Subscribe to this BlogFighting inflation: I-bonds vs. TIPS
Investors who want to hedge against inflation while still earning a decent return on their investment got some unhappy news Friday: The U.S. Treasury announced that buyers of its Series I U.S. Savings Bonds – 30-year bonds whose returns are adjusted for inflation – will earn nothing on I-bonds issued between now and October 31 of this year. That’s right: nada, zilch, zip. This marks the first time that I-bonds have had a zero rate of return for any six-month period since I-bonds were created in 1998.
Blame inflation or the lack of it: Consumer prices have plummeted since the economy ground to a halt last fall and the U.S. remains mired in recession. The Consumer Price Index plunged 5.6% from September through March, according to the Treasury. I-bonds have two components: a fixed rate of return, which is 0.1% on newly issued bonds (down from 0.7%) and an inflation adjustment, which thanks to negative inflation wipes out the fixed return for the next six months.
Of course, low prices can be a good thing. Cheap gas, less costly heating oil and lower food prices ease some of the strain of the recession on consumer wallets. But longer-term, there are a lot of folks who are worried that the government’s massive spending to battle the recession will ignite inflation in the next few years and they want to hedge their portfolios against that scenario.
So, what should you do to protect your savings if you’re worried about inflation roaring back in the not too distant future but can’t stomach the thought of a zero return on an investment? If you already own I-bonds, hang onto them. Prices will pick up soon enough and you can wait out a six-month period of zero returns (rates on I-bonds are adjusted twice a year in May and November). Remember, you can never lose your principal investment in I-bonds. And if you do cash in your I-bonds and have held them less than five years, you’ll pay a penalty of three-months interest.
But if you’re looking for a way to hedge against future inflation and aren’t already sunk into I-bonds, Treasury Inflation Protected Securities, or TIPS are a better strategy now. As a good piece on Motley Fool points out, the real rate of return on I-bonds has been steadily declining over the past decade, as high as 3.6% but just 0.1% today. As my colleague Janice Revell points out in this video on TIPS, TIPS are historically cheap, yielding a real, after-inflation return of 2%. Not a bad return for an ultra-safe investment that can protect you against future inflation. You can buy TIPS directly from the Treasury so you don’t have to pay any commission. One tax consideration to keep in mind: You can defer interest on I-bonds for the life of the bond, which means you can earn interest for up to 30 years without paying income taxes on that interest. But the interest on TIPS is taxed every year, so you’re best off holding TIPS in a tax-deferred account like a 401(k) or IRA. – Donna Rosato
Yes if you've held an ibond for less than 5 years, you pay a three-month penalty. But if you wait until your rate resets (for my ibonds purchased in 2008, the rate reset in August), wait three months, and sell, you will incur no penalty because you incurred no interest. The fixed rate on my bonds is 1 percent which probably won't allow me to ever exceed inflation after taxes, so I'm probably going to dump the bonds once three months are up, and wait until the fixed rate is higher before repurchasing. I only own $10,000 worth so I'll be able to get back in when I want to without too much trouble…
Is it possible to buy TIPS bonds directly from the Treasury and hold them in a Roth account. Is there an easy procedure to accomplish such a move when you buy online?
D. Wentworth
Seattle, WA
At first I was really surprised that the feds set the rate to zero. Obviously, they are going to sell very few of these bonds during the next few months. But after thinking about it, I'm not so surprised.
There are two reasons I can think of for them doing this. The first is that they would have to set a fixed rate too high to get a positive return and since they did not want to do that for possibly 30 years, they decided to just set the fixed rate close to zero.
The other guess is that they believe inflation will be so high eventually, that they do not want too many of these bonds to be out there.
Folks…stop chasing Wall Street carrots……. only to be SCREWED again!
Just get out of TOTAL debt and just enjoy your life!
See how simple it is! This stuff is a CROCK!
Avoid it and be happy!
Luke, 529 distributions are not taxable, and are NEVER in the control of the "student". A 529 is always controlled by the "owner", or parent/guardian who sets it up for the benefit of the child. If the child does not use the 529 for college, then any other famiy member, immediate or extended can use the funds for their own higher education related needs. A 529 is way better for college savings than an I Bond. Especially if there are a lot of years until the child/beneficiary goes to college.
