Hedging Against Inflation Using TIPS and I Bonds
Inflation is like kryptonite for bond investors. This article describes two fixed income investments that provide some inflation protection.
It is difficult to predict macroeconomic variables such as GDP, wages, productivity, and inflation. Many investors try to do this and routinely fail. Warren Buffett’s advice to Americans is to simply dollar cost average into a broad-based equity index fund during their working years and ignore macroeconomic predictions altogether.
If this is the case, why did I write an article like Death, Taxes, and Inflation last week? The premise of the article is that inflation has become inevitable, on par with death and taxes as certainties in life. I was not attempting to predict the precise level of inflation in the future. Instead, I argued that our experience over many decades suggests that investors cannot ignore the effects of inflation in the years to come.
I followed up with Warren Buffett's Advice on Stocks vs. Bonds and it probably did not surprise most readers to learn that Mr. Buffett has strongly favored investing in stocks over the years. The call he made on the superiority of stocks in 2010 was particularly prescient but is in keeping with his longstanding beliefs. Actions speak louder than words. If Berkshire Hathaway’s small fixed-maturity portfolio is any indication, Mr. Buffett still strongly prefers investments in stocks over bonds.
If stocks provide higher returns than bonds over long periods of time, why own any bonds at all? This is a valid question for a twenty-five year old just starting out, but there are good reasons for most investors to maintain an allocation to bonds.
A bond allocation can soften the volatility of a portfolio and help investors stay in the game for long periods of time rather than reacting in panic during a bear market. I’ve compared bonds to a financial flu shot that can protect against investor panic and I still think this is a valid reason to hold bonds. This is particularly true for investors who rely on their portfolio to cover living expenses. It is hard to stay rational if next month’s mortgage payment depends on selling stocks at a good price this month.
If one accepts the premise that some allocation to bonds is useful for most investors, then the question becomes how to achieve positive inflation-adjusted returns or, at a minimum, to not lose purchasing power over time. During the long years of extremely low interest rates, it was extremely difficult to avoid losing purchasing power in real terms while insisting on safety of principal. However, the situation has changed and there are now reasonable options for investors to consider.
There are many choices for bond investors including treasury securities, municipal bonds, investment grade corporate bonds, high-yield non-investment grade bonds, as well as more esoteric options including bonds denominated in foreign currencies. For purposes of this article, I have focused on treasury securities because they have no credit risk and interest is exempt from state income tax.1 However, interest rate risk, duration risk, and inflation risk remain critical issues when investing in treasury securities, as I described in The Risks of Investing in Bonds earlier this year.
This article describes two options for reducing inflation risk when investing in bonds: I Series United States Savings Bonds (I Bonds) and Treasury Inflation Protected Securities (TIPS). There are no firm rules that dictate whether I Bonds or TIPS are superior at all times. However, we can examine the features of these securities and establish a framework for assessing the relative attractiveness of I Bonds vs. TIPS. I will apply this framework based on conditions in June 2023.
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This is the final article in a three-part series about investing in an inflationary environment. The first article in the series was Death, Taxes, and Inflation which was followed by Warren Buffett's Advice on Stocks vs. Bonds.
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The United States Treasury issues securities that are not inflation protected as well as inflation protected securities (TIPS). Regular treasuries pay interest in nominal terms while TIPS pay a real rate and principal is adjusted based on actual inflation. Buyers of TIPS are locking in a real return while those who buy regular treasuries are locking in a nominal return and are accepting the risk of inflation eroding principal.
Before we delve into the intricacies of I Bonds and TIPS, let’s take a brief look at how inflation expectations have evolved in recent years. The following chart displays the ten year breakeven inflation rate which the St. Louis Fed calculates as the difference between the regular ten year treasury note and the ten year TIPS.2
As of June 6, 2023, the ten year breakeven inflation rate stood at 2.2% which is slightly above the Fed’s 2% inflation target. However, we can see that inflation expectations vary significantly over time. During periods of soft economic conditions, inflation expectations tend to decrease precipitously, as we can see in the shaded areas of the graph corresponding to the financial crisis and the pandemic.
We are not restricted to observing inflation expectations for the ten year breakeven since it is possible to compare the yield of regular treasuries and TIPS across the yield curve. The first table below shows the yields available on regular treasury securities and the second table shows the yields available for TIPS in early June 2023:
Regular Treasury Securities:
Treasury Inflation Protected Securities:
Although TIPS can be purchased on the secondary market for shorter maturities, they are only offered at auction for terms of five years and longer. In contrast, regular treasury securities are auctioned for terms as short as one month. From the tables above, we can observe the following embedded inflation expectations as of June 6:
5 Years: 3.85% - 1.71% = 2.14%
7 Years: 3.78% - 1.59% = 2.19%
10 Years: 3.7% - 1.5% = 2.2%
20 Years: 4.02% - 1.55% = 2.47%
30 Years: 3.87% - 1.64% = 2.23%
We should keep in mind that the Federal Reserve’s stated inflation target is 2%.
