Unclear on TIPS

[modhatter]

Why do all the books I read encourage you to buy TIPS as apposed to I-Bonds. I don't see any advantage. Only disadvatages. You have to pay income on interest that you don't receive. In cases of De-flation, they go down (very unlikely)

What am I missing? I must be missing something.

[. . . Yrs to Go]

Aren't investments in I-Bonds limited to a maximum investment / year? And aren't there penalties for selling early?

The small size can be a real limitation for some people considering we're talking about 7 figure portfolios in some cases. The tax deferral on the I-Bonds is very nice though. TIPS would be a lot more attractive if they didn't tax you on the whole nominal yield.

[wabmester]

Originally Posted by modhatter

Why do all the books I read encourage you to buy TIPS as apposed to I-Bonds.* I don't see any advantage.* Only disadvatages.* You have to pay income on interest that you don't receive.* In cases of De-flation, they go down (very unlikely)

What am I missing?* I must be missing something.

Yes, you're missing a few things:

1) TIPS pay more. You can hold an i-bond for 30 years and get 1.1% real, or you can buy a 20-year TIPS paying about 2% real right now.

2) i-bonds are sort of 5-year TIPS, but if you're an ER, you probably want an inflation hedge for more than 5 years.

3) Don't sweat the taxes. Unless you're using i-bonds for educational expenses, you'll have to pay taxes on the interest. For both TIPS and i-bonds, you don't pay state income tax. (Consider this before you blindly stick TIPS in your IRA, for which you'll probably pay ordinary income tax -- both state and fed -- for withdrawls).

4) TIPS can give you capital appreciation. I-bonds can't. Of course, this is a two-edged sword, so the value of TIPS can go down as well as up.

[WanderALot]

Originally Posted by wabmester

2) i-bonds are sort of 5-year TIPS, but if you're an ER, you probably want an inflation hedge for more than 5 years.

Don't I-Bonds provide you with an inflation hedge for however long you hold them (upto 30 yrs)? I thought the only thing that happened after 5 yrs is the penalty to cash them in?

[wabmester]

Originally Posted by WanderALot

Don't I-Bonds provide you with an inflation hedge for however long you hold them (upto 30 yrs)?* *I thought the only thing that happened after 5 yrs is the penalty to cash them in?

They "mature" in 5 years, but you can continue holding them for up to 30 years and collect the same rate. However, if you plan to hold them that long, you could purchase a TIPS and get a term premium.

[cute fuzzy bunny]

I'd recommend that you sweat the taxes extensively. Paying every year vs deferring the taxes for 20-30+ years by placing the tips in a tax deferred account might work out very, very well for a lot of people. Especially people making a high current income either from working or from investment income.

Its also worth pointing out that in the case of ibonds, you can cash them in and get your principal back; tips have to be sold on the secondary market. Trading costs and current values could vary wildly. Since issue, tips have generally done well selling on the secondary market...good increases in value. Its worth noting though that a lot of the historical 'goodness' comes from many of those early tips releases carrying interest rates in the 3-4%+cpi interest rates. Not the case with current tips.

[. . . Yrs to Go]

Originally Posted by wabmester

1) TIPS pay more.* * You can hold an i-bond for 30 years and get 1.1% real, or you can buy a 20-year TIPS paying about 2% real right now.

2) i-bonds are sort of 5-year TIPS, but if you're an ER, you probably want an inflation hedge for more than 5 years.

3) Don't sweat the taxes.* *Unless you're using i-bonds for educational expenses, you'll have to pay taxes on the interest.* *For both TIPS and i-bonds, you don't pay state income tax.* *(Consider this before you blindly stick TIPS in your IRA, for which you'll probably pay ordinary income tax -- both state and fed -- for withdrawls).

4) TIPS can give you capital appreciation.* I-bonds can't.* *Of course, this is a two-edged sword, so the value of TIPS can go down as well as up.

1) I think the current fixed rate of 1.2% on the I Bonds is stale. It was set on 5/1/05 when the real rates on TIPS were lower than they are now. I'd wait until they reset the fixed rate on 11/1/05. It will probably go up to 1.5%, consistent with current 5-year TIPS. It's still lower than the long-TIPS but the I Bonds can be "put" back to the treasury if real yields go up. With the TIPS your stuck with 2% forever. I don't know what the put option is worth, but it aint free and 50bps to have a 30 year put is probably not a bad trade off given how low real yields are now.

2) As said by another poster, I Bonds continue to pay interest for 30 years.

3) Interest deferral can be a HUGE advantage especially for someone who expects to retire into a lower tax bracket. A 5% before tax yield translates to 3.25% after tax for someone in the 35% tax bracket but 4.25% for someone in the 15% bracket. Also the tax deferral helps with tax planing and management. With TIPS you have to pay taxes on the full nominal yield every year, but with I Bonds you can chose to take earnings in years when you are in a lower tax bracket (e.g. no large capital gains) or defer them if you have a windfall one year.

4) Capital appreciation is a function of the discounted future cash flows of your bond and is irrelavent if held to maturity (very relavent if you need or want to sell the bonds though). On the other hand, if real rates go up your TIPS will decline in value preventing you from benefiting from the higher real rates. I Bonds, however, can be put back to the treasury and reinvested at the higher rate with no penalty (or a small penalty during the first 5 years).

I think I Bonds are hands down a better investment than TIPS. The only problem is small maximum investment size.

[wabmester]

Originally Posted by . . . Yrs to Go

I think I Bonds are hands down a better investment than TIPS.

OK, fine.* *I think most of the information is out there for people to make an educated decision.* *As far as i-bonds being the "hands-down" winner, if you plan to sell before maturity, real yields go up, you are in a high tax bracket, you don't want to hold them in an IRA, or you plan to use them for educational expenses, I agree with you.* *On the other hand, those attributes don't apply to all of us.* *Especially the ERs or near-ERs (you know, the people this board appeals to).

As far as predicting the November fixed rate on i-bonds, I'll go out on a limb and guess that the algorithm they use is something like the average real yield on the 5-year TIPS for the last 6 months less 10% (for the "free" put).* *That's basically how they do it for the EE.* *So, yeah, I agree that it'll probably be around 1.4 or 1.5% for the next issue.

[. . . Yrs to Go]

Originally Posted by wabmester

As far as i-bonds being the "hands-down" winner, if you plan to sell before maturity, real yields go up, you are in a high tax bracket, you don't want to hold them in an IRA, or you plan to use them for educational expenses, I agree with you.* *On the other hand, those attributes don't apply to all of us.* *

Point noted!