TIPS vs I Bonds

I have a lump sum of cash to put somewhere where it will not be needed but where I want to earn a better return than money markets. I am considering individual municipal bonds from my state ( there is a large enough amount of cash to buy individual bonds rather than a mutual fund). I also thought either I bonds or a ladder of Tips made sense. I realize the interest on I Bonds is deferred up to 30 years or until the bond is cashed in while Tips are taxed yearly. But Tips have a higher rate of interest with more volatility and at times can be below the principal invested and I Bonds can never go below the face value of the bond. I would appreciate the thoghts from this astute board of investors.

[BigMoneyJim]

How liquid do you need the money to be, and how long to you anticipate it staying invested?

TIPS and I-Bonds are out of my scope, but those answers will probably get you better suggestions.

[charlie]

Ron, IMHO it is usually better to use I-bonds in
a taxable account. You can cash I-bonds after
one year with a 3 month penalty and there is
no penalty after holding 5 years. Right now the
return is 3.67% tax deferred. I think it is likely that
the return will go up at the next reset time since
inflation year over year is currently at 3.52%.

Cheers,

Charlie

Not liquid at all and probobly won't need for 10-20 years.

With I Bonds I am locked into an interest rate but with TIPS, I could ladder and take advantage of rising rates.
I thought that might be an advantage. Cashing in will not be an issue as my timeframe is at least 10-20 years.
Since the I Bond interest is reset in the next couple months, does it make sense to wait until then if I decide to use some I Bonds?

[charlie]

Ron, the current real rate on I-bonds is 1%. That
is what you are locking in. The real rate may or
may not go up at the next reset. The current
CPI rate of I-bonds is 2.67% ..... that is the part
that is likely to go up at the next reset since
inflation is now about 3.52% (not 2.67%). If
you bought I-bonds now, currently paying 3.67%,
they would pay 1% plus the new CPI at the next
reset, assuming the real rate of 1% stays unchanged.
Thus it is an advantage to wait only if you expect
real rates to be higher at the next reset. Don't
forget that you can always cash in your I-bonds
after 1 year (with a 3 mo. penalty) and repurchase
them later if real rates go up.

Cheers,

Charlie

[Bob_Smith]

Ron, as usual Charlie is right on. I have both I-Bonds and TIPS. The I-Bonds are in taxable accounts and the TIPS are all tax deferred. But I wouldn't be interested in TIPS at this level, and I view I-Bonds as a temporary holding to fill a gap in hopes that something better comes along. There's really very little downside with I-Bonds - not so with TIPS. So if I was seeking a long term (10-20 years) bond holding, I'd sit on the sidelines with I-Bonds, CDs, or the Vanguard ST Corp fund (or whatever they call it now) and hope something better comes along in a year or two.

Quote:

Not liquid at all and probobly won't need for 10-20 years.

ron,

If you don't need this dough for 10-20, why don't you look at a Vanguard Retirement Fund. Put in there, Go Fishing ---- Then look at it in 20 years.

It'll probably be a Nice number.

Can any of the math wizards out there explain to me how significant the "tax deferral" effect is on I-bonds? Does the "effect" grow the longer you hold the bonds? I belong the the mathematically-challenged, but it seems to me that the effect should become more pronounced as time passes. I like the idea of earning interest on the "government's money" but I'd like to know how significant the effect of "tax deferral" can be and whether the effect increases the longer the investment is held. Most importantly, does one reach a point where it doesn't pay to cash the bonds in (until maturity that is)?

[charlie]

Ron, the benefit of tax deferral is that your investment
compounds faster if it is not taxed. Also, for many the
tax bracket when you cash them in may be lower
in retirement than when you are earning big bucks.

Cheers,

Charlie

[charlie]

Bob_Smith (or any other wiz),

How do you estimate the actual cash income you
would receive from a 3/78 TIPS selling for 137.2
maturing in 2029? The "offer" yield is about 1.94.

I know you bought some of these recently because
of the higher cash flow.

My tired old brain goes into latch-up thinking about
this. I realize that at maturity you will only receive
the issue value + accrued interest. The other thing
is that your initial cash income is indexed to inflation.
right? The premium you paid for the high coupon
is not recovered.