For many reasons, discussed in more detail in Death, Taxes, and Inflation, I view 2% as the minimum level of inflation that one can expect over the long run. The market is pricing in somewhat higher inflation, perhaps recognizing that the Fed is not likely to follow a period of high inflation by temporarily lowering their target below 2%.
Despite recent high levels of inflation, the market is not pricing in a large long term failure of the Fed’s stated 2% policy objective. We can see evidence of this by observing that the yield curve is currently “inverted” — that is, short term treasuries are offering higher yields than longer term treasuries. The market is acknowledging that inflation is high in the short run but expects a quick reversion to the 2% target.
The market is buying into the Fed’s narrative that we should experience a period of disinflation in the years to come. Market observers often confuse the term disinflation with deflation. Disinflation refers to a period of a declining, but still positive, rate of inflation. Deflation refers to a period of declining prices. The market expects prices to rise in the future, just at a lower rate than over the past couple of years. The market does not expect there to be a decline in the price level.
At a basic level, investors who expect inflation to be higher than the breakeven levels listed above should favor inflation protected securities over regular treasuries. Investors who believe that the economy will experience inflation lower than breakeven levels should favor regular treasury securities.
If we believe the Fed is serious about generating inflation of at least 2%, it makes sense to favor inflation protected securities to hedge against inflation overshooting the target, as we have seen over the past two years. For example, if inflation averages 4% over the next five years, investors in the five year TIPS should expect an annual return of approximately 5.71% compared to 3.85% in the regular five year treasury note.
Let’s now turn our attention to a more detailed examination of I Bonds and TIPS to determine which option makes the most sense in today’s environment.
Series I Savings Bonds
The United States Treasury introduced I Bonds in 1998 to allow small investors to have access to a relatively simple savings vehicle that promises protection from inflation. Prior to 1998, the Treasury issued several types of savings bonds that did not include explicit inflation protection. In addition to Series I savings bonds, Treasury offers Series EE savings bonds which are not inflation indexed and are not described in this article. I covered Series EE bonds in an article published in December 2020.
Investors must purchase I Bonds electronically from the Treasury via the Treasury Direct website. I Bonds can be purchased in any amount over $25. However, there is a purchase limit of $10,000 per social security number per calendar year. In addition, it is possible to direct up to $5,000 from a tax refund toward I Bonds in paper form. While the calendar year purchase limit is a significant constraint, it can be effectively doubled for a couple and it is possible to purchase bonds as gifts as well.
I Bonds do not make periodic interest payments. Instead, interest accrues on a monthly basis. Every six months, the principal value of the bond is updated by adding the interest earned on the bond during the prior six months. Thereafter, the interest rate on the bond is applied to the new principal value which results in semi-annual compounding. I Bonds do not generate recurring cash flow for investors. To generate cash flow from an I Bond, investors must redeem all or part of the bond.
I Bonds are not marketable securities and cannot be resold to other investors. The bonds cannot be cashed in at all for the first year. Bonds cashed in prior to five years are assessed a penalty of the last three months of interest. I Bonds continue earning interest for up to thirty years. With occasional exceptions, it is best to think of I Bonds as an investment intended to be held for between five and thirty years.3
When an investor purchases an I Bond, it comes with a fixed real interest rate that is held constant for the life of the bond. In addition, there is an inflation adjustment based on the consumer price index for urban consumers, known as the CPI-U. The inflation adjustment resets every six months over the life of the bond.
The fixed rate for newly issued I Bonds varies over time and is reset on May 1 and November 1 of every year. The fixed rate for I Bonds issued between May 2023 and October 2023 is 0.9%. At times, the fixed rate has been 0% but it has never fallen into negative territory. The following exhibit shows how I Bond fixed rates have changed over the past quarter century:
The following exhibit from Treasury Direct shows how the current composite rate for newly issued I Bonds has been calculated. The current inflation adjustment is added to the 0.9% fixed rate and brings the total composite rate for I Bonds to 4.3%. The inflation adjustment will be reset every six months over the life of the bond based on changes in CPI-U but the fixed rate will never change.
