I-Bonds article series:
- I-Bonds (you know, like how “Star Wars” is the first installment of the “Star Wars” series)
- Are I-Bonds the Fabled “Free Lunch”?
- I-Bonds vs. TIPS: Compare and Contrast
As we discussed in Part 2 of in this series, the U.S. government issues two different types of bonds whose payout is tied to inflation. If this seems like overkill, bear in mind that this is the same federal government that has about fifty different law enforcement agencies. And just like the Federal Bureau of Investigation’s raison d’être differs somewhat from that of the Railroad Retirement Board Office of Inspector General (or so I assume), so too do Series I Savings Bonds (“I-Bonds”) and Treasury Inflation-Protected Securities (TIPS) have different pros, cons, and use cases.
In this article, we lay out some of the similarities and differences between I-Bonds and TIPS, and we intersperse color commentary for…well…color. (For a rather dry but vastly shorter tabular comparison of the two instruments, head to this link at TreasuryDirect: https://www.treasurydirect.gov/indiv/products/prod_tipsvsibonds.htm. If that isn’t sufficient to ameliorate your insomnia, try clicking the “Learn More about Entity Accounts” link on that page!)
For a four-paragraph sorta-kinda summary, you can also skip to our final thoughts.
Inflation and Interest
I-Bonds act like a government-issued savings account. Your account balance never goes down. It accrues interest monthly. The interest rate is a combination of a fixed rate (a sub-exciting 0% for current I-Bonds purchases) and a variable inflation rate (starting off at a super-exciting 9.62% annualized for current I-Bonds purchases, through October 2022). On the off chance the trailing six-month (see below on “Inflation Accrual Lag”) inflation rate was negative, the total interest rate for the next six months (including the fixed rate, if it’s above zero to begin with) can be reduced, but only to a minimum of 0%.
Relative to a savings account, there are some differences in how I-Bond interest accruals work:
- I-Bonds purchased at different fixed rates continue to have different fixed rates over time. For example, anyone holding an I-Bond purchased at the record-high 3.6% fixed rate in mid-year 2000 is receiving 3.60% + 9.62% = 13.22% annualized interest on those bonds right now. Congrats, whoever you are!
- In savings accounts, interest is typically compounded daily, monthly, or quarterly, but with I-Bonds it is compounded semi-annually. For example, if someone purchases $10,000 in I-Bonds this month, it will accrue $10,000 * (9.62%/12) ≈ $80.17 per month for the next six months. Then it will compound (i.e., the interest will be converted to principal). Then the account will start accruing at the new monthly rate (derived from the inflation rate) on a base of the original $10,000 plus $10,000 * (9.62%/2) = $481, or $10,481 total. [EDIT 11/28/2022: While the foregoing is “close enough” for our purposes here, the precise formula for inflation accrual turns out to be rather more complicated–are you shocked?–as is explained in this excellent article from David Enna’s always excellent “TIPS Watch” website.]
TIPS act more like other types of bonds. They are issued with a pre-specified maturity date and face value. In other words, the bond promises to pay back a predetermined dollar amount (the “face” or “par” value) on a specific maturity (think “expiration”) date in the future. TIPS also make coupon payments twice per year, at a fixed percentage of face value, up until maturity.
The difference relative to “normal” bonds is that the face value changes over time. Every day, the face value of a TIPS bond increases—or decreases, if trailing inflation was negative—by an amount determined by prior changes in CPI-U. Since the coupons are a fixed percentage of then-current face value, this mechanism ensures that the coupon payments adjust with inflation as well. (Side note: In the unlikely event inflation is negative over the full life of the bond, it will pay the original face amount at maturity instead of the deflation-adjusted face amount.)
As detailed in Part 2, TIPS are marketable securities, so their prices are set by the market and will vary up and down prior to maturity. Thus, a TIPS bond promises a risk-free (i.e., government-guaranteed) real (i.e., inflation adjusted) payout only at maturity. Returns in the meantime will vary due to changes in market-derived real interest rates (think of this as the changing present cost of future real income) and may not even track inflation particularly closely day-to-day, month-to-month, or even year-to-year. This is why, when Round Table builds TIPS-based inflation-protected income for clients, our default method is to purchase a “ladder” of TIPS of varying maturities, to “lock in” the inflation-adjusted principal value across maturity dates (think “income dates”), as we described in our article on the subject.
