TIPS and I-Bonds share nice advantages

Dollars & Sense

October 05, 2003|By Sue Stevens | Sue Stevens,Morningstar.com

Although they initially met with a tepid reception several years ago, TIPS (Treasury Inflation-Protected Securities) and I-Bonds are finding places in more and more portfolios. Each has a component that offers inflation protection. And if we find ourselves in a deflationary environment, at least you will always get back the face value of the bond, and interest can never fall below zero.

In 2002, some investors started to chase performance in TIPS funds because returns were in the double digits. Performance year-to-date has been much more modest - about 3.2 percent. Chasing performance is the wrong reason to buy an inflation-protected bond. But there are plenty of right reasons.

Both TIPS and I-Bonds have low correlations with other asset classes. In other words, they don't behave like most other bonds or stocks. That means they can be used to diversify almost any type of portfolio.

I-Bonds are U.S. Savings Bonds that are designed to offer protection from inflation.

The interest that I-Bonds pay comes in two parts: a fixed interest rate and a variable interest rate. The fixed-rate portion is set when you buy the bond. Remaining interest payments come from the variable-rate portion, which changes twice a year based on inflation, as measured by the Consumer Price Index. The most recent I-Bond is paying a 1.1 percent annual fixed interest rate and a 3.56 percent annualized variable interest rate. That means the composite rate is 4.66 percent. Rates will be reset Nov. 1, 2003; most of us expect them to go down.

You can buy up to $30,000 worth of paper I-Bonds each calendar year at your local bank. In addition, you can buy up to $30,000 in electronic I-Bonds through TreasuryDirect. You must hold these bonds for at least six months before cashing out. If you cash out before you've owned the bonds five years, you will lose three months' worth of interest. Still, even minus the three months' interest, the rate may beat other alternatives.

You purchase I-Bonds at face value, and you don't have to pay any kind of brokerage commission. Each bond features a picture of an outstanding American:

$50: Helen Keller, advocate for individuals with disabilities.

$75: Dr. Hector Garcia, advocate for Mexican-American veterans' rights.

$100: Dr. Martin Luther King Jr., civil rights leader.

$200: Chief Joseph, Native American leader.

$500: Gen. George Marshall, military leader and Nobel Peace Prize recipient.

$1,000: Albert Einstein, creator of theory of relativity and Nobel Prize winner.

$5,000: Marian Anderson, world-renowned African-American vocalist.

$10,000: Spark Matsunaga, Japanese-American World War II hero.

You won't receive interest from your I-Bonds until you cash them in or they mature. So you don't have to pay tax on the interest as it accrues. This can be a significant advantage over a Treasury Inflation-Protected Security in a taxable account.

At maturity or redemption, interest on I-Bonds is subject to federal tax, but not to state or local tax. And if you meet certain requirements, interest may also be exempt from federal tax if you use the bonds to pay higher-education expenses.

For all these reasons, I-Bonds can be attractive candidates for many taxable accounts - but not all. In particular, investors in high tax brackets may lose the inflation-protection advantage of these bonds to taxes in a higher-inflation environment. How? If the money you receive from the fixed portion of the bond's interest is less than what you'd owe in taxes.

Say, for example, you bought a $1,000 bond that paid 3 percent in fixed interest and 7 percent in variable interest, reflecting an inflation rate of 7 percent. You'd earn 10 percent interest on the bond, or $100. If that $100 is taxed at a 35 percent rate, you'd owe $35 in taxes. Your after-tax income would be $65. But to keep up with a 7 percent inflation rate, you'd need to net $70.

To sum up: I-Bonds can play important roles in many taxable accounts. They act as a hedge against inflation, are guaranteed by the U.S. government and are affordable. And, unlike with a bond mutual fund, you'll always get back at least the face value of your I-Bond. On the downside, you may be able to earn a higher interest rate with other types of bonds. If you need to sell the bond less than five years after you bought it, you'll lose three months of interest. And, unless investors are careful about choosing a bond with a fixed rate that makes more income than is taken away in taxes, these bonds may not offer much protection to those in the highest tax brackets if inflation rises significantly.

TIPS are government-issued bonds that, like I-Bonds, provide a hedge against inflation.

TIPS set their interest rates when they are sold. However, the bond's underlying principal rises and falls with changes in the inflation rate, and as it does so, the amount you'll receive as interest also changes. However, at maturity you'll always get at least the par value of the bond.

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