In a recent blog post on low-risk investments for an inflationary environment, we focused on Series-I Government bonds, highlighting their purchasing power protection, their unique taxation benefits, and their marketability and liquidity profile. We also briefly mentioned TIPS (Treasury Inflation Protected Securities), a close relative of I-bonds, which are another variety of government issued bond that provides inflation protection. However, there are several significant differences between I-bonds and TIPS that you should understand before deciding which (if any) to purchase. Today we will delve more deeply into TIPS and attempt to explain their unique mechanics and notable differences compared to I-bonds. This is admittedly dry material so grab a glass of water and we’ll do our best to keep it brief and easy to digest.
Perhaps the biggest difference between TIPS and I-Bonds is how they compensate for inflation, which can have meaningful implications over the life of each security. While both TIPS and I-bonds take their cues from the Consumer Price Index (CPI), the mechanics of how they use the same input data to compensate the holder for inflation is different. With I-Bonds we explained their “hybrid” coupon, comprised of both a fixed and variable components, with the variable portion doing the work to hedge inflation. TIPS, on the other hand, are slightly more nuanced in that they carry a traditional fixed-rate of interest which computes interest due based on a variable face value. While the fixed rate never changes, it is applied to a fluctuating principal value, somewhat paradoxically resulting in variable interest payments. Whereas a traditional bond pays the same dollar amount of interest no matter what its face value (based on a stated interest rate relative to the bond’s issue price), TIPS use a constant interest rate relative to a variable principal value to compute the interest due, resulting in interest payments that fluctuate with and compensate for inflation. Did you get all that? Perhaps an example will better illustrate how TIPS work in practice.
Say you own $10,000 of TIPS, trading at par (bond speak meaning equal to its face value of $1,000/bond), with a stated annual coupon rate of 2% (paid semiannually at 1%). Thus, these TIPS will pay $100 every 6 months when the principal value is $10,000. Now assume that the rate of inflation is 4% (2% on a semi-annual basis) as reflected by the CPI. The principal value of the TIPS will increase to reflect the “official” inflation changes and then pay interest based on their coupon rate multiplied by the updated value. In this case, your bonds would have an inflation-adjusted principal value of $10,200 after 6 months (2% higher than the previous period) which is then used as the basis for computing the interest due. In this case, you would receive $102 (1% x $10,200), magically protecting your purchasing power by neutralizing the 2% semiannual increase in inflation. Taking it further, if inflation continues to trend higher at the same 4% rate (2% semiannually), the inflation-adjusted principal at the end of the first year would be 2% higher at $10,404 ($10,200 x 1.02%) and the corresponding interest payment in would increase to $104.04. Simple enough, right?
However, while TIPS are particularly useful in an inflationary environment, they do not provide the same level of safety in the event of deflation (a fall in the price index). With I-bonds we noted that the interest rate paid will never fall below 0% nor will the holder give up any previously accrued interest. In the case of TIPS, however, there is nothing stopping the principal value of the bond from falling below its $1,000 par value prior to maturity so holders of TIPS assume a greater (albeit still very low) level of risk than they would with I-bonds.
Looking again at our original example, let’s now see what happens in a deflationary environment. We’ll flip the numbers upside down and use a deflation rate of -4% (-2% semiannually). Starting with the same $10,000 face value, at the end of 6 months, the deflation-adjusted principal value of the TIPS would fall to $9,800 (2% lower than where we started). Further, the interest received would be just $98, less than the $100 originally received, though theoretically still providing the same purchasing power. Adding insult to injury, if you were to sell this bond before maturity you would lose $200 of principal resulting in a $102 loss on your original investment ($9,800 sales proceeds + $98 received in interest). Note that if and when inflation was to return, the principal value of TIPS and the corresponding interest payments would begin to adjust higher and continue to provide inflation protection. However, if deflation were to continue, the principal value of your bonds would continue to adjust lower.
The remaining similarities and differences between TIPS and I-Bonds are simple though notable.
Taxation: Like all government bonds, TIPS are subject to federal income tax while being exempt from state and local taxes. Interest payments from TIPS (as well as increases in the principal value due to inflation adjustments) are subject to ordinary income tax rates in the year they occur (even if the TIPS haven’t yet matured). Conversely, if the principal value decreases in a given year, it may be deducted against interest income for federal tax purposes. In the case of either a principal increase or decrease, the TIPS’ taxable basis is also adjusted higher or lower. This is a notable difference compared to the tax considerations for I-Bonds in which interest accrues over the life of the bond with taxes deferred until maturity (and potentially avoidable if the proceeds are used for qualified education expenses in the year they are redeemed).
Liquidity and purchase limits: TIPS are liquid, marketable securities and are actively traded on secondary exchanges. They can be purchased at auction, through TreasuryDirect.gov, or through banks, brokers, and dealers. Further, TIPS have very high purchase limits of up to $5 million at issue, per security, per auction. This means a person could conceivably purchase $5 million each of 5-, 10-, and 30- year Treasury TIPS in a single treasury auction (held regularly). Practically speaking then, there is almost no limit to the volume of TIPS a person could accumulate, provided they have the funds to do so. Compare this to the low $10,000 per person annual limit on I-bonds (with an additional $5,000 allowable amount if purchased via tax-refund).
Value at maturity: Even though the principal value of TIPS can be adjusted lower during the life of the bond, their value at maturity is the higher of their inflation adjusted principal value or their face value. Thus, an investor who purchases TIPS at issue and holds to maturity is guaranteed not to lose money on their investment. With I-bonds, a holder simply needs to hold the bonds for 12 months before they can be redeemed, and with no risk of loss of principal (though keep in mind that I-bonds redeemed within 5 years must forfeit the last 3 months of interest).
One final important point. Please do not confuse individual TIPS bonds with exchange-traded funds (ETFs) that hold TIPS–they are not the same thing. While these funds do invest in TIPS and can provide a simple and convenient way to add TIPS exposure to an investment portfolio, they are structurally more complex and also have underlying management fees that increase their cost of ownership. Further, since their holdings are diverse and are in a constant state of flux, these ETFs do not have a defined maturity date so investors can lose money holding them.
So, are TIPS better or worse than I-Bonds? Not necessarily either, they’re just different, and an investor should assess his or her goals and objectives against the benefits and limitations of each kind of bond to make sure they are Investing Smart. Check out TreasuryDirect.gov for more information on TIPS and I-Bonds.
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