This admittedly confusing concept points to one of the major axioms in the field of “lifecycle finance”: In a portfolio of marketable securities, you can have safe asset value or you can have a safe stream of future income, but not both!
- For safe asset value, an investor can hold something like cash or short-term Treasurys. The cash value won’t decline, but the amount of future income it can expect to produce may vary wildly with changes in interest rates.
- For safe income, an investor can buy a Treasury bond ladder. The cash value of the ladder can vary wildly with changes in interest rates, but the amount of future income it can expect to produce will be very stable.
- For an added wrinkle, an investor can use TIPS to build that ladder, to make future income safe in real dollar (i.e., inflation-adjusted) terms.
For more information on this topic, see the sidebar called “The Real Meaning of Risk in Retirement” in Nobel laureate Robert Merton’s “The Crisis Retirement Planning” article in the Harvard Business Review.
The non-marketable nature of I-Bonds (as noted in Part 2) produces a rather remarkable exception to this rule. I-Bonds don’t ever lose value in the present, yet if you want to designate them for inflation-protected future income over any timeframe between 1 and 30 years, they can produce that for you as well. And unlike with TIPS, you don’t have to decide in advance what maturities (i.e., what income-producing dates) to lock in.
The problem with this is that if you want to generate a substantial stream of future income, you’ll have to get started accumulating I-Bonds years earlier, since the amount of I-Bonds that can be purchased each year is limited. This is a major reason why Round Table uses TIPS rather than I-Bonds to build a portfolio for retirement income. Which brings us to…
With some exceptions, I-Bonds purchases are limited to $10,000 per person per year. Among the exceptions:
- If someone is due a tax refund, they can direct up to $5,000/year of the refund into I-Bonds via their tax return, increasing their personal limit to $15,000 total.
- I-Bonds can be gifted to others.
- Individuals can buy I-Bonds in “Minor Linked” accounts that they direct for their minor children, but any money so directed belongs to the child, not the adult. (Nothing in our articles is ever personal financial advice, but, like, maybe don’t plan to raid your kids’ inflation-protected piggy banks?)
- There are those “Entity Accounts” we chatted up in Footnote 2.
Regardless, there are decided limits on annual I-Bond accumulation, and for convenience we’ll stick with the nice, round $10,000 figure henceforward.
With TIPS, there are no limits to how much an individual can purchase on the secondary market (which is, for example, how Round Table would buy TIPS in client accounts). Technically there are limits on the quantity of each individual TIPS bond a person can buy through the Treasury’s initial auction, but we’re talking about a range in the neighborhood of a thousand annual I-Bond limits’ worth.
And even if those limits applied in the secondary market, which they don’t, they still apply per individual bond, so if you’re building, say, a 30-year ladder, that would be…you can do the math. The point is, for most practical purposes (for humans if not institutions), TIPS acquisition is unlimited.
We’ve seen a few financial advisors publicly disclaim I-Bonds due to the $10,000 annual limit. Or they view it only as a tool for younger investors with less money and more years to accumulate, but not for affluent (near-)retirees.
While we understand that viewpoint, we might humbly propose a different take: If, say, a $6,000-$7,000 annual limit doesn’t prevent someone from recommending Roth or Traditional IRAs, then perhaps a $10,000 limit shouldn’t proscribe I-Bonds either, for the same ultimate reason: Even an incremental benefit is still a benefit.
We have found that even quite affluent folks have been rather happy with us for alerting them to I-Bonds’ existence. Even if it’s just a parking spot for emergency fund dollars, current interest rate differentials vs. savings accounts are mighty attractive. (Provided, of course, that someone can restrict the dollar value of their emergencies in the first 12 months to $10,000 less than the amount they’ve fully funded, given the 12-month I-Bond redemption restriction.)
