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Can't say I didn't warn you.
Overcapacity and I-Bonds
The I-Bond rate resets on May 1st. The bonds currently pay a locked in rate of 0.7% above the CPI, tax deferred for up to 30 years. That's good enough for me in this environment. I have this sinking suspicion we'll be seeing 0.0% above the CPI at some point. What's my reasoning?
1. We've already seen it once (May 2008).
2. The "smart" economists want negative real interest rates.
The difference between 0.7% and 0.1% might not seem like all that much, but over the life of 30 years, that's actually a 20% difference.
Here's hoping the economy improves by November 1, 2010. That's looking to be the next time I buy I-Bonds (rates reset each May and November). Only so many can be purchased in any given calendar year. I'm done for 2009.
Rates on TIPS (Treasury Inflation Protected Securities) are much more desirable right now (by comparison anyway), thanks to the sell off in treasuries that's happened recently. Barring hyperinflation, that would seem to be the better bargain for those worried about inflation picking up.
Here's some updated charts on how the 0.1% I-Bonds currently stack up against the 1.74% 10 Year TIPS. It's all about tax brackets and expected inflation.
The charts assume holding the tax deferred I-Bonds the full 30 years to maximize their tax efficiency and reinvesting TIPS and the interest the full 30 years as well (under the assumption that the TIPS interest rate of future reinvestments remains constant).
As you can see, there's almost no situation where 0.1% I-Bonds are a good deal (although during a severe deflation they are as good as cash which is a very good deal). You'd be way better off hoarding toilet paper and socks if you are worried about future inflation. At least you wouldn't have to pay taxes on the gains (assuming you didn't resell them, but simply consumed them over the years).
The TIPS situation is much better long-term, but only if inflation doesn't really pick up. Heavy inflation hurts us three ways with TIPS. First, the investment isn't tax deferred. We get hit each and every year with taxation. Second, heavy inflation gives the government more to tax. Third, heavy inflation could force us into higher tax brackets. Note that it is a fairly good deal if we aren't taxed though (see the 0% rate line). That makes TIPS pretty good for tax deferred retirement accounts (we'd still pay serious tax when we withdraw, but at least we wouldn't be nickeled and dimed each and every year we own them).
That being said, if inflation protected TIPS end up being a really bad deal in non-retirement accounts because inflation picks up, then picture the damage that would be done to treasuries that aren't inflation protected. Ouch! Further, if the 1970s are any indicator the stock market won't keep up with heavy inflation either. That's why I have money in TIPS even outside my retirement account. As seen in the chart, it's not exactly a safe haven if we hyperinflate though.
This last chart shows the break even point between TIPS and I-Bonds at their current rates. Coming up with good estimates on future tax brackets and CPI inflation are extremely important in deciding which is the better value. Generally speaking, TIPS are currently the better value if inflation stays under 6% though, no matter what your tax bracket is. In the 25% tax bracket, inflation would have to average ~8% to make I-Bonds the better deal (and even then you'd lose money, as seen in the first chart).
It's really hard to see any value in 0.1% I-Bonds. If you pay any taxes at all, they are guaranteed to lose if held the full 30 years. They say gold doesn't pay interest or dividends. Well, I-Bonds now only pay 0.1%. However, there is some value. I-Bonds don't just offer inflation protection. They have deflation protection too. I-Bonds cannot earn negative interest rates. That makes them as good as cash in a deflationary environment (like one we are currently in). It clearly isn't cheap to insure against both inflation AND deflation, but that's what I-Bonds do to some degree and that's one reason I have liked them so much in the past.
TIPS also have deflation protection, but it isn't as good as I-Bonds. I-Bonds can never go down in nominal value. TIPS can. However, if you buy TIPS directly from the government you are assured that when they mature you will at least get face value. When I first started buying TIPS, I didn't think that would be important. It might be though, if we can't break free of this deflationary mess.
Please don't just blindly trust the math in my charts. I've made every effort to be accurate, but I'm not perfect. You can certainly recreate them on your own if you feel that the information is useful. This is NOT investment advice.
