Understanding I-bonds & TIPS

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asif408
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Understanding I-bonds & TIPS

Post by asif408 »

I've been doing a good bit of reading on I-bonds and TIPS lately, trying to better understanding the differences. I understand that the inflation protection difference between the two is mainly that, for I-bonds, the inflation adjustment is applied to the interest rate, while for TIPS it is applied to the principal.

Assuming I had the same amount of money in I-bonds and TIPS, I have two questions:

1) If I understand correctly, does that mean that an individual TIPS would be expected to provide a higher real return than an I-bond if inflation is positive over the time period held (assuming the TIPS is held in a tax deferred account)? Since TIPS don't have the put option that I-bonds have after the first year, I guess it would make sense that I-bonds would have a lower real rate of return.
2) If there was a period of long term deflation, would an I-bond have a higher real return compared to an individual TIPS held to maturity? I know that an individual TIPS cannot lose money if held to maturity, but I can't quite figure out if the I-bond would win out in this case, since the I-bond has the benefit of never going down in value, while the TIPS principal theoretically could during the time frame held.
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Ice-9
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Re: Understanding I-bonds & TIPS

Post by Ice-9 »

One obvious difference to note that was not mentioned in the original post is that the real rate for I-Bonds and the various maturities of TIPS will be different. In history so far, the various TIPS maturities usually have had the higher real rate, but that has not always been the case. In some recent years, the real return on many TIPS has been negative while the real return on I-Bonds at the time was 0% or higher. Even now, the five-year TIPS has a negative real return while the I-Bond rate is above 0%.

So, with regards to your question #1, the difference in real rates at time of purchase is a better indicator of the winner of the two choices in returns than whether the inflation adjustment is made to the principle or the interest rate.

The savings bond advisor website has a good table showing the historical I-Bond fixed rate versus the 10-yr TIPS:
http://www.savings-bond-advisor.com/ser ... ase-rates/
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asif408
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Re: Understanding I-bonds & TIPS

Post by asif408 »

Ice-9,

Thanks for the feedback, I hadn't thought about that. I will take a look at the link you sent.
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Re: Understanding I-bonds & TIPS

Post by Call_Me_Op »

asif408 wrote:I've been doing a good bit of reading on I-bonds and TIPS lately, trying to better understanding the differences. I understand that the inflation protection difference between the two is mainly that, for I-bonds, the inflation adjustment is applied to the interest rate, while for TIPS it is applied to the principal.
I would not agree with that. The principal is adjusted in both cases.

The main differences are (in a nutshell) I-Bonds are inherently tax-deferred, never lose nominal value in periods of deflation, and are not sold on the secondary market. There are other differences, but those are the main ones.
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Re: Understanding I-bonds & TIPS

Post by #Cruncher »

asif408 wrote:1) If I understand correctly, does that mean that an individual TIPS would be expected to provide a higher real return than an I-bond if inflation is positive over the time period held (assuming the TIPS is held in a tax deferred account)?
I'm not sure exactly what you're asking. But a TIPS with a real yield of R% held to maturity will provide the same pre-tax return (both nominal and real) as an I Bond with a fixed rate of F% when R and F are the same, the holding periods are the same, and the CPI doesn't fall during any 6-month period. [ * ] See my post I Bond & TIPS Returns and I Bond Composite Rate Formula for more.

It's difficult to compare the after-tax return of an I Bond to a TIPS held in a tax-deferred account. This is because when the I Bond is redeemed, tax is only payable on its increase in value. But when money is withdrawn from a tax-deferred account tax is generally payable on the entire amount. And the flip side is that the initial purchase of an I Bond is made with after-tax money, while the contributions to a tax-deferred account are generally made with pre-tax money.
asif408 wrote:2) If there was a period of long term deflation, would an I-bond have a higher real return compared to an individual TIPS held to maturity?
Both TIPS and I Bonds offer a potential "deflation bonus" where the holder gets a higher real return when the CPI falls. But for TIPS the CPI must fall over the entire term. This is very unlikely. The CPI hasn't fallen over a 5 or 10 year period since 1928-1933 and 1923-1933. (See eyebonds.info/downloads/pages/CPIU1913.html for more.)

