TIPS held to maturity as "bottom" of cash component?

[moda0306]

I found the formula... a bit screwy but I like these things.

Is the inflation adjustment the same no matter when you purchased your original ibond? 

[moda0306]

I tried another date just to check Nov. 2001.  4.4% for I-bonds vs 2.1 for 1 year treasury and 2.5 for 3 year treasury.

By god we've discovered something beautiful.

[moda0306]

I'm literally losing it after looking at these I-bond returns.  They are creaming 1-3 year treasuries.

Better start the buying spree w/ the $5,000 limit each year.

[Lone Wolf]

I have read on them, and I think I understand how they work.  The thing is, I can't really figure out how the fixed rate is determined.  

I also have no idea how the fixed rate is determined.  For all I know, it may be arbitrary.  Really makes me curious, especially with it sitting at 0% fixed rate right now.

One thing I like about I-bonds is that you get some real inflation protection (as their rates are indexed to CPI-U.)  T-bills of course also "slightly" compensate you for inflation via their interest rate but typically with a rate lower than the I-bond composite rate.  Plus, you pay taxes on the interest from t-bills while I-bond taxes can be deferred for 30 years.  So with t-bills I think you really do get a bit of a bad deal on your cash when inflation comes because you must pay the government tax money on the inflation it has caused.  (I find this very annoying.)

The variable rate is based on the CPI-U (which from what I understand includes food and energy but not health care.)  This tends to put I-bond rates at rates that are competitive with slightly longer-term treasury securities but without the interest rate risk.

They have the following disadvantages:
1. Setting up a TreasuryDirect account involves some rigmarole.
2. They have an irritating $5,000 per year limit from TreasuryDirect, plus an additional $5,000 per year limit as paper bonds.
3. When you walk into the bank and ask to purchase them, the teller may look at you like you have two heads.  Apparently nobody really bothers to buy these things except the occasional granny.  So it's just Lone Wolf and the grannies rockin' the I-bonds.  (Speaking only for my local branch -- it sounds like MT has been buying these for years!)
4. They cannot be traded on the secondary market.  You can either cash them in or hold on to them.
5. You must hold on to them for five years to avoid having to forfeit any interest.

I'm afraid that MT might be right that they'll try to discontinue them.  The ever-shrinking limits kind of hint at that.  Me and the grannies will get together and have a good cry when that happens.

[moda0306]

What a great tool for safe, tax-efficient, inflation protected return for the middle class.... A complete shame it's not being used better.

[MediumTex]

I-bonds rock!!!

[Lone Wolf]

I think they set rates a couple of times each year - say 4.75% total, and if inflation is 2% then they become inflation + 2.75% type returns.  If next week inflation rises to 3% they're in effect inflation + 1.75%.  If it keeps going that way they might set them to maybe 5% at the next 6 month review...etc.  But I'm way from sure.

Yeah, in the US the I-series savings bond "fixed rates" are set twice per year, May and November.  So you're theorizing that fixed rate might be reverse-engineered to meet a particular target?  Whatever the Treasury feels is the right "real" rate of return for the composite to produce?  Certainly as good of an explanation as I've got.  The fixed rate is a bit opaque to me.

Even at 0% fixed rate they're worth having (IMO) since the composite rate can't go below 0% (even if CPI-U goes negative for a stretch.)  The tax deferral makes these lousy real yields better than the lousy real yields of TIPS.  :)

Sorry to hear your equivalent UK savings bond got deep-sixed, Clive.    Hopefully they'll return one day!

[AdamA]

Great info, Lone Wolf.  I guess it's a good idea to keep some cash in something else that's a tiny bit more liquid if you're going to use I-bonds (to rebalance). 

It's more the tax benefit I like than anything else. 

I am a bit skeptical of the government issuing inflation protected anything.  It's kinda the fox guarding the hen house.  They can easily manipulate the CPI (no food or energy??!!), and you might not get true inflation protection, certainly not what you get with gold (which responds not only to inflation, but also the fear of inflation).    Nonetheless, the tax advantage and at least some inflation protection sounds like pretty good deal. 