That said, as already noted, TIPS are our weapon of choice in assembling a larger portfolio (e.g., to produce an inflation-protected stream of income), and this is a major reason why. This allows for sizable upfront allocations—though we can also propose a glidepath approach—and it allows for modifications over time in sizing and timing, if desired. (Again, none of this is personal investment advice, which Round Table can only offer through one-on-one collaboration. Please feel free to contact us if you would like to discuss your financial situation.)
One last oddity of note: The purchase limit on I-Bonds is 10,000 nominal dollars per year. Consequently, the inflation-adjusted amount that you can buy of this inflation-protected instrument declines each year by the rate of inflation. Go figure!
Inflation Accrual Lag
Barring the power of clairvoyancy (which might best be put to different uses anyway), it is impossible to design a product that adjusts with inflation while that amount of inflation is occurring in the economy. Rather, some amount of time is required to measure the changes in prices for products and services, compile that information into a CPI calculation, and then structure a bond’s payout to match the measured change in CPI. The result is inevitable lag between inflation itself and the accrual of inflation adjustment in TIPS and I-Bonds.
For I-Bonds, the lag is rather interesting, even upwards of extreme, albeit somewhat at the purchaser’s discretion. We’ll use the current 9.62% rate as an example. The change in CPI-U for the six months from October 2021 through March 2022 was 4.81% (i.e., half of the annualized 9.62% figure). The last monthly measurement, for March, came out in April. This enabled the government to announce 9.62% annualized as what we’ll call the “May rate.”
The May rate began accruing in May for I-Bonds that were purchased in May (not just this May, but any prior May) or November (i.e., any prior November). However, the May rate began accruing in June for I-Bonds purchased in June or December. And in July for I-Bonds purchased in July or January. And so on out to October/April, per this table from TreasuryDirect. Once the May rate takes effect, it continues in effect for six months, after which the analogous “November rate” kicks in.
This means someone can still lock in the 9.62% annualized “May rate” for 2022 if they purchase I-Bonds as late as this October. In that case, they will accrue that rate all the way through to April 2023—a full 18 months after the earliest month (November 2021) whose inflation contributed to the calculation of the “May” rate.
TIPS inflation accruals are almost clairvoyant by comparison, with a lag only about two months. For example, inflation for the month of July was announced in August, and TIPS “index ratios” (the numbers used to calculate the changes in face value over time) will accrue the July inflation rate in September.
Admittedly the words “upwards of extreme” may represent an interpolation of “commentary” into the “facts” section on accrual lags. But there’s an even wilder observation to make down here:
The abnormally verbose (even for me) Footnote 10 in Part 2 claimed that lag differential between I-Bonds and TIPS should mostly even out over time. I stand by that assertion in general, especially for long holding periods. But for the month of September, the differential in inflation accrual between I-Bonds and TIPS has got to be a record.
First off, inflation for the month of July (stand-alone) was 0%. Actually, it was ever so slightly negative, with CPI-U coming in at about -0.01%, or -0.1% annualized. Consequently, I-Bonds on the “May rate” schedule (see above) will accrue a 9.62% annualized inflation rate in September while TIPS will accrue a -0.1% annualized inflation adjustment at the same time! Holy smoke!
Now, for anyone who bought I-Bonds and TIPS in the past, that seemingly huge differential in I-Bonds’ favor is just a relic of the fact that your TIPS already accrued the 4.81% inflation that landed in the months of November through March, so by steady-state reckoning this is really “advantage TIPS.” But for anyone presently contemplating the purchase of one or the other, the option with I-Bonds to grab yesterhalf’s inflation rate looks awfully appealing at the moment.
Acquisition and Disposal
Aside from the tax refund trick, I-Bonds can only be purchased through the “TreasuryDirect” website (www.TreasuryDirect.gov).
While the amount of I-Bonds that can be purchased is limited (see above), there is no cost—beyond TreasuryDirect-induced grey hairs (see below)—to purchase them. But then they cannot be sold for the first twelve months. And if they are sold within the first five years, the last three months’ worth of interest accruals is forfeited. After five years, there is no cost to redeem I-Bonds.
