I Bonds vs TIPS

I savings bonds and Treasury Inflation Protected Securities (TIPS) both offer inflation protection. This article compares the similarities and differences between the two instruments. The Treasury Department has an excellent comparison table, but their language isn't the easiest to understand. We elaborate and explain in more details here.

Market price fluctuation
After TIPS are issued, they can be bought and sold on the secondary market. If the real interest rate goes down, the previously-issued TIPS with higher real rates go up in value. They can be sold on the secondary market for their true market value. Since there is no secondary market for I Bonds, they can only be redeemed at accrued value from the U.S. Treasury. If you have high fixed rate I Bonds, your best option would probably be to hold on to them until maturity. Advantage: TIPS.

On the other hand, if the real interest rate goes up, I Bonds can be redeemed at accrued value anytime after you've held them for at least 12 months (you'd lose the last three months' interest if redeemed prior to five years), while TIPS go down in value. Advantage: I Bonds.

Pricing transparency
The TIPS prices (and yields) are set by the market. The I Bonds fixed rates are set by the U.S. Treasury. As the bond issuer, the U.S. Treasury has an incentive to set the fixed rates on I Bonds as low as they feel they can to still reach their desired sales goals. Investors do not necessarily get a competitive yield from I Bonds. Advantage: TIPS.

Purchase limits and fees
There is no practical limit for purchasing TIPS. I Bonds are limited to $10,000 in TreasuryDirect per Social Security number and $5,000 in paper bonds purchased with IRS tax refund. TIPS can also be purchased through a mutual fund. I Bonds cannot be bought through a mutual fund. TIPS can be bought in an IRA. I Bonds cannot be bought in an IRA (they are already tax-deferred). Advantage: TIPS.

There is no fee for purchasing I Bonds. There is no fee for purchasing TIPS at auction from TreasuryDirect or through certain brokerage firms if the order is placed online. As of May 2008, Fidelity and Schwab charge no fee for auction orders placed online. Vanguard Brokerage Services charges $10 for online auction orders unless you are a Voyager client or higher. All brokers charge a markup for secondary market orders. If you hold a TIPS mutual fund, you will pay a management fee; Vanguard charges 0.20%, and 0.11% for Admiral shares. Advantage: I Bonds.

Inflation adjustment
I Bonds are adjusted for inflation every six months. TIPS are adjusted for inflation every day. Advantage: TIPS.

Interest accrual and payments
Interest on I Bonds are accrued until the bonds are redeemed. TIPS pay out interest every six months. Whether one is better than another depends on whether the investor needs the interest payment or not.

Tax treatment
I Bonds are tax deferred. Taxes are due in the year in which the I Bonds are redeemed, unless the investor elects to pay tax on the interests every year. If the I bonds are used to pay educational expenses, the interest may be fully or partially tax-free, depending on your income. Interest payments and inflation adjustments on TIPS are taxable every year. For this reason, it's often suggested that investors hold TIPS in a tax-deferred account. There is no practical way to hold I Bonds in a tax deferred account. Advantage: I Bonds.

A note on negative real rates
The fixed rate component of both TIPS and I Bonds is based on real interest rates, which are normally positive. Real interest rates can sometimes go negative, however. When real interest rates are negative, the fixed rate on TIPS is also negative.

However, the fixed rate component of the I Bond has a floor at 0% and cannot go negative. This is a large advantage of I Bonds when purchasing during a period of negative real interest rates. You can view current levels of real interest rates here. Advantage: I Bonds