Adam

[MediumTex]

I am a bit skeptical of the government issuing inflation protected anything.  It's kinda the fox guarding the hen house.  They can easily manipulate the CPI (no food or energy??!!), and you might not get true inflation protection, certainly not what you get with gold (which responds not only to inflation, but also the fear of inflation).    Nonetheless, the tax advantage and at least some inflation protection sounds like pretty good deal. 

Adam

This is an important point and I think that one of the good uses of I-bonds as a cash component of the PP (as opposed to a gold substitute) is that you are NOT relying on the government to accurately track or compensate you for inflation; rather, you are simply recognizing that I-bonds seem to be a way of getting higher returns than t-bills provide with better tax treatment, but with the same safety.

[moda0306]

Plus, after 1 year you can sell them, so if the inflation calculation is pathetically inadequate, then just sell them and buy a t-bill.  I don't necessarily "trust" them either, but luckily these securities are liquid so you don't need to trust them.  Just sell them when they quit being honest.

[fnord123]

Well bleh, my TIPS thread has been hijacked into an I-Bonds discussion.

I-Bonds are great for all the reasons mentioned. They also are limited to $10K/year investment.  So assume somebody has $40K in the cash segment of their PP.  They could go get $10K in I-Bonds (5 online, 5 paper). Great. Now what about the remaining 30K?

They can put the $30K in a FDIC insured account, taking on FDIC risk. All yields will be taxed as income both by the feds and by the states.
They can put the $30K in short term treasuries (or an equivalent ETF or mutual fund). All yields will be federally taxed (but not state or local iirc).

My thought was to put a portion of that $30K (let's say, $10K) into TIPS and hold to maturity.  If I understand correctly, the tax treatment here is identical to the tax treatment that short term treasuries get, so that isn't an argument against TIPS, is it?

Is the anti-TIPS sentiment the idea that someone will need all of their cash segment (not just 75% of it) fully liquid?  The only possible scenario I can come up with for that is if the other 3 segments (gold/LT treasuries/stocks) drop to something like 10% of their value and one needs to rebalance 80%+ of the cash in their cash segment into the other segments.  For that to happen, the S&P 500 would need to hit 130, gold $130/ounce, and 30 year treasury interest rates would need to be something like 0.2%.  Is the economy even functioning at that point?  Or is there some other scenario I am missing?

[MediumTex]

I-bonds are also a good way of teaching your kids about money.

I showed my daughter an I-bond and told her that if I put it in a drawer for 20 years it would be worth a lot more than it is today. 

I then showed her some currency and told her that if I put it in a drawer for 20 years it would be worth a lot less than it is today.

I then showed her a silver eagle coin and told her that if I put it in a drawer for 2000 years it would basically be worth the same as it is today.

She looked at me quizzically.

[MediumTex]

Well bleh, my TIPS thread has been hijacked into an I-Bonds discussion.

I-Bonds are great for all the reasons mentioned. They also are limited to $10K/year investment.  So assume somebody has $40K in the cash segment of their PP.  They could go get $10K in I-Bonds (5 online, 5 paper). Great. Now what about the remaining 30K?

If you're married your spouse can do another $10,000.

In 11 months you and your spouse can do it again. 

Problem solved.

I think that for most people the I-bond limits are really not that problematic.  For a couple working together, in only a few years you could have a pretty large amount of I-bonds.

[fnord123]

I-bonds are also a good way of teaching your kids about money.

I showed my daughter an I-bond and told her that if I put it in a drawer for 20 years it would be worth a lot more than it is today. 

I then showed her some currency and told her that if I put it in a drawer for 20 years it would be worth a lot less than it is today.

I then showed her a silver eagle coin and told her that if I put it in a drawer for 2000 years it would basically be worth the same as it is today.

She looked at me quizzically.

Given that the I-Bond tracks the CPI-U, with zero additional interest (at least for I-Bonds one can buy today), and that CPI-U is at best tracking inflation (and many people argue understates inflation), won't the I-Bond at best be worth about the same as it is worth today in terms of purchasing power?  So other than less volatility risk (but additional risk in terms of understating true inflation), the I-Bond seems similar to the silver eagle.

