Pssst. Want Some Hot TIPS? Buying Inflation Protected Bonds.

One of the blogs I read regularly is The Finance Buff.  This past week, he has posted four times on the topic of inflation-protected bonds, TIPS and Series I Savings Bonds.  As a result, I thought I’d post some pointers and comments here.

First, as I mentioned in my personal finance series, Series I savings bonds are an interesting option for an cash emergency fund.   Series I savings bonds have the following advantages:

  • After 12 months, you can cash them in at a moment’s notice.  Great liquidity.
  • You can buy up to $30K of them in any year.
  • You can buy them direct from the government with no fees at the Treasury Direct website.
  • You owe no income taxes at all until you sell them.
  • You never owe state or local income taxes on the gains, even when you do sell them.
  • You won’t owe federal income taxes on the gains if you use the money towards a qualified educational expense, like college tuition.
  • Your money is guaranteed to grow above the rate of inflation, re-adjusted every 6 months, for the next 30 years.  You are given a fixed rate above inflation, measured by the CPI-U index, which measures inflation in urban areas.

Right now, Series I Savings Bonds pay 1.4% + inflation.  Given that historically, money market funds have basically matched inflation over time, and bonds have only beaten inflation by about 1.7%, that’s a pretty good deal, by historical standards, for something that is at least as liquid as a 1-year note.

In any case, the Finance Buff doesn’t like the Series I Bond rate.  In fact, because inflation is so low, he sold his Series I Bonds in November, taking the 3-month interest penalty.

Instead, the Finance Buff likes TIPS, which are the inflation-protected version of normal US Government Bonds.  TIPS are offered in terms of 10 years and 20 years, and right now they are paying a whopping 2.63% over inflation!  Given that the historical return of bonds is below that amount, I can see why he likes them.

Unfortunately, TIPS do have a down side or two:

  • While you are paid the interest every year, the inflation value accrues every year to the bond principal.  What that means is that you owe taxes on the inflation gain every year, but you don’t get the cash to pay the taxes.
  • TIPS are only available in high dollar amounts.
  • TIPS, like other bonds, can be sold before maturity.  However, there is no guarantee of the price you’ll get if you sell them before they mature.  To guarantee your return, you have to hold them the full 10-year or 20-year period.

Here is a great post from the Finance Buff on TIPS.

I have to post this great snippet from his follow up article on pricing TIPS.  It’s fairly complex, but I love seeing the hard math posted for some reason.  Check it out:

I tip my hat to you, sir, for posting that.  🙂

In any case, I had to think about why I’m still such a fan of the Series I Savings Bonds.  I think it is because of the context that I use them – as a cash-equivalent emergency fund.  I’m not looking at them as a bond investment, but as a form of cash.

As I stated, cash equivalents, like money market funds, over time have returned an average of 0% over inflation.  So the idea of getting better than that on my “safety money” appeals to me.

That being said, the rates on high yield internet savings accounts, like Emigrant Direct, are well over 5% now.  With inflation as low as it is, that’s a serious yield also.  With no risk, money available at any time.  Government protected, even, up to $100K!  Hard to argue with that.

The problem is, there are penalties around selling Series I Bonds too early, and there are significant tax advantages to consider.  Interest on a bank account goes on your 1040 every single year, and is taxed at federal and state levels.  There is also no guarantee that these type of high-yield savings accounts will be around forever, although they’ve been pretty consistent over the past 5-7 years.

I’m lucky, because the Series I savings bonds I purchased in 2002 have a 2.0% premium over inflation, so they are paying a higher rate that the bonds you can buy today.  As a result, I’ll be keeping mine for a while.  Sometimes, like this period, they pay less than 3% interest.  Other periods, they have paid almost 8%!  In the end, to be comfortable with them, you have to be comfortable with earning a fixed amount over inflation over time, and leaving it at that.

You can find out more about TIPS and Series I Savings Bonds on the Treasury Direct website.