unexpected inflation.
Like TIPS, I Bonds are inflation-adjusted bonds backed by the U.S. Treasury. I Bonds offer a fixed interest rate and an inflation-adjusted rate, providing a return for up to 30 years.
Inflation Indexing
I-Bonds and TIPS both protect against inflation, but the approach each one uses is different.
TIPS offers protection against inflation by adjusting the principal of security based on inflation. When the principal increases due to inflation, the corresponding interest payment also increases. Likewise, the corresponding interest payment decreases when the principal decreases due to deflation.
The interest rate used to calculate TIPS interest payments remains unchanged during the entire maturity period — the interest payment changes based on the value of the principal. The principal adjusts on a semi-annual basis based on an index ratio.
I Bonds, on the other hand, use a compound interest rate. A portion of the interest rate remains fixed during the entire maturity period. However, the second interest rate component is linked to the CPI.
This means that I Bonds maintain a constant principal, only increasing due to semi-annual interest payments accumulated, but the interest rate increases and decreases with inflation.
Marketability
TIPS are highly marketable, while I Bonds are not.
You can’t trade I Bonds on secondary markets. Secondary markets are where investors purchase securities or assets from other investors. I bonds generate interest while you own them, but the interest payments and principal are all paid when you redeem the I bond.
TIPS, on the other hand, are highly marketable. You can trade tips with other investors before maturity on the secondary market.
Accessibility
You can only buy I Bonds via TreasuryDirect.Gov or purchase paper bonds with your tax return through the U.S. Treasury. Buying I bonds is easier, but you’ll have more ways to buy TIPS.
In contrast, you can buy TIPS on TreasuryDirect.Gov. You can also buy TIPS on the secondary market with a bank, dealer, or broker via auctions.
Tax Treatment
Tax implications affect the after-tax value of your investments. TIPS owners pay federal income tax on interest payments and principal growth in the year they occur, and receive a 1099-INT and a 1099-OID for these.
I Bonds are also subject to federal income taxes, but differ in that taxes on interest payments are due at maturity or redemption. I Bond holders can choose to pay taxes on interest yearly or defer until maturity or redemption.
Also, I Bonds offer a tax-advantaged savings option for qualified education expenses, a feature not available with TIPS.
Both TIPS and I Bonds are exempt from state and local taxes.
IRA Eligibility
TIPS can be bought and held in an IRA account, including funds that hold TIPS, which allows for tax deferred growth. However, I Bonds can’t be held in any tax-advantaged accounts.
Should You Invest in TIPS or I Bonds?
If rates are expected to fall, TIPS are the better choice; if they’re expected to rise, I Bonds hold the advantage. Overall, the choice between TIPS and I Bonds will depend on your specific investment priorities and goals.
