why i don’t want i-bonds

Brett Arends

The U.S. government was so eager to buy “I-bonds,” or inflation-protected bonds, that the TreasuryDirect website crashed.

I-bonds have been one of the hottest investments of the year. People who never talk about investing keep telling me about the I-bonds they keep buying. Market strategists keep asking me if I “still” buy my I-bond configuration.

Investors who bought before Friday’s deadline locked in a (brief) rate of 9.6%, and if you miss it, it’s estimated to drop to 6.5%.

Well, you can leave me out. I’m not in a rush to buy I-bonds, I’m baffled by the excitement they seem to cause. I think they’re a pretty mediocre deal overall, and there are better things out there.

Why are they mediocre deals? Well, your value is limited to $10,000 per year (if you overpaid federal taxes and got a refund, you could squeeze it down to $15,000—no thanks). Interest is fully taxable. You must hold them for five years to receive full interest. The “9.6%” interest is an annualized version of the 6-month return, and it’s poised to plummet. Oh, and most importantly (maybe), the so-called “true” return is bupkis: zero.

The “real” return is what economists call interest rates in constant dollars: in other words, interest rates in purchasing power after adjusting for inflation. (For example, if an investment has an interest rate of 8% but inflation is 8%, its “nominal” rate of return is 8% and its “real” rate of return is 0%.)

The reason I’m not interested in I-bonds has nothing to do with inflation. It’s clearly shifted away from energy prices, and it’s likely to last a lot longer than Wall Street seems to assume right now.

However, if you’re as concerned about the risk of persistent inflation as I am, then I find other investments more attractive than I-bonds. They offer better returns. They offer the same federal guarantee. However, they were largely ignored by the frenzied “refresh” crowd on TreasuryDirect’s website.

I’m talking about TIPS: Treasury Inflation Protected Securities.

These are bonds or IOUs issued by Uncle Sam and backed by the full trust and credit of the U.S. government, just like you would get from Treasury bills, 10-year Treasury bills, etc. But they had a turning point. Instead of paying you a fixed rate like traditional U.S. Treasuries, they guarantee paying you a fixed rate each year on top of inflation.

Now, while the “real” interest rate paid by I-bonds is 0%, that is, inflation plus 0%, long-term TIPS exceeds that rate by nearly 2 percentage points per year.

You can buy unlimited TIPS. You can have them in a tax-sheltered retirement account. Oh, and they’re easy to buy. You can buy individual TIPS bonds directly through any broker. Or you can own them through mutual funds or exchange traded funds such as Vanguard Inflation Protected Securities Fund, iShares TIPS Bonds ETF (TIP), iShares 0-5 Years TIPS Bond ETF (STIP) or Pimco 15+ Year US Tip ETF (LTPZ ).

Check out the chart above. It shows the average “real” return on a 30-year TIPS bond and how it has changed over time. The higher the line, the better the return. Now, we’re getting our best offer in over a decade. A 30-year TIPS bond will pay you about 1.8% inflation per year. A 10-year TIPS bond will pay you inflation plus about 1.6%.

If I buy a 10-year bond and hold it until 2032, I’m guaranteed to end up 16% richer in real purchasing power, regardless of inflation over the next 10 years. That’s completely risk-free.

If I buy a 30-year bond and hold it to maturity in 2052, I can guarantee that my real purchasing power will increase by 70% by then.

I don’t care what happens to inflation at all. won’t affect me. It just directly affects the higher interest rates on my bonds.

For the record, long-term average returns on stocks have traditionally been much higher, roughly between 5% and 7% per year above inflation (depending on who calculates it and how). These TIPS returns should be understood as “risk-free” assets, not the (potentially) higher long-term returns you can get from risky assets.

Currently, 10-year TIPS bonds pay inflation plus 1.6%, while regular (non-inflation-adjusted) 10-year notes pay a fixed 4% per year. So regular Treasuries are a better bet only if inflation averages 2.4% or less over the next decade.

Good luck.

TIPS has bounced back over the past few days. That means prices for some have gone up a bit and interest rates have come down. (Bonds are like a seesaw: when prices rise, yields, or interest rates, fall, and vice versa.) But interest rates remain attractive.

TIPS are an orphan asset class, which may be why they seem to be overlooked. Institutions and investors who want “treasury bonds” typically only buy regular bonds that pay a fixed interest rate.

TIPS was originally created by the US government in the late 1990s. They follow the British government, which created its own government in the 1980s. But both were created after the runaway inflation of the 1960s and 1970s. As such, they were never (yet) used for the reason they were created, which is to protect you from constant, year-over-year inflation. I sometimes think of them as fire insurance for a city that hasn’t had a big fire yet.

This may be the reason why TIPS prices have fallen this year, even during inflation scare. Investors have sold all of their bonds, and the longer the bond falls, the worse it gets. It doesn’t help that TIPS are grossly overvalued this year by the most rational measure: if you buy TIPS bonds today they will pay you a positive real return, if you buy them late, they will have a 0% real return, or even a negative real return last year.

The PIMCO 15+ U.S. TIPS Index ETF (LTPZ) is down nearly 40% so far this year, almost in line with the Vanguard Extended Duration Treasury ETF (EDV). This makes little logical sense unless you’re just looking at TIPS as another bond. Long-term nominal bonds depreciate in an inflationary spiral because all these future interest payments are worth much less in real purchasing power. By definition, TIPS bonds are not.

Legendary British money manager Jonathan Ruffer has been advocating TIPS and inflation throughout the year. The price has come a long way so far. Maybe he was wrong about them. Or maybe he came too early.

Former US “bond king” Bill Gross recently came out to do short-term TIPS.

Compared to I-bonds, TIPS has one major potential disadvantage: If you buy TIPS through an ETF, or if you buy individual bonds and then sell them before they mature, you could theoretically lose money. That’s because of price volatility — as we’ve seen this year. In theory, if you bought them well above face value, you could also lose money if we suffered years of deflation (which seems unlikely).

On the other hand, I’ve been buying individual TIPS bonds at, near, and even below par, and I’d happily hold them until they mature. So I’m not worried. I’m guaranteed to get back the face value, plus all the accumulated inflation for the time I held the bond, plus interest.

My biggest risk is “opportunity cost”. If I buy long-term bonds to pay inflation plus 1.8%, I might miss out: Bonds might keep falling, and those who wait might get a better deal. If I hold TIPS bonds earning inflation plus 1.8% per year and the stock market earning inflation plus 6% per year, I’d also miss out.

(Incidentally, over 30+ years, an asset earning 6% a year would increase your wealth by 470%, not 70%, in “real” terms.)

While their prices can go down, they can also go up. In fact, two weeks ago I was in London for dinner with a fund manager who had predicted a crash this year and his fund would rise in 2022 and he said their biggest bets were on long term bonds, mostly TIPS and UK etc. price bond. They argue that in the event of a crash (people will want bonds), recovery (interest rates will likely come back down and people will want bonds), or persistent inflation (people will want inflation protection), these will all pay off.

Do whatever you want. If long-term TIPS keeps dropping, you can laugh at my efforts. But as long as I stick with my investments, I’m guaranteed to make money in the end – no matter what happens.

– Brett Arends


(End) Dow Jones Newswires

10-29-22 0915ET

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