As I may have mentioned previously (ha!), TIPS are marketable securities. They can be purchased in brokerage accounts just like other bonds, stocks, or funds. They can be sold back into the market at any time in the same manner. The buyer will incur trading costs (commissions and/or spreads) in both directions, but these costs should be minimal. If TIPS are held to maturity, there should be no cost to receive the final disbursement (or, for that matter, the coupons along the way).
This also means previously issued TIPS are available on the secondary market, which increases the range of maturities available to buyers. The Treasury issues TIPS with maturities of 5, 10, and 30 years, but because you can buy “off-the-run” older TIPS, you can grab maturities of less than 5 years (even less than a year) or almost anything in between 5 and 30 years.
Since basically any brokerage accounts are fair game for holding TIPS, they become part of the conversation about so-called “asset location”: I.e., should TIPS be held in taxable accounts, tax-deferred accounts, Roth-style after-tax accounts, etc.? You’ll be shocked to learn that we think this is a question with no single best answer, and that we’d be happy to have a discussion with you about your personal financial situation, including our thoughts on asset location.
With I-Bonds, on the other hand, the options are limited to paper bonds from a tax return or an account at TreasuryDirect. The scuttlebutt is that the Treasury Department is in the process of updating the TreasuryDirect site, but in the meantime…well, let’s just say we might view part of that 9.62% interest rate as government penance for making us navigate TreasuryDirect. This also means you can’t hold I-Bonds in IRAs or other tax-privileged accounts, but that’s okay because I-Bonds themselves are tax-privileged. Speaking of which…
First a caveat: Nothing in our articles is ever tax advice! (Note the emphatic exclamation point!) Consult your CPA!
*Phew* With that off our chest, here is the basic idea:
With I-Bonds, taxes are owed, at ordinary income tax rates, on all interest accruals (fixed rates—if nonzero—plus inflation rates). However, taxes can be deferred until the year the I-Bonds are redeemed. Or they can be paid annually if there is some reason to prefer that. There is also a potential option to eliminate some or all the tax burden if I-Bond proceeds are used to pay for qualified educational expenses.
With TIPS it is all a bit more complicated, assuming they are held in a taxable account. Ordinary income tax rates still apply on interest and inflation accruals. Taxes are owed annually, not deferred to the end. There are three components to the annual tax calculation:
- The semi-annual coupon payments are taxable.
- Inflation accruals on face value (assuming they are positive) are taxable, even though they are not paid out to the investor as cash. This is the infamous “phantom income” (ooooh, spooky) on TIPS.
- If the bond was bought at a “discount” (i.e., for less than the bond’s face value), a complex formula effectively increases the amount of interest accrued annually on the bond. If the bond was bought at a “premium” (i.e., for more than the face value), investors are allowed to employ a similarly complex formula to effectively decrease the amount of interest accrued on the bond. In either case, you can think of these formulas as narrowing the gap between the coupon payment and the “true” interest rate at which the bond was purchased.
If TIPS (like other bonds) are sold before maturity, a capital gain or loss will likely be incurred as well, depending on the sale price.
One nicety, though: Since they are U.S. Treasury securities, both TIPS and I-Bonds are exempt from taxation at the state level.
Okay, so I-Bonds clearly have better tax treatment, since you can defer payment until redemption. Got it.
But about that phantom income… Think about it this way: If someone chooses to be one of those people who want to pay taxes on I-Bond accruals, they will pay taxes on both the fixed rate of interest (if it’s positive) and the inflation rate of interest. Similarly, items 1 and 3 above mean a TIPS investor pays taxes on the “real rate” (analogous to a fixed rate) of interest, and item 2 means the investor also pays taxes on the inflation accruals (analogous to I-Bonds’ inflation rate of interest). Either way, you’re essentially paying taxes on the same stuff!
