I-Bonds vs. TIPS?

[jonathan_b]

I can't help feeling I'm missing something here - other than the low annual investment limitations on I-bonds (savings bonds that are inflation adjusted - see the treasury direct web site for more info). It seems to me that the I-bonds have several potential advantages, as well as a couple of disadvantages vs. TIPS:

Advantanges
1. Tax deferred - these bonds are federal tax deferred until they are cashed in.

2.State tax exempt (TIPS are also, I believe)

3. Potentially tax exempt if used for education, assuming you follow all the rules and register the bonds correctly (same rules as EE savings bonds)

4. Higher yield! I have no idea why, but the I-Bills have a higher yield currently than TIPS.

5. Liquidity - this is also a potential problem, but after an initial waiting period, the I-Bonds can be cashed in whenever it makes sense for you.

6. no fees!

Disadvantages:
1. Liquidity - There is an initial 12 month waiting period before you can cash out, plus if you cash out before the end of 5 years there is a 3 month interest penalty. This is not a short term investment.

2. Low investment limits - $30,000 per year per SS #

We are replacing a ladder of 2-3 year CD's that we had built up in the 1990s that kept our emergency cash invested at longer term rates. Basically, we had it timed so that the CDs matured one per month, and each CD had at least a balance of 2 months expenses in it. We are taking advantage of the liquidity and inflation protection feature of the I-Bonds to achieve the same goal, now that most CDs have effectively negative real interest rates. Due to the liquidity, we don't even have to ladder them (although we are doubling up on our cash reserves until we get past the 1 year waiting period).

Although the 3 month interest penalty is annoying, even with the penalty, the 12 month performance of the investment if we do need the cash before the end of the 5 year period should still outperform a money market account (on current interest rates, quite handily). Combined with the federal tax deferral and the state tax exemption, this really seems like a good way to stash away our emergency cash, plus we will gradually be moving our fixed income portion of our portfolio in here.

So, why aren't more people using this vehicle? What am I missing?

JB

JB,

I can only speculate on why more people are not using I bonds. One possible reason is that I bonds do not have the possibility for capital gains like TIPS or Treasuries. All those fleeing from stocks to high quality bonds (e.g. the people who usually chase performance; who bought stocks like crazy in 1999) see that TIPS and Treasury funds are/were returning 9% and more and think why should they settle for low returning Savings Bonds when their bond funds are doing so well. Duh. I am sure these types of people will realize way too late that I bonds have much, much lower interest rate risk.

Also, the financial services industry can not make money off of I bonds. Since the owner cannot sell Savings Bonds, there is no secondary market for Savings Bonds. No intermediaries (brokerages) are needed to purchase I bonds. Have you seen any article or publication by a mutual fund company, bank, or brokerage house even mentioning I bonds as a possible alternative? I bonds compete directly w/ TIPS funds, CDs, and fixed annuities that the financial services industry can make money off of.

Alec

[Ted]

Quote:

Advantanges 4. *Higher yield! *I have no idea why, but the I-Bills have a higher yield currently than TIPS. 5. *Liquidity - this is also a potential problem, but after an initial waiting period, the I-Bonds can be cashed in whenever it makes sense for you. JB

Because of the various advantages that I-bonds do have (especially in terms of tax deferral) the guaranteed yield on them is, in fact, substantially lower (by about 100 basis points) than on TIPs.

Liquidity is not a particular problem with TIPs because they can (a) be owned through a no load, low cost mutual fund or (b) owned directly and sold through a broker at a relatively low commission.

The price appreciation on TIPs that occurs as the result of the annual "bump up" in their par value is treated for tax purposes as original issue discount, subject to federal tax each year (unless the TIPs are held in a tax-advantaged account, which is a good idea). That is a genuine disadvantage relative to I-bonds, which causes investors to demand a higher guaranteed interest rate on TIPs.