4 comments:
S-Mark,
Could you provide some insight on how these Inflation-protection plays might work out within a tax-deferred savings account such as an IRA or 401(k)?
I have been pondering swapping into inflation protected assets in my company-sponsored plan (from "cash", aka money market fund), but don't have a good feel for how such an investment might work out within the realm of tax deferred account.
We have a mysteriously good deal in Britain at the moment. Index-Linked Savings Certificates underwent two new issues on April 29th. They pay a rate of 1% per annum above Retail Price Inflation, tax-free, for three years or five years. If RPI becomes negative, as it is at the moment, then you still get 1% per annum nominal. If you cash them in early there is a penalty. In the first year you get your cash back, with no interest; after that you get RPI plus a boost that's a bit less than you'd get if you held them to maturity. The only downside is that you are betting that the United Kingdom government will not default. As these certificates are held by individuals, i.e. voters, that's a decent bet.
Anonymous,
My IRA is sitting in TIP.
http://us.ishares.com/product_info/fund/overview/TIP.htm
As of 4/30/2009, the real yield was 1.85%.
That means that it grows 1.85% over inflation (as seen in the CPI-U). The fund has 0.2% operating expenses, so that 1.85% is closer to 1.65%.
Normally, I'd have to pay tax on the distributions that the fund makes each year (the 1.65% growth and the tax on the amount the underlying TIPS bonds appreciate since they are inflation protected). Since they are in an IRA, the distributions stay within the IRA and remain tax deferred though. I've setup a dividend reinvestment plan to use those distributions to reinvest in more shares of the fund itself. That allows the profits to compound.
I'm ~45 years old. If I kept doing this until age 70 say, that would be 25 years of compounding.
At that time I'd be forced to start cashing it out. Since I haven't paid tax on any of the fund, it is all taxable. 25 years of 1.65% growth is roughly a 50% real inflation adjusted gain. Subtract off 1/3rd in taxes (assuming a 33% tax bracket), and you are left with your original investment back (adjusted for inflation). Although it doesn't sound all that great, it would still be quite the accomplishment if inflation crept up to 10% or more. Investors embracing safety did not fare nearly so well in the 1970s.
So now let's compare to what that fund does outside of a retirement account with 10% inflation.
It pays 1.65% over inflation (after fees). That would mean you are getting an 11.65% return each year. That's not bad. However, you have to pay tax on it. That 11.65% becomes 7.77% after taxes. If inflation is 10% and you are only getting 7.77%, then you are losing 2.23% per year in real terms. 25 years of losing 2.23% amounts to a loss of 43%. Ouch. It gets even worse if inflation is higher. The higher inflation goes, the more tax you'll have to pay on the inflationary gains (each and every year). In theory, the gains could be so great (serious hyperinflation) that you'd have to pay 1/3rd of your entire fund in taxes each year. It wouldn't take many years of that before you had nothing left. That's why being able to defer the taxes is so important. The taxes would only hit you once, and not every single year.
There's one more thing to keep in mind. If inflation does start to pick up again, I would expect that 1.65% rate that it is currently paying to drop (as more people buy TIPS for safety). That's great news in the short-term if you already own the fund (since the fund goes up in price), but is awful news long-term (since the lower real yield makes it harder to keep up with inflation long-term).
Overall, at least for me, the awful news trumps the great news. I'd prefer people stayed out of the fund, since that's where I want to be long-term. I'd also prefer tame inflation going forward. I'm not all that optimistic seeing 0.1% I-Bond fixed rates though, I'll tell you that.
dearieme,
"The only downside is that you are betting that the United Kingdom government will not default. As these certificates are held by individuals, i.e. voters, that's a decent bet."
Yeah, that's yet another reason why I like I-Bonds so much, or at least did before they killed off the interest rate. It also concerns me greatly that the government reduced the maximum I can buy each year from $30k to $5k ($10k if I buy both paper and online). The conspiracy theorist in me thinks the government might know it actually has to honor I-Bonds long-term. How else do you explain restricting the purchase of 0.1% I-Bonds (which are already nearly guaranteed to lose money for the investor as seen in my first chart).
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