What if the economy experiences a period of deflation? Deflation can offset the fixed rate, but the composite rate can never fall below 0%. In other words, if deflation more than fully offsets the fixed rate, the bond’s value will still never decline. This means that I Bonds provide an important hedge against the unlikely prospect of deflation.
Like other treasury securities, I Bonds are exempt from state and local income taxes. Savings bonds can be exempt from federal income taxes as well if used for higher education, subject to income limitations. However, most investors can expect to pay federal income taxes on both the interest and inflation adjustment for I Bonds at the time they are cashed in. Not only does tax deferral simplify annual taxes but it allows the magic of compounding to work in the investor’s favor on a tax deferred basis.
It is not possible to own I Bonds within an individual retirement account. However, it would be undesirable to do so even it was possible because I Bonds already benefit from tax deferral. For example, I purchased I Bonds in October 2001 with a fixed rate of 3% plus the inflation adjustment. I have never paid income taxes on the accrued interest and inflation adjustments for these bonds and will not have to do so until they mature in 2031. Holding these bonds within an IRA would have been redundant.
Investors should purchase I Bonds at the end of a calendar month because interest is credited for the entire month in which a bond is issued, even if it is purchased on the last day of a month. For the same reason, investors should cash in I Bonds toward the beginning of a calendar month to capture interest for the entire month.
The fact that I Bonds are not marketable securities means that they have no interest rate risk. If you purchase an I Bond with a fixed rate of 0.9% today and the fixed rate goes up to 1.9% a year from now, it will be possible to cash in your I Bond for what you paid for it plus accrued interest and inflation adjustments. However, the flip side is that investors cannot benefit from a decline in interest rates. If the fixed rate for new I Bonds falls to 0% a year from now, you cannot sell your I Bond at a premium.
I Bonds offer optionality. You must hold the bond for at least a year but are free to cash it in at any time thereafter, subject to the three month interest penalty if cashed in prior to five years. If new I Bonds offer a higher fixed rate in the future, you are free to cash in your I Bond and invest in a new one, although you will have to pay federal income taxes to do so and will be subject to the $10,000 calendar year purchase limit.
For small investors, I Bonds serve an important purpose by eliminating both credit and interest rate risk. While I Bonds do provide inflation adjustments, I will not go so far as to say they completely eliminate inflation risk since the adjustment is based on the CPI-U index which is constantly revised by the Bureau of Labor Statistics with changes that have tended to lower the reported level of inflation over time.
With these caveats in mind, I have owned I Bonds for decades as part of my bond portfolio. The I Bonds that I purchased in October 2001 with a fixed rate of 3% have compounded at an average annual rate of 5.6% on a tax deferred basis. This trails the returns provided by stocks but came with no market risk and was always available as an emergency fund if needed at any time. I found it easier to cope with market meltdowns in 2009 and 2020 knowing that I held I Bonds as ballast for my portfolio.
Treasury Inflation Protected Securities (TIPS)
The United States Treasury introduced TIPS in January 1997 in response to investor demand for a treasury security with inflation protection. Like regular treasury bills, notes, and bonds, TIPS are marketable securities that are initially sold at auction and then trade on secondary markets which generally offer ample liquidity.
Individual investors can purchase TIPS at auction via Treasury Direct or through brokers such as Fidelity and Vanguard without paying commissions. TIPS held at Treasury Direct cannot be sold unless they are first transferred to a broker, so investors who might sell their bonds prior to maturity should consider buying them through a commission-free broker.
TIPS are offered at auction for five, ten, and thirty year terms but may be purchased in the secondary market if an investor desires a maturity that is not offered at auction. Individual investors may purchase TIPS at auction in $100 increments. While there is a $10 million limit per auction for the non-competitive bids made by individual investors, there is no limit to the total amount of TIPS an investor may accumulate.
In addition to periodic coupon payments, the TIPS principal is adjusted based on the same CPI-U inflation index that is used to adjust the principal of I Bonds. During periods of inflation, the principal value of TIPS will increase. During periods of deflation, the principal value will decrease. However, when TIPS mature, investors will always receive the original principal back at par value even if sustained deflation has pushed the adjusted principal value below the original principal value.4
The inflation adjustment process is considerably more complex for TIPS than for I Bonds. The Treasury publishes detailed CPI Data that allows a bondholder to figure out adjusted principal value on a daily basis. Semi-annual interest payments are made based on the adjusted principal value for TIPS on the day of the interest payment.
To illustrate how the mechanics of auctions, inflation adjustments, interest payments, and price fluctuations work, I will use the example of the five year TIPS maturing on April 15, 2028 which was auctioned on April 20, 2023. I participated in this auction by bidding for $50,000 of bonds at par value and will use my purchase for this example.
