TIPS and I-Bonds

By Philip Brewer on 2 September 2007 (Updated 8 September 2007) 4 comments

There are risks in any investment. The market might go down--or the market might go up, but your investment might go down anyway. The company that issued your stock or bond might go bankrupt. Even cash has the (virtually certain) risk that it'll be worth a bit less next month due to inflation. There are a couple of investments that eliminate almost all these risks: TIPS and I-Bonds.

Having just talked about gold as an investment, I thought this might be a good time to talk about these other inflation hedges.

In some ways these securities are pretty similar. They're both issued by the US government and they're both indexed to the Consumer Price Index. Although the details of inflation adjustment are quite different, the results are pretty similar.

They don't eliminate all risks, of course. The calculation of the CPI could understate inflation (it probably does, although not by a lot). The inflation rate that matters to you--the rise in costs of the goods and services that you buy--could be higher (or lower) than the government's calculation, even if the goverment's number fairly represents the average inflation faced by the average person. The US government could collapse. Overall, though, these investments are about as safe as cash and offer a higher return.

TIPS (Treasury Inflation Protected Securities)

These are a lot like other treasury notes and treasury bonds. They're sold with a face value of $1000, and the interest rate is determined in an auction. Individual purchasers can skip the auction process and just buy at the auction price (which guarantees you the same return as the investment professionals whose bids won the auction).

The interest rate is usually pretty low (currently running around 2.3% to 2.4%), which is not as bad as it sounds, because it is paid on the inflation-adjusted face value of the bond. An adjusted face value is calculated for each day and is announced monthly when the new CPI numbers are released. For example, the face value of the 3% 10-year TIPS that was auctioned in 2002 was 1158.80 on September 1st. As long as inflation continues, the face value will go up--and the interest payments, calculated as a percentage of face value, will go up as well.

At maturity you get the final adjusted face value. The face value won't go below $1000, giving you some protection against deflation as well.

If you have to sell before maturity, though, you're not guaranteed the face value. The price will depend on current interest rates and current inflationary expectations.

I-Bonds

These are savings bonds, rather like ordinary savings bonds. They're sold in various denominations, from $25 to $10,000. They also pay a fixed rate plus an inflation adjustment, but the calculation is different. Instead of calculating an adjusted face value and then applying the fixed rate to that, the treasury calculates a "composite earnings rate" that combines both parts. The composite rate is calculated every six months, based on the inflation rate of the previous six months.

The fixed part of the rate is determined by the Treasury twice a year. It applies to all bonds sold for the next six months, and remains in effect for the lifetime of the bond (30 years).

You can't cash in an I-Bond in the first 12 months after you buy it, and if you cash it in after less than five years, you lose 3-months of interest.

After-inflation return

Back when inflation-adjusted bonds were new, they paid a pretty good rate. If you'd bought one in 2000, you could have gotten a 10-year TIPS that paid 4.25% over inflation. Until about 2003, you could generally get 3% over inflation. Since then, the rates have dropped, mostly because interest rates in generally are lower now.

One way to think about the rate on a TIPS is that it should be exactly the same as the rate on an ordinary treasury security of the same maturity minus the expected inflation between now and then. So the rate on a TIPS goes down anytime the expected inflation rate goes up, plus it goes down anytime other interest rates go down.

The rates on I-Bonds used to be reasonably competitive with the rates on TIPS (from 1998 until 2001 they were 3% or higher). Since then, though, they've fallen quite low. The current fixed rate on an I-Bond is just 1.3% over inflation.

Tax Considerations

One reason to consider I-Bonds, despite the very low rate, is that they've got the same tax advantages of other savings bonds. You can choose to pay taxes on the interest every year (if, for example, you're a child with almost no income who will owe no tax) or you can chose to wait and pay taxes on the income only when you cash in the bond. Further, if you use the money to pay for certain kinds of education expenses, you don't need to pay taxes on it at all.

TIPS, on the other hand, have a unique tax problem: you not only owe taxes each year on the interest that you get, you also owe taxes on the increase in face value due to inflation (even though you don't actually get that money until the bond matures). Some people consider this a big deal, and don't recommend that you buy such bonds except in a tax-sheltered plan such as an IRA or a 401(k). Personally, I don't see how it's much worse than the tax treatment of a mutual fund where you're reinvesting the dividends, where you still owe taxes on the dividends and the capital gains, even though the money has been reinvested in the fund.

The interest on TIPS and I-Bonds, like all US Treasury interest, is exempt from state and local income taxes.

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Karl Schulze

If anyone remembers the financial crisis that occurred in this country in 1988, now would be a good time to learn its lessons and put that knowledge to use. First of all, what’s happening now is already worse than what happened in 1988. In 1988 so many lending institutions failed that the FDIC and the FSLIC couldn’t handle all of the assets and liabilities of the hundreds of failed banks, savings & loans, and other financial institutions. In response, the federal government created the RTC (Resolution Trust Corporation). When the RTC was finally dissolved by Congress, some 20,000 foreclosed properties had still not been disposed of!