However, for I Bonds one can get this bonus whenever the CPI falls during any of the 6-month periods March - September and September - March used to determine the semi-annual inflation rate. When this happens, the negative inflation rate is combined with the fixed rate in the normal way. But the resulting composite rate is limited to a minimum of 0%. (See Combining the two rates for more info.)

This has happened once since I Bonds were first issued in the late 1990's. From September 2008 - March 2009 the CPI fell fell 2.78%. This was large enough that every I Bond outstanding at that time got a bonus. See column of "0.00's" headed "509 -2.78" on this web page. This floor is most beneficial for I Bonds with a small fixed rate. For the extreme case, an I Bond with a 0% fixed rate gains a bonus corresponding to the entire decline whenever the CPI falls during one of these 6-month periods.

* Ignoring the longer lag time in applying the CPI changes to I Bonds than to TIPS.
Call_Me_Op wrote:
asif408 wrote:... for I-bonds, the inflation adjustment is applied to the interest rate, while for TIPS it is applied to the principal.
I would not agree with that. The principal is adjusted in both cases.
I would say that the total value of both is adjusted for inflation. But the mechanism for doing so differs. For TIPS the principal is adjusted and a constant interest rate is applied against the adjusted principal. For I Bonds the interest rate itself is adjusted. Since they aren't really bonds -- but more in the nature of a savings account -- it doesn't really make sense to speak of an I Bond's "principal", unless one is just referring to the initial amount purchased.
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Re: Understanding I-bonds & TIPS

Post by nisiprius »

Forgive me for not answering your question and for answering a question you didn't ask.

In my opinion THE BIG difference between the two, and I mention it because for some reason a lot of people don't understand this, is that I bonds have no interest rate risk. This makes them significantly less risky than TIPS and means the risk/reward tradeoff needs to be thought through.

I bonds are not marketable securities. They do not have a market value. There is only one way to exchange your I bonds for money, and that is to redeem them with the Treasury. That is done according to a formula that takes inflation into account, but not interest rates. The redemption value is unaffected by interest rate movements.

Moreover, whatever the redemption value of an I bond is at any give time, a month later it cannot be lower.

They can only go up in dollar value, never down. This means to me that they resemble cash or bank CDs much more closely in their risk characteristics than they resemble bonds or TIPS.

If you are already perfectly clear on this, than forgive me for bringing it up.

(P.S. For some reason, the concept of "non-marketable security" really bothers some people, and there are financial sophisticates who insist that the appropriate number to use for "the value of an I bond" is not the amount of money you can exchange it for, but the amount of money it would be worth if it were marketable on a free market. I don't want to get into that debate beyond mentioning acknowledging that there is a debate.)
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Re: Understanding I-bonds & TIPS

Post by Sagenick48 »

This is very simplistic but if the government proposes a "deal" that it limits you in making with it, it is probably a good deal, otherwise, they would let you buy an unlimited amount. So, using that admittedly fractured logic, I Bonds are a better DEAL than TIPS. Yes, we can talk about about all kinds of different alternatives, but when the government limits how much in I Bonds I can buy, that sends me a signal, to buy as much as I can.
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Re: Understanding I-bonds & TIPS

Post by Svensk Anga »

Another difference is that interest compounds for I-bonds while for TIPS, one receives coupon payments for the real rate every six months. Whether compounding at the original real rate (plus inflation) of I-Bonds or buying new securities with your TIPS coupons is the better deal depends on what has happened to interest rates since the original purchase. Its not a big deal with current real rates.
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Re: Understanding I-bonds & TIPS

Post by Call_Me_Op »

Sagenick48 wrote:This is very simplistic but if the government proposes a "deal" that it limits you in making with it, it is probably a good deal, otherwise, they would let you buy an unlimited amount. So, using that admittedly fractured logic, I Bonds are a better DEAL than TIPS. Yes, we can talk about about all kinds of different alternatives, but when the government limits how much in I Bonds I can buy, that sends me a signal, to buy as much as I can.
Excellent point. I don't think people (in general) appreciated how good a deal I-Bonds were until very recently - right about when the Government greatly restricted their availability. (Coincidence?)
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Re: Understanding I-bonds & TIPS

Post by asif408 »

nisiprius wrote:Forgive me for not answering your question and for answering a question you didn't ask.

