[First published in 2022. Updated on August 25, 2023.]
I Bonds are great, but they’re better for the short term than the long term when the fixed rate is low. Although the Treasury Department raised the fixed rate on I Bonds to 0.9% for new I Bonds bought between May and October 2023, it’s still much lower than the current real yield on TIPS, which 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.
What 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 TIPS as you want, in all types of accounts — including IRAs and HSAs, at a broker you already use, both as individual bonds and in a mutual fund or an ETF. You don’t have to use TreasuryDirect to buy TIPS.
TIPS yields were negative during some periods in the past, which meant investors were guaranteed to lose to inflation when they bought TIPS at that time. As I updated this on August 25, 2023, the yield on 5-year TIPS was +2.15%. This means if you buy a 5-year TIPS and hold it for five years, you’ll beat inflation by 2.15% per year. This is much better than the fixed rate on I Bonds. The yield on TIPS hasn’t been this high for a long time.
The market will continue to change. The yields on TIPS may go up some more, or they may come back down. You can see the latest yields on TIPS of different maturities on the Interest Rate Statistics page at TreasuryDirect (click on the second heading for Daily Treasury Par Real Yield Curve Rates) or on this page from Wall Street Journal.
Interest Rate Risk
A disadvantage of TIPS over I Bonds is the 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. They behave like a bank CD.
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 plus interest and inflation adjustments.
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 August 2024, 2023 was only 0.53%. The short-term return was low because market interest rates went up in those months.
The 0.53% short-term return on the TIPS fund was actually not much better than the return on a comparable non-TIPS bond fund. For instance, the year-to-date return on Vanguard Intermediate-Term Treasury Index Fund (VSIGX) was 0.28% in the same period.
Both a TIPS fund and a regular bond fund have interest rate risk. A TIPS fund can perform better or worse than a regular bond fund over any period.
Breakeven Inflation Rate
The tradeoff between TIPS and non-TIPS bonds 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.
|Better Off With
|> Breakeven Inflation Rate
|< 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 about what future inflation will be. Sometimes the market estimated the future inflation too high. Sometimes the market estimated too low.
You see the current 5-year breakeven inflation rate and 10-year breakeven inflation rate from the Federal Reserve Bank of St. Louis. It’s between 2.0% and 2.5% at this moment. 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?
It’s not. The best time to invest in TIPS was October 2008 when you could’ve locked 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 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 higher. The breakeven inflation rate compensates investors in other bonds for their lack of inflation protection.
Market participants collectively come to the 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.
Handicapping whether inflation in the coming years will be above or below the current breakeven inflation rate isn’t a good way to invest.
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 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 to inflation for a chance to beat more, 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 an ETF that holds TIPS. Buying a mutual fund or an ETF is the easiest, in the same way as you invest in other bonds for the long term. When you’re new to TIPS, start with a mutual fund or an ETF unless you’re planning to liquidate all your holdings on a specific date or over a short period of time. See Two Types of Bond Ladder: When to Replace a Bond Fund or ETF.
The popular total bond market index funds and ETFs don’t include TIPS. Investing in both a TIPS fund and a total bond market index fund will make your bond investments more complete.
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 funds invest in short-term TIPS (maturities up to 5 years):
|iShares 0-5 Year TIPS Bond ETF (STIP)
|Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
|Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX)
These funds invest in TIPS of all maturities:
|Fidelity Inflation-Protected Bond Index Fund (FIPDX)
|Schwab Treasury Inflation Protected Securities Index Fund (SWRSX)
|Schwab U.S. TIPS ETF (SCHP)
|Vanguard Inflation-Protected Securities Fund Admiral Shares (VAIPX)
Buying individual TIPS gets more complicated. Please read my book Explore TIPS if you’re interested in buying individual TIPS.
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