[MediumTex]

My thought was to put a portion of that $30K (let's say, $10K) into TIPS and hold to maturity.  If I understand correctly, the tax treatment here is identical to the tax treatment that short term treasuries get, so that isn't an argument against TIPS, is it?

Is the anti-TIPS sentiment the idea that someone will need all of their cash segment (not just 75% of it) fully liquid?  The only possible scenario I can come up with for that is if the other 3 segments (gold/LT treasuries/stocks) drop to something like 10% of their value and one needs to rebalance 80%+ of the cash in their cash segment into the other segments.  For that to happen, the S&P 500 would need to hit 130, gold $130/ounce, and 30 year treasury interest rates would need to be something like 0.2%.  Is the economy even functioning at that point?  Or is there some other scenario I am missing?

Why TIPS, though?

Do you think the CPI is about to explode?

If you had no other options, then I would say sure, buy the TIPS and hold to maturity.  With other options available, though, it just makes TIPS that much less appealing to me.

[MediumTex]

Given that the I-Bond tracks the CPI-U, with zero additional interest (at least for I-Bonds one can buy today), and that CPI-U is at best tracking inflation (and many people argue understates inflation), won't the I-Bond at best be worth about the same as it is worth today in terms of purchasing power?   So other than less volatility risk (but additional risk in terms of understating true inflation), the I-Bond seems similar to the silver eagle.

In 2000 years an I-bond will be long burned, soaked, torn up or thrown away.

An I-bond is just a piece of paper.

The silver has a much better chance of hanging around and still being valued by people.

My point was more about the transitory nature of human institutions than about whether I-bonds accurately track inflation.

[fnord123]

If you had no other options, then I would say sure, buy the TIPS and hold to maturity.  With other options available, though, it just makes TIPS that much less appealing to me.

What are the other options?

I-Bonds have positive attributes, I agree.  The main negative attribute (other than the annoying per-year limit) is that the I-Bonds people can buy today give 0% interest above CPI-U.  That stinks.  Here's a TIPS bond listing from Vanguard that is for sale right now - these are the 20 year bonds issued a couple years back:

CUSIP - Issue - Coupon - Maturity - Price - Yield
912810PV4 - T Tips (Tips) -1.750 - 01/15/2028 - 99.886719/100.199219 -1.758/1.736

So one could take $10,019.92 dollars, and buy these TIPS, that have 1.750% coupon (plus CPI-U).  If held 17 years there is all of $19.92 in principal risk (0.19%), but there is a 1.75% higher coupon than current I-Bonds.  That is pretty hard to beat imo, even if you factor in taxation.  Am I missing something?

[MediumTex]

If you had no other options, then I would say sure, buy the TIPS and hold to maturity.  With other options available, though, it just makes TIPS that much less appealing to me.

What are the other options?

You could buy Series EE savings bonds.   

They will double in value in 20 years, which guarantees you a return of at least 2.35% or so.

Given the choice of TIPS or regular treasurys, though, I would just go with the regular treasurys.

In fact, if you are willing to buy a 20 year TIPS bond and hold it until maturity and treat this as a cash holding in your PP, why not just buy a 20 year treasury bond right now and hold it until maturity?  That will pay you 4% or so.

[AdamA]

The five year Treasury is at 2%.  You could consider that.  Easier to hold to maturity (shorter term), and better for tax purposes. 

[Lone Wolf]

I am a bit skeptical of the government issuing inflation protected anything.  It's kinda the fox guarding the hen house.  They can easily manipulate the CPI (no food or energy??!!), and you might not get true inflation protection, certainly not what you get with gold (which responds not only to inflation, but also the fear of inflation).

This is absolutely true.  However, from what I understand, I-bonds use the "CPI-U" metric for I-bonds, which does include food and energy.  The "Core CPI" measure excludes food and energy, and this is the one that Federal Reserve chairmen like to use to reassure everyone that inflation is under control.