In my opinion THE BIG difference between the two, and I mention it because for some reason a lot of people don't understand this, is that I bonds have no interest rate risk. This makes them significantly less risky than TIPS and means the risk/reward tradeoff needs to be thought through.

I bonds are not marketable securities. They do not have a market value. There is only one way to exchange your I bonds for money, and that is to redeem them with the Treasury. That is done according to a formula that takes inflation into account, but not interest rates. The redemption value is unaffected by interest rate movements.

Moreover, whatever the redemption value of an I bond is at any give time, a month later it cannot be lower.

They can only go up in dollar value, never down. This means to me that they resemble cash or bank CDs much more closely in their risk characteristics than they resemble bonds or TIPS.

If you are already perfectly clear on this, than forgive me for bringing it up.

(P.S. For some reason, the concept of "non-marketable security" really bothers some people, and there are financial sophisticates who insist that the appropriate number to use for "the value of an I bond" is not the amount of money you can exchange it for, but the amount of money it would be worth if it were marketable on a free market. I don't want to get into that debate beyond mentioning acknowledging that there is a debate.)
nisiprius,

No need to apologize. Your insight is very much appreciated. I never thought about the fact that they are essentially the only type of bond to have no interest rate risk. The more I read about I bonds the more I realize they have some characteristics that are desirable and unique in the bond world. I recently just purchased my first I bond and plan to buy more to build up an emergency fund.
Call_Me_Op wrote:
Sagenick48 wrote:This is very simplistic but if the government proposes a "deal" that it limits you in making with it, it is probably a good deal, otherwise, they would let you buy an unlimited amount. So, using that admittedly fractured logic, I Bonds are a better DEAL than TIPS. Yes, we can talk about about all kinds of different alternatives, but when the government limits how much in I Bonds I can buy, that sends me a signal, to buy as much as I can.
Excellent point. I don't think people (in general) appreciated how good a deal I-Bonds were until very recently - right about when the Government greatly restricted their availability. (Coincidence?)
I admit I did not. In fact, I had never heard if an I bond until I became a Boglehead. :oops: I guess the brokers don't promote them because they can't sell them and the banks don't mention them because they are competitive with bank CDs.
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Re: Understanding I-bonds & TIPS

Post by Call_Me_Op »

#Cruncher wrote: For I Bonds the interest rate itself is adjusted. Since they aren't really bonds -- but more in the nature of a savings account -- it doesn't really make sense to speak of an I Bond's "principal", unless one is just referring to the initial amount purchased.
Can you think of a better word to use? The treasury itself uses the word "principal" to describe the interest-paying basis for a TIPS, so it doesn't seem like a big stretch to use the same word for the interest-paying basis for an I-Bond.
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Re: Understanding I-bonds & TIPS

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Call_Me_Op wrote:Can you think of a better word to use ... [ than "principal" ] for the interest-paying basis for an I-Bond [ ? ]
I would just say "value". But if you want to say "principal" that's cool. The Treasury uses both words:
in [url=http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm#interest]How do I Bonds earn interest[/url] TreasuryDirect wrote:The interest is compounded semiannually. Twice a year, on the 6th and 12th month anniversaries of the bond's issue date, all interest the bond has earned in previous months is in the bond's new principal value on which interest is earned for the next 6 months. (underline added)
But then you're simply using "principal" as a synonym for the total accumulated value of an I Bond. While for a TIPS -- or any coupon bearing bond -- the principal is only one part of its value.
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Re: Understanding I-bonds & TIPS