You said you are not interested in 2% TIPS and I
am not either .... I need the higher cash flow now.

Your strategy seems to provide an inflation indexed
income stream (like Vanguard's new inflation indexed
annuity) yet leaves something for the kids.

It looks like a good compromise to me.

Cheers,

Charlie

[charlie]

I pulled this chain again just to entice a response
to the above inquiry.

Cheers,

Charlie

Hello Charlie and all. Just a quick thought. I have always been very aware of the theory that you would probably be drawing from your IRA (or other tax deferred device) when your tax bracket was lower.
What I did not realize was that I would be able to wait
until my tax rate was effectively -0-. This is another area
where I dodged a bullet because I was considering
starting an early (maximum) IRA withdrawal in 1993 at age 49. The very next year I went back to work temporarily, and jumped back into a pretty
high fed. tax bracket. If I had started the IRA
withdrawal, all of those monies would have been added
on top of my salary and etc. I looked again at starting
to draw as of 1-1-05 (age 60 now). Looks like I can defer for at least another year or so. This development
was truly serendipitous.

JG

[Peter]

Quote:

Bob_Smith (or any other wiz), How do you estimate the actual cash income you would receive from a 3/78 TIPS selling for 137.2 maturing in 2029? The "offer" yield is about 1.94.

I'd like to hear a definitive answer on this, as well. The way TIPS are quoted in the secondary market seems rather confusing.

As I understand it, the offer yield-to-maturity is the yield you will get on the actual dollars you use to buy the TIPS, but it does not include future interest increases due to inflation indexing.

And I think the money you get back at maturity is the same dollar amount as anyone holding those particular TIPS will get -- in other words, the original cost, plus accrued inflation as defined by the CPI.

If I'm wrong about one or both of these, I'd love to know ...

Peter

[JWR1945]

Quote:

..As I understand it, the offer yield-to-maturity is the yield you will get on the actual dollars you use to buy the TIPS, but it does not include future interest increases due to inflation indexing. And I think the money you get back at maturity is the same dollar amount as anyone holding those particular TIPS will get -- in other words, the original cost, plus accrued inflation as defined by the CPI. .. Peter

This is my guess as to what you are after.

The TIPS coupon rate remains constant. The principal amount adjusts to match inflation. [If it falls below par, you receive par at maturity.]

The TIPS coupon rate is a real interest rate.

All of the standard bond formulas apply. The difference is that you must use inflation-adjusted (i.e., real) dollars instead of nominal dollars.

The yield to maturity and other numbers are all in terms of real dollars.

Have fun.

John R.

[charlie]

JRW1945,

Please humor me and tell me how much I would
get per year, today, in acutal dollars if I bought
a TIPS with 3 7/8% coupon quoted at 137 maturing
in 2029. Please assume the invested amount is $1000
and CPI is 3.52% and the offer yield is 1.94%. I
assume that the "offer yield" is the same as YTM,
but I don't think that is the actual cash flow yield
based on invested dollars. It seems logical to me
that the current cash flow yield would be 3 7/8%
multiplied by the ratio of the inflation adjusted
principal divided by 1.37. But what do I know?

Also please confirm, it true, that future annual income in actual dollars would be indexed to future CPI.

I believe that you have already confirmed that the
bond at maturity would be worth the issue price plus
inflation over the bond life. Right?

Sorry to trouble you about this, but discussion of
real dollars gives me a head ache!

Cheers,

Charlie

[Bob_Smith]

Quote:

How do you estimate the actual cash income you would receive from a 3/78 TIPS selling for 137.2 maturing in 2029? *The "offer" yield is about 1.94.

Charlie, I checked that particular bond tonight. The YTM is 1.943%, as you stated above, but the current yield is 2.824%. So the cash income should be about 2.8% of the amount you pay. The principal will grow along with the CPI and continue to pay roughly 2.8% of whatever the principal is at the time. At least that's my understanding.

When I got my first interest payment, I checked to be sure I was getting what they had calculated the current yield to be when I bought the bonds, and it was very close.

