More Inflation Protection with TIPS After Maxing Out I Bonds

I Bonds are great, but there’s a limit on how much you can buy each year. After you buy all the I Bonds you can buy in your personal account, trust, business, as gifts, from your tax refund, and , then what? A natural answer is TIPS. They are another type of government bond with inflation protection.

I have a lot to say on this topic because I wrote a book about TIPS back in 2010. Amazingly little has changed in all these years. Specific interest rates changed, and some new mutual funds and ETFs came out, but the principles are still the same. I’ll give you the gist of TIPS in this post.

Table of ContentsWhat Are TIPS?No Purchase LimitYield Can Be NegativeInterest Rate RiskLesser of Two EvilsBreakeven Inflation RateWhen to Invest in TIPSHow to Invest in TIPSWhat Are TIPS?

TIPS are Treasury Inflation-Protected Securities. They’re a type of bond issued by the U.S. government. Both the principal and the interest are linked to inflation. If inflation goes higher, you get paid more interest and the principal repayment also goes higher.

No Purchase Limit

The biggest advantage of TIPS over I Bonds is that there’s no annual purchase limit in TIPS. You can buy as much as you want, in all types of accounts — including IRAs and HSAs, at an online broker you already use, both as individual bonds and in a mutual fund or ETF. Although you can also buy TIPS through TreasuryDirect, you don’t have to use TreasuryDirect.

Yield Can Be Negative

The biggest disadvantage of TIPS over I Bonds is that the yield on TIPS can be negative, which means they can be guaranteed to lose to inflation whereas I Bonds are guaranteed to at least match inflation.

5-Year TIPS yIELD: 2010 – April 2022

The chart above shows the yield on 5-year TIPS from 2010 through April 2022. It turned negative shortly after I published my book in 2010 (great timing, huh?). It stayed consistently positive only between November 2016 and December 2019.

The yield on 5-year TIPS was -0.46% as I wrote this on April 26, 2022. It means you’re guaranteed to lose 0.46% per year to inflation for five years if you bought a 5-year TIPS on that day and you hold it to maturity. No one likes to lose to inflation but there may not be a better choice after you buy all the I Bonds you can buy. Institutional investors invest billions of dollars in TIPS. They settle for a guaranteed loss to inflation to protect against losing an even larger amount to inflation.

You can see the latest yields on TIPS of different maturities at Daily Treasury Par Real Yield Curve Rates (click on the second link on the web page) and on this page from Wall Street Journal. As I wrote this, although the 5-year TIPS yield was still negative, it wasn’t as negative as before. It was -1.6% only 1-1/2 months ago. The 10-year TIPS yield was barely negative at -0.08% at this moment.

If TIPS yields become positive, this disadvantage can turn into an advantage. When TIPS yields were positive in the past, they were higher than the fixed rate on I Bonds.

Interest Rate Risk

The next disadvantage of TIPS over I Bonds is interest rate risk.

I Bonds are guaranteed never to lose money regardless of when you cash out. You forfeit the last three months of interest when you cash out within five years but you’re guaranteed to have your principal back plus the interest you get to keep.

It’s a different story with TIPS. You’re guaranteed to have your principal back only when you hold TIPS to maturity. If you must sell TIPS early, you get the market value, which can be higher or lower than your original investment.

Bond prices go down when market interest rates go up. You can lose money in TIPS over the short term even when inflation is high. For instance, Vanguard Inflation-Protected Securities Fund (VAIPX) invests 100% in TIPS. Its year-to-date return through April 25, 2022 was -4.41%, and that was with the high inflation so far in 2022. The short-term return was negative because market interest rates went up in recent months.

Lesser of Two Evils

Although the -4.41% short-term return on the TIPS fund sounds bad, it was actually a lot better than the returns on comparable non-TIPS bond funds. For instance, the year-to-date return on Vanguard Intermediate-Term Treasury Index Fund (VSIGX) was -6.81% in the same period.