The Treasury released the following auction results on April 20:
The coupon rate for the bond was set at 1.25%, but the bonds were sold at 99.904611 which means that I paid $49,952.31 rather than $50,000 and the effective yield was 1.32%. This can be regarded as the real yield on the bond.5
On the original date of issue, the bond will have an “index ratio” of 1.0 and this index ratio will be adjusted upward and downward on a daily basis based on the CPI-U index. For example, on June 6, 2023, the index ratio stands at 1.00714 representing the inflation adjustment from April 15 to June 6. Every month, the treasury will release an updated set of index ratios for all TIPS that have yet to mature.
The first semi-annual interest payment on my bond will occur on October 15, 2023. At this point, we do not know what the index ratio will be on that date, but let’s hypothetically assume that it is 1.025 on that date, representing semi-annual inflation of 2.5%. If this is the case, my first interest payment will be calculated as follows:
Par Value of Bond x Index Ratio = Adjusted Principal
50,000 x 1.025 = $51,250
Adj.Principal x (Interest Rate/2) = Interest Payment
$51,250 x (0.0125/2) = $320.31
The index ratio will continue to reflect changes in the CPI-U index until the bond matures on April 15, 2028 at which time I will receive the adjusted principal value. For example, assume we experience 5% annual inflation over the term of this bond. If that is the case, the index ratio will be approximately 1.276 when the bond matures and the adjusted principal will be $50,000 x 1.276 = $63,800. The final semi-annual interest payment will be $63,800 x (0.0125/2), or $398.75.
As we can see from this example, inflation has the effect of increasing the principal value of the security in addition to increasing the semi-annual interest that is received by the investor. The interest payment can be regarded as the real interest paid on adjusted principal. In other words, the investor can theoretically spend that interest payment without suffering a decline in the purchasing power of the principal.
The complexity of TIPS increases when one considers the role of income taxes. While it is not surprising to learn that semi-annual interest payments are taxable at the federal level, many investors are surprised to learn that adjustments to the principal of TIPS due to inflation are also taxable on an annual basis. This is true even though the investor does not receive the inflation adjustment until the bond matures. Investors sometimes refer to TIPS inflation adjustments as “phantom income” because although it keeps accruing constantly, it is not received until maturity.
Using the same five year TIPS as an example, let’s say that inflation runs at 5% on an annualized basis in 2023 and the index value for my bond is at 1.04 at the end of the year to account for 9.5 months of inflation. In addition to paying income tax on the $320 interest payment received in October 2023, I would also have to pay income tax on the increase in adjusted principal of approximately $2,000.
The need to pay income taxes on “phantom income” is a serious issue that gets worse during periods of high inflation. For this reason, many investors choose to own TIPS within traditional or Roth IRAs. In the case of traditional IRAs, income tax is not due until withdrawals are taken from the account and Roth IRAs are not subject to income taxes upon withdrawal. I personally use TIPS as part of a five year bond ladder, as I described in an article published earlier this year. Unfortunately, this is in a taxable account so I have to deal with the unpleasant reality of taxes on phantom income.
TIPS are securities that I believe are best held to maturity because this guarantees that the investor will receive the adjusted principal as scheduled. However, the fact that TIPS are marketable securities provides the option of selling the bond prior to maturity. While this optionality is valuable, investors must realize that the price of TIPS will vary based on fluctuations in the real interest rate.
To illustrate this point, recall that an earlier exhibit showed that the current real interest rate on five year TIPS is 1.71% which is considerably higher than the 1.25% interest rate on the five year TIPS I purchased less than two months ago. This means that if I sell my five year TIPS in the secondary market today, I can expect to receive less than par value. According to Vanguard, the price I would receive if I sold today is 98.22842 which means that I would realize about $49,114 resulting in a capital loss since my original purchase price was $49,952. On the flip side, if real interest rates decline, I would be able to sell my bond at a premium and realize a capital gain.
My use of TIPS is restricted to the five year maturity since the purpose is to build a five year bond ladder. It is possible to invest in longer term TIPS with maturities extending out to thirty years. Fluctuations in real interest rates will have a greater impact on the price quotations of longer term TIPS compared to shorter term TIPS. This is the law of financial gravity that impacts all fixed-maturity securities which I discussed in more detail in The Risks of Investing in Bonds.
Comparing I Bonds and TIPS in June 2023
How should investors think about the relative attractiveness of I Bonds and TIPS based on conditions that prevail in June 2023?