Do you have a Vanguard brokerage account? If you do, you can call up a list of the TIPS on the secondary market. Click on the detail link of the bond you're interested in, and toward the bottom of the page you'll see the "current yield". That's the number you're looking for. You may want to verify this with the bond desk, but that's my understanding.

Since you're paying a premium for the bond, you'll get less in the end than if you had bought a bond at auction, but that's exactly what I preferred to have because it gives me more income and diminishes the need to sell bonds as I go. More as I go and less in the end works best for me.

[Bob_Smith]

Quote:

As I understand it, the offer yield-to-maturity is the yield you will get on the actual dollars you use to buy the TIPS, but it does not include future interest increases due to inflation indexing.

Not really. The YTM may understate the income you'll actually receive. A bond paying 3.875%, for example, may have a YTM of 2.5% but a current yield of ~3.1%. IOW, you'll get an income of 3.1% of your purchase price. However, there's no free lunch, so you'll get commensurately less in the end.

Quote:

And I think the money you get back at maturity is the same dollar amount as anyone holding those particular TIPS will get -- in other words, the original cost, plus accrued inflation as defined by the CPI.

You won't get your original cost back (plus inflation), unless you buy at par. Since you pay a premium for a much higher yielding bond on the secondary market (than can be purchased directly at auction), the principal amount of the bond you bought is actually less than you paid, sometimes far less. That's the amount of principal you're starting with - NOT what you paid. As you hold the bond over the years, the principal will be adjusted upward as the CPI increases, but remember that the amount that is being adjusted upward (or downward in deflation) starts out as quite a bit less than you paid. On the other hand, you're getting 3.875% of that smaller principal amount, which is WAY more than the market is currently paying (in my case that came to ~3.1% of the amount that I actually paid for bonds that had a YTM of 2.5%). So:

-- I start with less principal than what I paid
-- but I get more income as I go (3.1% of what I paid vs. the 2.5% I would have received if I had bought at par - which I couldn't have done at the time since they had stopped selling 30 year TIPS)
-- and in the end I get less back than if I had bought the bonds at par, because I started out in the hole due to the premium I paid.
-- But when it's all said and done, I end up with the same yield to maturity, 2.5%, that I would have received if I had bought at par through Treasury Direct (if it had been possible to do so at the time). I just chose to receive more income in exchange for less principal in the end.

Yes, the principal does keep pace with inflation, but if you pay a premium for the bond, you start out with a principal amount that is less than you actually paid. The YTM is the most important number because it defines what you're actually getting in real dollars, ALL things considered. But if you want to know the amount of the "real" income you'll receive, based on your purchase price, you look for the "current yield", not the YTM. Just remember that when the current yield is higher than the YTM, you'll get less back in the end - there's no free lunch. I prefered to do it that way because it reduces the need to sell bonds as I go which 1) removes most market risk from the equation if I hold to maturity, and 2) eliminates the brokerage fees that would have accompanied those sales.

It's getting late - I don't know if any of this makes sense, but I'm sure someone will correct me where I'm wrong, or do a better job of describing it than I'm doing.

[charlie]

Bob,

Thanks for your detailed reply. You confirmed my
understanding to a "T". I was not aware that
the "current" yield is quoted. I did not see it
anywhere on Vanguard's screen for the particular
bond we are discussing.

Can you estimate the current yield by multiplying
the bond coupon rate by the ratio of the inflation
adjusted original price divided by the price you
pay in the secondary market? For example if the
bond was issued 5 years ago and the average
inflation has been 3% then the inflation adjusted
principal would be approximately $1159 and the
current yield would be 3.875 x 1150/1370 = 3.25%

Thanks for your patience. I think your strategy
is brilliant.

Yes I recently reactivated my Vanguard brokerage
account in my IRA ....... and bought a 2% + CPI
CD that matures in 9 years.

Cheers,

Charlie .

I sure got his great board thinking and I appreciate all your input. another question, since you can only buy $30,000 of I Bonds from a bank or broker each year and another $30,000 from treasury direct, can I use a joint trust account with my wife to buy $60,000 from a broker and can I buy $60,000 from Treasury direct?