Post by Nerdicus »

So if you're doing a 60/40 stock and bond allocation via your 401(k) and have a TIPS fund available and you want to add it. What would be a good percentage to allocate of your bond portion to the TIPS fund? Is there a rule of thumb?
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Re: Understanding I-bonds & TIPS

Post by Call_Me_Op »

#Cruncher wrote:
Call_Me_Op wrote:Can you think of a better word to use ... [ than "principal" ] for the interest-paying basis for an I-Bond [ ? ]
I would just say "value". But if you want to say "principal" that's cool. The Treasury uses both words:
in [url=http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm#interest]How do I Bonds earn interest[/url] TreasuryDirect wrote:The interest is compounded semiannually. Twice a year, on the 6th and 12th month anniversaries of the bond's issue date, all interest the bond has earned in previous months is in the bond's new principal value on which interest is earned for the next 6 months. (underline added)
But then you're simply using "principal" as a synonym for the total accumulated value of an I Bond. While for a TIPS -- or any coupon bearing bond -- the principal is only one part of its value.
NC,

Great point. For an I-Bond, since the interest is inherently re-invested and since it is not subject to valuation by a secondary market, perhaps just using the term "value" is more appropriate.
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Re: Understanding I-bonds & TIPS

Post by MarginalCost »

I've found the Bogleheads Wiki page on I-Bonds vs. TIPS a useful starting point for this discussion.

Note also that because I-Bonds don't have interest rate risk, that includes upside risk as well. In a high-interest rate environment, you couldn't make a quick profit from an unforeseen drop in interest rates. That's probably not too big a deal today, but worth considering in future years.
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Re: Understanding I-bonds & TIPS

Post by Call_Me_Op »

MarginalCost wrote:I've found the Bogleheads Wiki page on I-Bonds vs. TIPS a useful starting point for this discussion.

Note also that because I-Bonds don't have interest rate risk, that includes upside risk as well. In a high-interest rate environment, you couldn't make a quick profit from an unforeseen drop in interest rates. That's probably not too big a deal today, but worth considering in future years.
That's why it's probably a good idea to include I-Bonds as only part of your fixed income allocation. Of course with the upside of interest rate sensitivity comes the downside. I like to include a whole range of unique vehicles in my FI allocation.
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Re: Understanding I-bonds & TIPS

Post by asif408 »

MarginalCost wrote:I've found the Bogleheads Wiki page on I-Bonds vs. TIPS a useful starting point for this discussion.

Note also that because I-Bonds don't have interest rate risk, that includes upside risk as well. In a high-interest rate environment, you couldn't make a quick profit from an unforeseen drop in interest rates. That's probably not too big a deal today, but worth considering in future years.
MarginalCost,

It seems that if interest rates increase and inflation were relatively low down the road you could always move some money into CDs to earn a higher yield.
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Re: Understanding I-bonds & TIPS

Post by sscritic »

MarginalCost wrote: Note also that because I-Bonds don't have interest rate risk, that includes upside risk as well. In a high-interest rate environment, you couldn't make a quick profit from an unforeseen drop in interest rates. That's probably not too big a deal today, but worth considering in future years.
It matters what the real rate is. If you buy them in a high interest rate environment with a high real rate, you don't get a pop, but you do get to keep collecting high nominal rates when the rest of the world is making do with 1%. Just ask Mel and the others who own 3% real I bonds.

If you own low real rate bonds in a high interest rate environment and inflation is high as well (I think low inflation, high rates are rare - I got a 13% CD because of the effort to defeat high inflation), you are collecting high nominal rates because of the inflation component. If rates fall, what you get will fall as well. Again, no pop, as you say.

P.S. The same is true of a regular bond. If you buy in a low interest rate environment and rates go up, your bond goes from $100 to $90 say. When rates drop and your bond goes back to $100, is that a pop or is it just getting back all the money you lost?
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