Investors who purchase I Bonds today will receive a real rate of 0.9%. TIPS investors can lock in a real rate of between 1.5% and 1.7% depending on the duration of the bond. Although the mechanics differ, both I Bonds and TIPS receive inflation adjustments based on the CPI-U index.
While these rates might seem modest, we should recognize that both I Bonds and TIPS offer positive real returns. This is not always the case. I Bonds offered a 0% real rate as recently as 2022 and the real rate on five year TIPS was in negative territory from March 2020 to June 2022. In comparison to conditions that prevailed earlier this decade, investors at least have opportunity for modest positive real returns.
Small investors who would like to minimize complexity and defer taxes outside of a retirement account might want to opt for I Bonds over TIPS despite the lower real rate. I Bonds are a “set it and forget it” type of security. Once purchased via Treasury Direct, you can just forget about them for up to thirty years. There is no record keeping or annual tax consequences to deal with and there is no need to worry about price fluctuations. I Bonds can be part of an emergency fund after the minimum one year holding period is met since they can be liquidated at any time.
For small investors with access to a tax deferred retirement account, TIPS can be relatively simple to deal with since there are no annual taxes due. For those who are very likely to hold the TIPS to maturity, price fluctuations are also a non-issue. It makes sense for small investors to own TIPS within a retirement account to take advantage of the higher real rate.
Larger investors who need to commit funds in excess of the $10,000 annual limit on I Bonds will have to deal with the complexities of TIPS if held in taxable accounts. Many investors might choose to put the maximum amount allowed into I Bonds and then invest the balance in TIPS. This is the approach that I have used in the past for my five year bond ladder. However, I currently favor TIPS over I Bonds due to the higher rate and the fact that I’m used to dealing with the tax complexities of TIPS.
Many investors will argue that the entire premise of this article misses the point if the goal is to preserve wealth in real terms because history shows that a broad based equity index fund does that job very well.
I would not disagree with this argument except to point out that the majority of investors are temperamentally unable to tolerate the volatility of a 100% stock portfolio. For those who rely on their investments for cash flow to cover personal expenses, it is too traumatic to depend on selling equities every month or quarter.
By constructing a five year bond ladder, investors can view the volatility of their stock portfolio with equanimity, knowing that they are not going to be forced sellers in the near term. The only action investors need to take is to periodically reallocate a portion of their stock investments to replenish their bond ladder, and this need not occur during the depths of an equity bear market.
To the extent that owning bonds makes sense, I do not like the idea of taking credit risk or much interest rate risk, and to the extent possible I would like to take inflation off the table as a cause for worry. Under current conditions, both I Bonds and TIPS seem to fit these requirements quite well. These securities will not make anyone rich, but they might provide the ballast required to be more venturesome in the equity portion of the portfolio which does have the potential to build wealth over time.
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Despite the recent drama over the debt ceiling, the prospect of the United States government defaulting on treasury obligations is almost nonexistent. A government that is able to issue debt in its sovereign fiat currency has no incentive to default. Such a government may resort to money printing resulting in inflation risk, but contractually due payments on principal and interest are very unlikely to be missed.
The Fed provides a more precise description as follows: “The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities (BC_10YEAR) and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average.”
During periods of very low interest rates, I Bonds can be useful as an alternative to one year treasury bills. I wrote about this possibility in November 2009 when one year treasury bills were yielding 0.35% while the composite rate for I Bonds was 3.36%. Even after paying the three month interest penalty after one year, I Bonds provided a higher return than T-bills. A Similar situation took place in recent years and I wrote about it in late 2020 and late 2021.
Deflation protection is better with I Bonds than with TIPS. In the case of I Bonds, accumulated inflationary adjustments to principal can never be “clawed back” in the event of deflation. This is because the I Bond composite rate can never fall below zero. In contrast, TIPS inflation adjustments can be “clawed back” due to deflation. For example, let’s say that a $1,000 TIPS principal was adjusted to $1,100 to reflect 10% inflation during the first year after it is issued. This is followed by deflation of 5% during the second year. The TIPS principal will decline from $1,100 to $1,045 to reflect the deflation. However, deflation will never push the TIPS principal below $1,000 if held to maturity.
In addition, I paid accrued interest of $22.25. The bond issue date was April 28, 2023. The first coupon payment for the bond on October 15, 2023 will be for six months interest from April 15, 2023 to October 15, 2023. Since investors did not pay for the bond until April 28, they must reimburse the treasury for accrued interest from April 15 to April 28. This is one of the intricacies of purchasing marketable securities that are avoided by I Bond investors.