TIPS can lose to inflation but other bonds can lose more to inflation. When TIPS yields are negative, after buying all the I Bonds you can buy, your choice isn’t losing to inflation or not losing to inflation. It’s losing a known amount to inflation with TIPS or losing an unknown amount to inflation with other bonds.

Breakeven Inflation Rate

The tradeoff comes down to how much inflation there will be in the future. No one knows. The market participants come out with an estimate. That’s the breakeven inflation rate, which is the difference between the yield on TIPS and the yield on nominal Treasury bonds of the same maturity. You’re better off with TIPS if inflation in the future comes out above this breakeven inflation rate. You’re better off with regular Treasuries if inflation in the future comes out below this breakeven inflation rate.

David Enna at TIPS Watch tracked the breakeven inflation rate at the time when TIPS bonds were first issued versus the actual inflation experienced during their lifetime. The data showed the market is always wrong on what future inflation will be. Sometimes the market estimated too high. Sometimes the market estimated too low.

You see the current breakeven inflation rates but you don’t know which way they’re wrong or by how much.

When to Invest in TIPS

Most of the questions on TIPS are really on whether it’s a good time to invest in TIPS right now.

Is it the best time to invest in TIPS right now?

Absolutely not. The best time to invest in TIPS was October 2008 when you could lock in a positive 3% yield above inflation for 20 years but we don’t have a time machine.

Should I wait until TIPS yields go higher in the coming months?

No one knows whether the yields on TIPS will go higher or lower. Money waiting in the wings also loses to inflation.

Is it better to switch from other bonds to TIPS now when inflation is high?

No one knows. High inflation isn’t a secret. When everyone expects high inflation, the breakeven inflation rate is also high. This compensates investors in other bonds for their lack of inflation protection.

Market participants collectively come to a conclusion that the current yields on TIPS and other bonds make them no better off or worse off one way or the other. You’re better off in TIPS when the market underestimates future inflation but no one knows whether the market is underestimating or overestimating right now.

Then how do you decide whether to invest in TIPS right now or not?

You decide by whether you want inflation protection or you want to take your chances relative to inflation.

When you invest in TIPS, you know how much you’ll earn or lose over inflation. Invest in TIPS if you’re satisfied by this number no matter what inflation turns out to be in the future. Other fixed-income investments may end up doing better or doing worse than TIPS but you don’t care. Your goal is to protect your investments from inflation.

On the other hand, if you don’t mind losing more to inflation for a chance to lose less, you don’t need to go out of your way to invest in TIPS. No one knows whether TIPS will do better or worse.

Finally, there’s always diversification. You don’t have to go either 100% TIPS or zero TIPS. You can invest in both TIPS and other bonds.

How to Invest in TIPS

If you decide to invest at least some money in TIPS, you can either buy individual TIPS or buy a mutual fund or ETF that holds TIPS. Buying a mutual fund or ETF is the easiest, in the same way as you invest in other bonds. When you’re new to TIPS, start with a mutual fund or ETF.

As in other bonds, short-term TIPS have a lower interest rate risk than longer-term TIPS but, in general, they also have a lower yield.

These mutual fund and ETFs invest in short-term TIPS (maturities up to 5 years):

MinimumExpense RatioiShares 0-5 Year TIPS Bond ETF (STIP)None0.03%Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)None0.04%Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX)$3,0000.06%

These mutual funds and ETF invest in TIPS of all maturities:

MinimumExpense RatioFidelity Inflation-Protected Bond Index Fund (FIPDX)None0.05%Schwab Treasury Inflation Protected Securities Index Fund (SWRSX)None0.05%Schwab U.S. TIPS ETF (SCHP)None0.05%Vanguard Inflation-Protected Securities Fund Admiral Shares (VAIPX)$50,0000.10%

Buying individual TIPS gets more complicated. Please read my book Explore TIPS if you’re interested in buying individual TIPS.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post More Inflation Protection with TIPS After Maxing Out I Bonds appeared first on The Finance Buff.