Which Are A Better Buy?

The CPI-linked savings bond isn’t all it’s cracked up to be. TIPS offer slightly better protection from inflation.

Personal-finance pundits love those I bonds. Suze Orman: “The No. 1 investment that every single one of you should have no matter what.” Burton Malkiel: “Absolutely superb.” Last month a stampede for these things crashed the TreasuryDirect website.

Contrarian view: I bonds are absolutely mediocre. They pay worse than marketable Treasury bonds, they clutter up your retirement portfolio and they are guaranteed to make you poorer.

The stampeding will no doubt continue, given the unpleasant surprise (8.6%) with the most recent inflation report. The bonds are indeed a better deal for long-term savers than any bank account. But they don’t do what their holders want them to do, which is to immunize savings from the dollar’s decay.

I bonds are savings bonds that pay a fixed interest rate plus a semiannual adjustment keyed to the Consumer Price Index. You buy these bonds after linking a bank account to Treasury’s clumsy website. Maximum purchase per calendar year is $10,000 per person ($20,000 for a couple). The bonds cannot be cashed in during their first 12 months; from then until the 60-month mark a redemption comes with the loss of three months of interest.

After five years an I bond can be redeemed without penalty. The buyer has the option to defer taxation until the bond is cashed in or matures, and usually that’s a smart thing to do. At maturity in 30 years the bond ceases to accrue interest. Interest on I bonds, as on all U.S. government debt, is exempt from state income tax.

The fixed rate on an I bond purchased today is 0% for the life of the bond. The inflation adjustment changes every six months and now generates an annualized 9.62%. That is, if you put in $10,000 now, you’ll be credited $481 of interest for your first half year.

In an era of crappy bank yields, a $481 semiannual coupon looks pretty good. But the 0% fixed rate means that, net of inflation, you are earning zilch. Moreover, even though you are just treading water in terms of purchasing power, you will eventually owe income tax on your putative interest. Allow for that tax and you find that your real return is negative.

Hypothetical example: You are in the 24% bracket, your principal balance is $10,000 and inflation is 10%. After a year, you have a balance of $11,000 but owe $240 in tax, to be paid now or later. The $10,760 that belongs to you buys less than $10,000 did the year before.

Understand what is going on. The government is running a deficit. It covers that in part by printing money to hand out and in part by borrowing from savers. The savers are made poorer with each passing year. Note that the tax collector and the borrower are the same entity, the U.S. Treasury.

This is a raw deal. You can do better—slightly better—by buying Treasury Inflation-Protected Securities, a.k.a. TIPS. The TIPS due in ten years pay a real return of not quite 0.4% and the ones due in 30 years pay a real return of not quite 0.7%. TIPS buyers must pay immediate tax on both their real return and their annual inflation allowances.

You can buy TIPS directly from Treasury at one of its periodic auctions, buy them second-hand from a broker, or—best for smaller sums—buy shares in a low-cost fund like the Schwab U.S. TIPS ETF. TIPS also deliver a negative real return after taxes, but it isn’t quite as negative as the return on I bonds.

The grim results are plotted in the two graphs below. The first graph assumes that inflation starts out high—8% over the first year, 5% over the second—and then slumps to a low level that brings the 30-year average in line with bond market expectations.

Further assumptions: The buyer is in a moderately high tax bracket, takes advantage of the tax deferral option available on the I bond and opts for a 30-year maturity when buying TIPS.

In this scenario the I bond’s tax deferral is worth something, but it’s not enough to overcome the 0.7% yield advantage that TIPS have.

What if inflation runs hotter? The second graph assumes inflation two percentage points higher over the next 30 years than what’s built into bond market pricing.

Here, the tax deferral enables I bonds, at the end of a long holding period, to run a tie with marketable TIPS. But this doesn’t mean an I bond holder should pray for high inflation. Higher inflation means more phantom income to be taxed away. With higher inflation, the depletion of wealth happens faster.

Besides the tax deferral, the savings bond has another advantage: It comes with a free put option. You don’t have to stay invested for the full 30-year term. Any time after five years you can hand in the bond for principal plus accrued interest.

If real interest rates rise, that option will be worth something. You could cash in the I bond, pay tax on the interest, and use the proceeds to buy long-term TIPS paying better than the current 0.7%.

But now look at the main disadvantage to I bonds. They are available only in small doses. If a $10,000 bond would be a large fraction of your net worth, this doesn’t matter. But if it’s a small element in a retirement portfolio, it will create financial clutter.

You are permitted to buy an additional $5,000 a year of I bonds if you overpay your income tax and take the refund in the form of a paper savings bond. That’s more clutter. Avoid it.

I bonds can’t be held with other assets at your broker. You have to maintain a separate TreasuryDirect account, with its own log-in and password. Any chance you or your heirs will lose track of this asset in the next 30 years? Think about this. Take note that the Treasury is sitting on $29 billion of matured and unclaimed paper savings bonds.

Pick your poison. No matter what the bond, the U.S. Treasury will make you poorer when you lend it money. The I bond assuredly beats bank CDs for long-term savings, but for prosperous investors the marketable TIPS probably make more sense.

We’re talking here about newly acquired bonds. If you are lucky enough to have bought I bonds years ago, when the fixed rate topped 3%, hang on to them until they mature.

The graphs of aftertax bond values assume an investor who is in the 24% bracket today and will be kicked up to the 33% when the 2017 tax law expires at the beginning of 2026; those rates would apply to a married couple now reporting $250,000 in taxable income. The bond market’s assumption about future inflation is taken as the yield difference between nominal and real bonds, minus a 0.1% allowance for a risk premium on nominal bonds.

For more on I bonds:

Tipswatch is a useful reference site.

The U.S. Treasury compares TIPS to I bonds here.

The Hazard With Those Savings Bonds: Lost And Found Department is a warning.