Yes, you say, but I don’t have to pay taxes on I-Bonds every year, and it’s annoying to pay taxes on stuff I’ve accrued (i.e., face value increases on TIPS) but that hasn’t been paid out to me. Okay then, think about it this way: As we explained here and here, interest rates on nominal (i.e., non-inflation-protected) Treasury bonds can be decomposed into a real interest rate component, a component for the market’s expectations for future inflation, and (presumably) a little bit extra in the form of an inflation risk premium. But you pay taxes on the whole nominal interest enchilada, not just the tortilla (beef? cheese? hmm…bad analogy) portion that matches real interest rates.
For an impressive, if excruciatingly detailed, treatise on this subject, see “Are Treasury Inflation Protected Securities Really Tax Disadvantaged?” by the Federal Reserve Bank of Atlanta. Phantom income just makes taxation on TIPS more-or-less equivalent to taxation on other Treasurys. If someone winds up paying a lot more taxes on TIPS than they would have on nominal Treasury bonds, that will probably be because inflation turned out to be a lot higher than expected, and TIPS protected them a lot more than nominal Treasurys would have!
Also on the topic of income that is “paid out” by a bond vs. income that isn’t: As we’ve noted repeatedly, if anything it is really the coupon payments on TIPS that are a minor annoyance, not the inflation accruals!
Notably, this still leaves open the question of what type of brokerage account is best for holding TIPS. To which you already know our (non-)answer.
I-Bonds have some notable advantages. In my opinion, the single biggest advantage to I-Bonds is the fact that their principal value does not fluctuate, thanks to their nature as a non-market-traded direct agreement between the purchaser and the U.S. government. This creates flexibility in the use case for I-Bonds since you can redeem them for principal-plus-interest any time between one and thirty years after purchase. TIPS, conversely, fluctuate with the markets, and it is only at maturity that an inflation-protected payout is fully realized. Consequently, if low-risk inflation-protected return and/or income is the goal, care must be taken with TIPS maturity selection.
However, the biggest advantage to TIPS is that an investor can accumulate a sufficiently large portfolio to accomplish any relevant goal at whatever pace is desired. The individual limit on annual accumulation of I-Bonds distinctly reduces the range of potential use cases.
If inflation is a concern, if future income is a need, or if you’re not sure what to think about all this stuff, we encourage you to reach out to us to have a conversation about your personal financial situation.
 Okay, the whole “Entity Accounts” thing is kind of interesting. The gist is that if a legal entity (corporation, estate, etc.) has its own tax ID but a single individual has decision-making authority over it, the individual can purchase I-Bonds for the entity, effectively adding another $10,000/year of I-Bond buying power.
 Rather frustratingly, you’ll have to take the government’s word for it. Logging into a TreasuryDirect account after six months, the home page will show only the original purchase amount (e.g., “SAVINGS BONDS $10,000”). After clicking on the “SAVINGS BONDS” link, a table shows the “Amount” as the original purchase amount, and “Current Value” as…something noticeably less than the amount of interest you thought was accruing. This is because the website is showing what you would get if you redeemed the bonds now, which would incur a 3-month interest penalty. (That is, if they could be redeemed at all, which they can’t, because there’s a 12-month lock-up and this example is after just six months.) I emailed the folks at TreasuryDirect to ask why they don’t also show the total accrued interest, and their response was, and I quote, “It would be too confusing for most people to see this full amount…” Yup, right, we don’t want to confuse people.
 In this article (and others), we (as do others) make the simplifying assumption that CPI-U represents the (or perhaps “a”) “true” inflation rate. Of course, every individual’s personal inflation rate is unique, varying by geography, consumption habits, time of life, etc. We’ll address this eventually, but not today. For now, we’ll only stress that we believe CPI-U is a decent approximation for “average” inflation for the “average” U.S.-based individual. In this article, we also gloss over the inherent lag between actual inflation and inflation accruals in TIPS and I-Bonds, except of course in those places where we do not gloss over it.