That being said, you are 100% right to be skeptical of CPI calculations.  The methodology was changed circa 1990 and could be changed again.  The government can save itself a lot of money when it comes time to pay off TIPS investors by taking another look at how the CPI is calculated.  Thus my overall expectation is that the real purchasing power of even the I-bond is likely to erode a bit over time (although much more slowly than other cash instruments.)

Well bleh, my TIPS thread has been hijacked into an I-Bonds discussion.

Sorry about that.  It amazes even me the things I can get excited talking about.

How far out on the yield curve were you thinking of venturing out?  30 years is a mighty long time when you plan to hold to maturity.  With 75% of your portfolio invested and not highly liquid, I like the idea of having 25% of the portfolio with relatively high "agility" if I need to make a big purchase.  If you find yourself needing to spend that money, you suddenly are on the hook for the interest rate risk.

Or were you maybe thinking something more along the lines of 5 years or 10 years?  That seems like much less of a scary commitment than 30 years.  That seems plenty workable, especially if you've bought all the I-bonds you can buy, maxed HSA, etc.  You are probably the best judge of how liquid your cash portion needs to be.

I'm much more amenable to the idea of TIPS in the "cash" slice than I am TIPS in the "gold" slice (something people so often find themselves wanting to do.)

[MediumTex]

I'm much more amenable to the idea of TIPS in the "cash" slice than I am TIPS in the "gold" slice (something people so often find themselves wanting to do.)

Remember that sign on the wall of the guitar shop in "Wayne's World" that said "NO STAIRWAY"?  When Wayne started playing "Stairway to Heaven" the guy in the store stopped him and pointed to the sign.

I would like to put up a sign in this forum with something similar about not substituting TIPS for gold in the PP.

[fnord123]

MediumTex: I agree that TIPS for gold is a horrible idea. TIPS and gold are not at all correlated with one another and do not represent the same risks or upside at all.

LoneWolf: The suggestion of holding some medium-dated treasuries to maturity in the "bottom" portion of the cash segment seems like an interesting alternative to TIPS.  I'm going to have to go off and look at some yield curves. Thanks for the idea!

[Lone Wolf]

LoneWolf: The suggestion of holding some medium-dated treasuries to maturity in the "bottom" portion of the cash segment seems like an interesting alternative to TIPS.  I'm going to have to go off and look at some yield curves. Thanks for the idea!

Yeah, that seems like a pretty good way to go (although the credit for that one goes to Mr. MediumTex and\or adam1226!)  I'd be interested in hearing what you find.  Ultimately, that approach does bear interest rate risk as well.  It's hard to find the free lunch unfortunately.

Also, since TIPS have such craptastic tax treatment, would your plan work better if you can squeeze some extra space out of your tax-deferred accounts?  The thing that I really hate about TIPS is that you pay tax immediately on the principal increase due to inflation even though you don't get that money until the security matures, kinda like some sort of zero-coupon bond.  All based on inflation that the government causes and measures itself!

I find myself kind of unable to think straight about TIPS because this particular tax "feature" makes me so upset.  :)

Edit: Clive's idea also strikes me as a very interesting one.

[fnord123]

 The thing that I really hate about TIPS is that you pay tax immediately on the principal increase due to inflation even though you don't get that money until the security matures, kinda like some sort of zero-coupon bond.  All based on inflation that the government causes and measures itself!

Whoops - I didn't realize this part.  TANSTAAFL!

Just curious - if the principal goes down (due to deflation) does that act as an offset to other income earned during the same year?  I.e. if someone earned $50K in income, but their tips went down $5K in principal, would they then report $45K AGI on their year-end taxes?

[fnord123]

If the principal goes down (due to deflation) does that act as an offset to other income earned during the same year?  I.e. if someone earned $50K in income, but their tips went down $5K in principal, would they then report $45K AGI on their year-end taxes?

So I poked around in the IRS forms a big (publication 1212 in particular).  Looks like principal reductions can be used to offset the TIPS 1099 interest at least.  What isn't clear is if a deflation-driven yearly principal reduction can apply to interest income from other things the invest holds. I'm betting the answer is no, but cannot find anything clear about it online