Much has changed since then. The United States economy now ranks a weak third in the world instead of a strong number one (China is first, India is second, and the European Union may soon overtake us for third!). We no longer even produce most of our own basic necessities! Worse still, we are now embroiled in foreign conflicts and “nation building” exercises that are costing us hundreds of billions of dollars every year while multi-national corporations are reaping whatever profits are to be had.

Even our government “of the people, by the people, and for the people” is out-sourcing many basic projects and tasks to businesses in other countries. Most of our country’s ports are run by foreign corporations. And with our entire military mobilized and mostly deployed in some 163 foreign countries, the NATO troops stationed here out-number our own troops!

Consequently, we cannot reasonably expect our economy to rebound as quickly or strongly as it did in 1988. Furthermore, the present financial crisis is by no means finished. Indeed, it may still have a long way to go before it bottoms out. The Feds have already sunk over 140 billion dollars in less than a week to shore up the stock market. It has already reduced its discount rate by half of a percentage point. And it has loosened up requirements for FHA loans to help some homeowners with ARMs to refinance.

Yet financial institutions continue to fail. They continue to lay off employees. They continue to foreclose on the increasing number of homeowners who can not pay the higher payments resulting from their ARM’s new rate. Since the lending institution now has an additional property that it must pay insurance, taxes, and upkeep on, it has not only lost the principal and interest from the loan that was defaulted on, but it now has an additional expense as well! Instead of working with homeowners restructuring their loans so that payments remain the same, or are even reduced, these institutions act as if they have no choice but to foreclose on the property or force the homeowner to pay higher payments (which results in eventual foreclosure anyway). It seems that these institutions would rather fail than to reduce their profit margins.

Go now you who are rich, cry for your despair that shall come upon you. Your riches are tainted and your garments are moth-eaten. Your gold and silver are cankered and the rust of them shall be a witness against you. And it shall eat into your flesh as it were fire. You have heaped up wealth together for the last days. Behold, the just wages of the laborers who have reaped from your fields, which you keep by fraud, cries. And the cries of them who have reaped have entered into the ears of Yahu’ah Sabaoth. You have lived in pleasure on the Earth and have been wanton. You have nourished your hearts as in a day of slaughter. You have condemned and killed the just and they do not resist you. (James 5:1-6)

The results of the 1929 crisis was more government regulation of our economy. The results of the 1988 crisis was even more government regulation of our economy. So what will the results of this crisis be? As the government increases its control of our economy and as we develop a cashless economy, our ability to buy or sell without the government’s knowledge or consent will be gone. In order to buy or sell we shall have to have a personal identifier recognized by the government. So please consider the following:

And that no man might buy or sell, unless that he have the mark, or the name of the beast, or the number of his name. (Revelation 13:17)

And the third angel followed them saying with a loud voice, “If anyone worships the beast or his image and receives his mark in their forehead or in their hand, the same shall drink of the wine of the wrath of Yahu’ah which is poured out without mixture into the cup of His indignation. And they shall be tormented with fire and sulfur in the presence of the holy angels and in the presence of the Lamb (our lamp, Yah Shua HaMashiach). And the smoke of their torment shall ascend upward forever. And they shall have no rest day or night whoever worships the beast or his image and whoever receives the mark of his name.” (Revelation 14:9-11)

Judgment is at hand. Now and only now, as you read this, do you have to repent and to make good the injustice and suffering you have allowed and caused. Your fate is at hand and your doom is now. Repent in your heart, give all you have for the purposes of Yahu’ah Sabaoth through His Son, Yah Shua HaMashiach, and forgiveness and eternal life may yet be obtained. But you must do it now. So says an oracle of Yahu’ah Sabaoth.

Philip Brewer's picture

I remember worrying about the various crises you mention, and others--the New York bankruptcy of the mid-1970s, stagflation of the late 1970s, the high interest rates of the early 1980s, a couple of Mexican devaluations, the Asian debt crisis--the list goes on.

Several times I thought economic collapse was a likely possibility, and yet the economy recovered each time. Eventually, I became rather blase about the risk of a genuine collapse.

If there's a real collapse, then your TIPS or I-Bonds may be worth nothing--but that'll be the least of your worries.

Of course, there's nothing wrong with repenting too.

Guest's picture
Guest

My TIPS just came to maturity and were redeemed. The report to the IRS was what the final price was. My cost when I bought them is way under this amount, but I have beem paying tax on the gains with the OID each year.

When I file my oncome tax return what do I use as cost basis? Surely not what I paid for them as I have been paying tax all the time on the gains each year. that would be double tax.

Philip Brewer's picture

I'm no tax expert, but I think you're right--your cost basis should be what you paid for them, plus all the OID amounts that you paid taxes on each year. In fact, if you bought it at face value, I think that will come to the amount that you receive at maturity, so I don't think you have a capital gain at all--the entire change will have been income that you already paid taxes on.