I-bonds vs TIPs

Lucky timing.

I nearly bottom-ticked the TIPs market with my trade last week. I explained in that article that my estimate for the trade’s 1-year expected return is about 8.50% with ~7.50% volatility. That suggests a weekly vol of ~1%

It’s already up 2% in one week or nearly 2 standard deviations. We’ll see if the yield holds as a high. The last time I bought TIPs, I also wrote about it in October 2023 and that high in yields held until just recently.

Anyway, a friend (and mentor!) who read my recent TIPs article reached out to say I should remind readers that I-bonds might be a better choice if their income is under certain thresholds because of the education tax exclusion. I-bonds, like TIPs, are state and local tax-exempt, but you can also avoid federal tax when used for qualified higher-education expenses.

There are income limits:

I bought them for all the members of my household back in November 2021, when they paid 7.12%. I wrote up the details in I-Bonds For You.

Five other differences worth knowing:

1. Price risk. I bonds have no market-price swings. TIPS can lose value if real yields rise, creating a loss if you sell before maturity.

2. Liquidity. I bonds are locked for one year. Redeem before five years and you sacrifice the latest three months’ interest. TIPS can be sold in the market before maturity.

3. Tax timing. I bonds let you defer federal tax until redemption or maturity. In a taxable account, TIPS generate annual taxes on both coupons and inflation adjustments even though you haven’t received the adjusted principal yet.

4. Purchase limits. I bonds generally cap you at $10,000 per person per calendar year. TIPS accommodate much larger investments.

5. How you get paid. I bonds adjust their interest rate and compound internally. TIPS coupon rates remain fixed, but the principal adjusts. They pay cash coupons every six months.

TIPs don’t have limits on how much you can buy, but the other major benefit is a yield you can lock in. I-bonds usually have a paltry fixed rate portion. Since you buy them directly from the Treasury at par, you are locking in a lower fixed return vs TIPs at current pricing. The higher TIPS yield can outweigh the I-bond’s friendlier features such as the potential tax exclusion and the lack of “phantom taxes”.