We have all felt the pain of rising prices as we go about our daily lives, whether it’s at the gas pump, the grocery store, or when we travel.
Inflation in the U.S., as measured by the Consumer Price Index (CPI), hit a 40-year high of 8.5% in March. This leaves many of us wondering how we can preserve purchasing power in their investment portfolios, particularly in fixed income.
Two topics have been front-of mind for many whom Domani Wealth supports. These are two different forms of inflation protected bonds: Treasury Inflation Protected Securities (TIPS) and I Bonds. Both are bonds offered by the U.S. Treasury that are designed to help investors during times of inflation. However, there are some key differences between the two securities, and both have several caveats that are important to consider.
Treasury Inflation Protected Securities (TIPS) are U.S. Treasuries that pay a fixed coupon twice per year. The actual dollar amount, or principal of the bond, fluctuates with inflation. When TIPS mature, the investor receives the adjusted principal or the original principal, whichever is greater.
TIPS have gotten increased attention lately based on higher inflation, which makes us think TIPS will automatically pay out more upon maturity. Unfortunately, TIPS are one of the most misunderstood fixed income instruments in the bond universe. It’s commonly believed that TIPS provide a return that is equal to inflation plus a stated percentage. However, this is not the case.
Interest Rate Risk
TIPS are offered with maturities of 5, 10, and 30 years. The longer duration means TIPS can be negatively impacted by fluctuating interest rates. In periods of rising interest rates (like we are currently experiencing), the value of the bond can decrease due to rising rates. Even in periods of higher inflation, the decrease in value caused by rising rates may outweigh the inflation (increase in value) component. In fact, TIPS can be priced at negative yields – meaning they are worth less upon maturity than they were when they were first purchased.
Buying and Selling
TIPS can be purchased directly via auction through https://www.treasurydirect.gov/. They can also be purchased through the secondary market at current prices.
TIPS can be sold prior to maturity. Of course, investors would forego any remaining interest payments and the holding would be sold at current market values. If selling before maturity, TIPS may not benefit from an increase in value due to inflation. In addition, TIPS can be harder to sell than typical U.S. Treasuries, especially in times of economic stress or market volatility.
The semiannual interest payments and principal adjustments of TIPS are federally taxable in the year they occur. However, they are exempt from state and local taxes.
Caveats of Owning TIPS
TIPS can provide a hedge against unexpected inflation. Expected inflation is already reflected in the price of the security. Therefore, TIPS only work as an inflation hedge if actual inflation is greater than what is expected or already priced into the market.
The yield spread between TIPS and U.S. Treasuries of the same maturity is referred to as the breakeven spread. This number represents the average inflation rate required throughout the life of the TIPS for it to outperform a U.S. Treasury bond of the same maturity (i.e. length).
For example, a five-year TIPS was recently yielding 0%, and a five-year US Treasury was yielding 3%. The breakeven spread is calculated as: 3% – 0% = 3%. Inflation must exceed 3% over the five-year period for the TIPS to perform better than the U.S. Treasury bond.
As we can see, the return on TIPS is dependent on more than just an inflation figure. It involves some complexities of interest rates, market stress, and calculations.
Domani’s Take on TIPS
Due to the interest rate sensitivity and longer maturities, Domani Wealth does not typically include TIPS as a dedicated allocation within portfolios. However, some of our bond managers may include TIPS as part of their allocation when TIPS are priced attractively relative to inflation expectations.
I Bonds are U.S. savings bonds with adjustable interest rates based on inflation. Interest rates on I Bonds are adjusted every 6 months (May and November) based on the Consumer Price Index (CPI).
I Bonds have been in the news quite a bit lately based on the most recent interest rate adjustment, which for these bonds is based on our current high inflation numbers. However, there are some other characteristics that need to be considered when thinking about purchasing I Bonds.
The interest earned on I Bonds resets every six months based on inflation. With the May adjustment, I Bonds are now yielding 9.6% annualized. However, it is important to remember that this interest rate is only good for the next 6 months and will reset again in November. If inflation subsides, as many analysts expect, the coupon will reset at a lower rate.
Investors do not receive interest payments until the bond matures. Instead, the interest earned is added to the value of the bond twice per year. This means that the principal amount on which you earn interest increases every six months, which amplifies the compounding effect over time.
Maturity & Liquidity
I Bonds have a rather long maturity of 30 years and must be purchased directly through https://www.treasurydirect.gov/.
In addition, there is no secondary market for I Bonds. They must be cashed out directly with the U.S. Treasury.
There is a one-year minimum holding period and penalties for cashing out early, as shown in the table below. For these reasons, investors should make sure they will not need the funds before the 5-year time period.
Maximum Holding Size
Investors can purchase up to $10,000 of I Bonds annually per person. You can purchase another $5,000 with a tax refund. Also, I Bonds cannot be held in IRA accounts.
Tax reporting of interest may be deferred until redemption, final maturity or other scenario involving selling the bond. I Bonds are exempt from state and local income taxes, but not federal. They may be entirely tax free if used to pay for college tuition at an eligible institution.
Domani’s Take on I Bonds
Domani Wealth cannot purchase I Bonds in client accounts nor hold them at Charles Schwab. All purchases must be made directly through the U.S. Treasury.
However, I Bonds could be an attractive investment and/or savings vehicle for clients who have idle cash that they do not need for at least 5 years.
We know these times of higher inflation can be unsettling. Although TIPS and I Bonds may provide some help against inflation, it is also important to be aware of price fluctuations, liquidity constraints and other restrictions. Please see the table below for a side-by-side comparison of the two investments.
While Domani Wealth does not hold TIPS or I Bonds directly as part of our standard portfolios, each of our client portfolios is tailored to their specific financial plan and goals. Our financial plans for clients may include recommendations for one or both of these if the parameters, market factors, and client goals align.