Thursday, August 12, 2010

TIPS vs. I-Bonds

Here's what we can expect to earn on 0.2% I-Bonds purchased today if we hold them the full 30 years.



Even though I-Bonds have inflation protection we really don't want to root for inflation. The higher the average inflation rate over the period, the less purchasing power we will ultimately have. It tends to taper off at higher inflation rates though, since nearly all of the bond's worth is based on the inflationary gains and we are only taxed the one time.

Here's how that works out per year.



Here's what we can expect to earn on today's 1.05% 10-Year TIPS held outside a retirement account (and reinvested at 1.05%). Unlike I-Bonds, TIPS are not tax deferred. This can cause substantial pain for those in high tax brackets if inflation moves higher.



In the 35% tax bracket, annual inflation as little as 2% will create a loss of purchasing power. 20% inflation would create serious pain due to the taxation of the inflationary gains each and every year. For those in the 15% tax bracket, it takes an inflation rate of about 6% before purchasing power is lost though.

Here's how that works out per year.



The following chart shows the break even point between TIPS and I-Bonds based on tax rate and average inflation rate assumptions.



In the 35% tax bracket, 0.2% I-Bonds held 30 years are superior to 1.05% TIPS held outside a retirement account if inflation averages over 4.5%. In the 15% tax bracket, it takes an average inflation rate of roughly 8% before I-Bonds become superior.

To add insult to injury for holders of TIPS, higher inflation rates would also tend to push us into higher tax brackets as we earn more and more inflationary based income. In my opinion, for those worried about future inflation, I-Bonds generally offer better protection for money held outside tax deferred retirement accounts. That's probably one reason that the government clamped down on I-Bond purchases in 2007.

December 3, 2007
Annual Purchase Limit For Savings Bonds Set at $5,000

The reduction from the $30,000 annual limit in effect for both series since 2003 was made to refocus the savings bond program on its original purpose of making these non-marketable Treasury securities available to individuals with relatively small sums to invest.

Who is buying that reason? Alan Greenspan stated in 1966 that "The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves." I am fortunate that I was able to get many of my horses out of the burning barn before the doors were closed. Let's just put it that way.

I-Bonds also offer superior deflation protection since they can never drop in value. Any inflationary gains they receive are always locked in place. They can never deflate. The reason is that I-Bonds appreciate each month based on an interest rate tied to the CPI. That interest rate can never be less than 0% though. This effect is not shown in the charts above. It is an added bonus for I-Bonds.

TIPS offer limited deflation protection, as we are only guaranteed to get our original principal back. If TIPS inflate up, then they can deflate back down.

Holders of TIPS and I-Bonds should NEVER root for inflation. It may hurt us less than those without inflation protection, but it does still hurt us.

As a side note, I am still bracing for more deflation. As a saver and holder of TIPS and I-Bonds, deflation does not scare me. The government can't tax inflationary gains that don't exist.

This is not investment advice. I am not a financial adviser. It is something I factor in every time I make a TIPS or I-Bond purchase though. Nearly my entire life savings sits in I-Bonds and TIPS. They are not a safe store of value though. Nothing is. I simply consider them safer than the alternatives.

There is no safe store of value. - Alan Greenspan, 1966

3 comments:

  1. Back in the day, say 2004, I bought savings bonds for my kid. I bought the old variable interest bonds, thinking that interest rates were more likely to go up than the fixed rate ones, or the i-bonds...

    Oh well.

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  2. Anonymous,

    If it is any consolation, when I turned bearish in 2004 I thought 25 years of falling interest rates and falling inflation rates would come to an end at some point. We just keep sliding though, at least so far.

    I can say that the current 0% yield on the 5-Year TIPS is pretty much done falling though.

    I just hope that somebody in power understands that rates will someday be MUCH higher if we keep running trillion dollar deficits. Those higher rates may come without much warning, much like the last straw that breaks a camel's back. Sigh.

    The CPI comes out soon. The consensus is 0.2%. Briefing.com expects 0.1%. I'll guess 0.2% and save my deflationary thoughts for a second half slowdown and a questionable Christmas.

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  3. I think she is still guaranteed the face value, though, so that is not so bad.

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