The CPI-linked savings bond isn’t all it’s made out to be. TIPS offer slightly better protection against inflation.
Personal finance experts love these bonds I. Suze Orman: “The #1 investment every one of you should have no matter what.” Burton Malkiel: “Absolutely superb.” Last month, a stampede for these things crashed the TreasuryDirect website.
Contrarian view: I bonds are absolutely mediocre. They pay less than marketable treasuries, they clutter up your retirement portfolio, and they’re guaranteed to make you poorer.
The rout will no doubt continue given the unpleasant surprise (8.6%) of the latest inflation report. Bonds are indeed a better deal for long-term savers than any bank account. But they are not doing what their holders want them to do, which is to immunize savings against the fall of the dollar.
I bonds are savings bonds that pay a fixed interest rate plus a semi-annual adjustment pegged to the consumer price index. You buy these bonds after linking a bank account to the clumsy Treasury website. The maximum purchase per calendar year is $10,000 per person ($20,000 for a couple). Bonds cannot be redeemed during their first 12 months; from then until the 60 month mark, a redemption comes with the loss of three months interest.
After five years, an I bond can be redeemed without penalty. The buyer has the option of deferring taxation until the bond is cashed or matures, and that’s usually a smart thing to do. Upon maturity in 30 years, the bond ceases to earn interest. Interest on I Bonds, like all US government debt, is exempt from state income tax.
The fixed rate on an I bond purchased today is 0% for the life of the bond. The inflation adjustment changes every six months and now generates an annualized rate of 9.62%. In other words, if you invest $10,000 now, you will be credited $481 in interest for your first semester.
In an era of shitty bank yields, a $481 semi-annual coupon looks pretty good. But the fixed rate of 0% means that, after deducting inflation, you earn nothing. Moreover, even if you tread water in terms of purchasing power, you will eventually have to pay tax on your putative interest. Take this tax into account and you will find that your actual return is negative.
Hypothetical example: you are in the 24% bracket, your principal balance is $10,000 and inflation is 10%. After a year, you have a balance of $11,000 but owe $240 in taxes, to be paid now or later. The $10,760 you own buys less than $10,000 the previous year.
Understand what is happening. The government is in deficit. It covers this partly by printing money to distribute and partly by borrowing from savers. Savers are getting poorer year after year. Note that the tax collector and the borrower are the same entity, the US Treasury.
It’s raw business. You can do better, a little better, by buying Treasury inflation-protected securities, aka TIPS. TIPS due in ten years pay an actual yield of just 0.4% and those due in 30 years pay an actual yield of just 0.7%. Buyers of TIPS must pay immediate tax on both their actual yield and their annual inflation allowances.
You can buy TIPS directly from the Treasury at one of its periodic auctions, buy them used from a broker or, preferably for smaller sums, buy shares in a low-cost fund like the Schwab US TIPS ETF. TIPS also offer a negative real after-tax return, but it is not as negative as the return on I bonds.
The grim results are plotted in the two graphs below. The first chart assumes inflation starts high – 8% in the first year, 5% in the second – then drops to a low level that brings the 30-year average back in line with bond market expectations.
Other assumptions: the buyer is in a moderately high tax bracket, takes advantage of the tax deferral option available on the I bond and opts for a 30-year maturity when buying TIPS.
In this scenario, Bond I’s tax deferral is worth something, but it’s not enough to overcome the 0.7% yield advantage enjoyed by TIPS.
What if inflation accelerated? The second chart assumes two percentage points higher inflation over the next 30 years than is priced into the bond market.
Here, the tax deferral allows the I bonds, at the end of a long holding period, to be linked to the tradable TIPS. But that doesn’t mean an I bondholder should pray for high inflation. Higher inflation means more phantom income to tax. With higher inflation, the depletion of wealth occurs faster.
In addition to the tax deferral, the savings bond has another advantage: it comes with a free put option. You don’t have to hold your investment for the full 30-year term. At any time after five years, you can surrender the bond for principal plus accrued interest.
If real interest rates rise, this option will be worth something. You can cash in the I bond, pay taxes on the interest, and use the proceeds to buy long-term TIPS paying better than the current 0.7%.
But now let’s look at the main drawback of I bonds. They are only available in small doses. If a $10,000 bond is a big chunk of your net worth, it doesn’t matter. But if it’s a small item in a retirement portfolio, it will create financial clutter.
You are allowed to buy an additional $5,000 per year of I bonds if you overpay your income tax and receive the refund in the form of a paper savings bond. It’s more cumbersome. Avoid it.
I Bonds cannot be held with other assets at your broker. You must maintain a separate TreasuryDirect account, with its own login and password. Is there a chance that you or your heirs will lose track of this asset within the next 30 years? Think about it. Take note that the Treasury is sitting on $29 billion in matured and unclaimed paper savings bonds.
Choose your poison. Whatever the bond, the US Treasury will make you poorer when you lend it money. The I bond definitely beats bank CDs for long-term savings, but for successful investors tradable TIPS probably make more sense.
We are talking here about newly acquired bonds. If you’re lucky enough to have bought I bonds years ago when the fixed rate rose above 3%, hold onto them until they mature.
The charts of after-tax bond values assume an investor who is in the 24% bracket today and will rise to 33% when the 2017 tax law expires in early 2026; these rates would apply to a married couple now declaring taxable income of $250,000. The bond market’s assumption for future inflation is the difference in yield between nominal and real bonds, minus a 0.1% provision for a risk premium on nominal bonds.
To find out more about the I bonds:
Tips is a useful reference site.
US Treasury Compares TIPS to I Bonds here.
The Danger With These Savings Bonds: Lost and Found Department is a warning.