 Some analysts have noticed the low periodic inflation correlation of medium-to-long-term TIPS and concluded that short-term TIPS are a better inflation hedge. Notably, Vanguard made this mistake and incorporated it into the design of their target date funds. But short-term TIPS are only good for protection against unexpected inflation in the short-term. A persistent spike in inflation will simply reset inflation expectations and thus reset the cost to purchase short-term TIPS when you roll them forward. Medium-to-long-term protection against unexpected increases in inflation requires medium-to-long-term TIPS. Potential low correlation in the short-term is due to the market setting and resetting the cost of medium-to-long-term inflation protection. In this area, Dimensional Fund Advisors got it right with the design of their target date funds, and Vanguard got it wrong.
 As we also described in that article, the coupon payments complicate the calculus. In effect, each coupon is like a little mini-bond that promises an inflation-adjusted payout on its own unique “maturity” date (i.e., the coupon payment date). Thus, for example, a 30-year TIPS bond is a combination of a promise to pay out a big guaranteed inflation-adjusted amount in 30 years, plus 60 promises to pay out little guaranteed inflation-adjusted amounts every six months along the way. The value set by the market for the bond today accumulates the market’s opinion on the present value of all 61 of these promises.
 Unless short-term interest rates go negative, but this concept is complicated enough without introducing that, so I won’t. (Wait…)
 Or an annuity, but that’s a different topic altogether, and this concept is complicated enough without introducing that, so I won’t. (Wait…)
 Or rather, not an exception, since the rule clearly specified “marketable securities.”
 Which is to say $10 million, and even that isn’t a strict limit if you’re willing to make a “competitive bid,” in which case…who are you exactly, and why are you even reading this article?
 Or I can: $300 million. By the way, if you’re tossing that kind of scratch at a TIPS ladder, even a notoriously “safety-first” advisor like yours truly may begin to wonder if you’re being a tad bit too conservative with your portfolio choices. (Also, you can’t currently build a complete 30-year TIPS ladder, due to some missing maturity dates. We addressed this and discussed our solution—“duration matching”—in another article.)
 I mean, maybe. The superpower of real-time inflation protection sounds awesome to me.
 For reasons I cannot begin to guess, new monthly inflation accruals begin on the second day of a month. For example, the June inflation rate is applied to TIPS face values through September 1st, and then the July rate starts accruing daily on September 2nd.
 This fact has caused an astonishing and marginally comical quantity of confusion and consternation among pundits, politicians, etc. First, inflation rates are not generally reported as monthly figures. Rather, they are reported as trailing 12-month figures. This makes sense, because inflation (especially so-called “headline” inflation, which includes volatile food and energy prices) can be very noisy month-to-month, such that trailing 12-month rates give a much more stable and generally more sensible idea of “prevailing” inflation. However, this can also cause confusion, since each month’s inflation number is 11/12ths overlapping with the prior month’s inflation number. The only differences come from the old month that gets dropped off the back end and the new month that gets added to the front-end of the 12-month queue. Most recently that new month was a 0% inflation rate for July (due mostly to a sizable drop in energy prices offsetting positive inflation elsewhere). When added to the 8.5% cumulative inflation for last August through this June, this produced the 8.5% year-over-year inflation figure for July.
To be sure, the 0% “headline” inflation rate in July by no means implies a sudden disappearance of inflation, as indicated both by the 8.5% trailing 12-month rate and the still-elevated 0.3% month-over-month “core” inflation rate, a less volatile metric that excludes food and energy price changes.
 For I-Bonds still on last year’s “November rate” schedule, the differential is “only” 7.12% vs -0.1% annualized.
 There are some years in the 2030s for which the Treasury hasn’t yet issued TIPS maturities. See the section on “duration matching” in our previous article for a discussion on how we handle this in income-targeting TIPS portfolios.
 Even someone who receives paper I-Bonds via their tax return may be better off converting them to electronic form on TreasuryDirect. Think of it as a tradeoff between, “Why is this website so blasted complicated?” and, “Honey, when we moved last summer, did I put the I-Bonds in the safe or the attic or the glove box or…?”
 By the way, this is a subset of a more general harangue that I will undoubtedly memorialize in this blog someday, questioning the investing public’s evident predilection for investments that create tax liabilities by effectively handing back some of the value invested with them. I.e., dividends, coupon payments, etc. Stay tuned…
 Again, less three months of interest, if redeemed in the first five years.
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