Anyone remember when oil was $150 per barrel? What did the government say inflation was then? 3%?
I mean, seriously, buying government bonds at this point is like flushing money straight down the toilet.
Precious metals are the only way to go… HINT: They can't be printed by bankers or bureaucrats. Are you surprised that a financial website doesn't realize this? Or are they just not telling you?
Hmm… Promises to pay from Obama and friends? Or bars of Gold and boxes of Ammo?
LMAO… I guess there's a sucker born every minute…
Donna, it was the consumer price index that plunged by 5.6%, not the annual rate of inflation. The annualized inflation rate was -5.6% over this rime period.
Just a technicality in terminology.
This is a great article; if you held mattress money over the last 6 months, you made 5.6% return on it after inflation (which was -5.6%) !!! S&P500 was -30% during that period. Mattress money also beat the S&P over the past 12 years.
Having money in I-bonds earning 5.6% every six months sounds like a good deal to me. And, this does not include housing costs returning to earth (they're down >50% from the peak in CA).
The Fed will not allow deflation to go on forever, but it has little choice for now: everyone wants cash, so cash goes up in value and everything else goes down.
We needed this correction.
One thing that's not mentioned is the tax benefit of I-Bonds when used for a child's college education. Subject to certain income limitations, the I-Bonds are completely tax free when used that way. This is much better than a 529 where control is lost to the child — you can keep it and not use it for the child if you prefer.
When used for college, I think it's a much higher return than a TIP with its annual tax liability. Any feedback from experts?
A penalty of three-months interest on the I-bond for early redemption doesn't seem too bad, considering the interest on the I-bond is now zero.
Will you guys ever use the four letter word as a hedge against inflation? Warren couldn't do it on the weekend & CNN can't. Repeat after me- G O L D. The enemy of the US.
Vince, you earn 0% for 6 months cause the inflationary rate is -5% or somewhere around there; thus, decreasing your 3% rate to zero.
George:
Yes, TIPS are still a better way to go than I-bonds if you're buying now and worried about inflation and that's true if you buy TIPS through a mutual fund or directly from the Treasury. But to dampen the tax issue (since you have to pay taxes on the interest income you earn in TIPS), best to invest in a mutual fund through your IRA or 401(k) which allows you to defer the tax on the interest income until you withdraw that money when you retire. One that Money magazine recommends is Vanguard's Inflation-Protected Securities fund (VIPSX).
Hope that helps…
Donna Rosato
Senior Writer, MONEY Magazine
donna_rosato@moneymail.com
Vince: If you bought an I-Bond several years ago, the fixed rate you purchased it at (3%) remains the same for the life of the bond. But I-bonds have two parts: an annual interest rate that reflects the combined effects of a fixed rate (in your case 3%) and a semi-annual inflation rate. The interest accrues over the life of the bond – interest is added monthly and is paid when you cash in the bond. The 0% rate of return I blogged about is the other component of your return, the variable part. Since the CPI was down so much, this means you won't earn any interest on your I-bonds the next six months.
Hope that helps…
Donna Rosato
Senior Writer, MONEY Magazine
donna_rosato@moneymail.com
You will not get interest on any I-bond during the next 6-month period. The negative inflation compenent wipes out any base rate component (but not below zero).
Hold on here. Obviously there is no reason to buy Series I's right now because they are no better than cash, but overall the way I see it, Series I's are a not only a steal as far as risk free investing goes, but this zero growth limit on the down side makes them even more valuable as volatility increases. (For the mathematically challenged, compare returns for steady 2% inflation with those for say a -5% & +10% cycle).
With respect to my I's, I'll gladly let them sit for 6 months because they have done very well before and will do even better later. Of course it helps that I bought them when the Nasdaq was at it's peak so I am getting 3+% on the fixed part. I wouldn't put everything in them, but they are an excellent place to put some cash. Furthermore they will be tax free when I use them for my kids to go to college.
What does this mean for someone who bought an I Bond several years ago when the fixed rate was 3%? I thought that the fixed rate was always safe. If you have a good fixed rate do you get any of it?
Great article and as discussed recently, TIPS are going to be a great hedge for rising inflation once the weak US dollar comes home to roost