 Picking
between TIPS and Series I bonds
|  Dear
Dr. Don,
New reader, old question. In the long run, is there
any advantage or disadvantage to buying I bonds from TreasuryDirect
vs. TIPS from a low-cost mutual fund (e.g., Vanguard)? -- Ross
Rates
 Dear
Ross,
Let me start by pointing out that Treasury Inflation
Protected Securities, or TIPS, don't have the same security as Series
I savings bonds. TIPS adjust the principal amount for inflation,
but pay a set coupon interest rate on the principal. The coupon
payment will increase over time as the principal increases with
inflation. The investor receives semiannual coupon payments and
has to decide whether and where to reinvest the payment. Federal
income taxes are due annually on both the coupon payments and the
principal balance as it accrues, unless the TIPS are held in tax-advantaged
accounts.
In contrast, the Series I savings bond pays interest
based on a combination of a fixed rate paid over the life of the
bond and a variable inflation component based on the inflation rate.
Interest is paid when the savings bond is redeemed. This avoids
a reinvestment decision. Taxes on the interest can be deferred until
the bond is redeemed or can be paid annually as it accrues. The
interest income on both savings bonds and Treasury securities are
exempt from state and local income taxes.
Buying a mutual fund that invests in TIPS has some
advantages and some disadvantages. Professional money management
is an advantage. The fund manager can adjust the average maturity
of the fund's holdings to potentially improve the fund's return
much more efficiently than an individual investor can do by trading
his holdings. Turnover in the fund, however, can generate additional
tax liabilities since mutual funds have to pass through income and
realized capital gains to the shareholders.
Vanguard Inflation-Protected Securities, or VIPSX,
has had a great run since its start in 2000. The fund is up 2.53
percent this year through the end of May and has a one-year total
return of 10 percent. If, instead, you had bought the 20-year TIPS
when it was first offered last July, you would have paid $997.29
for a note that trades at $1,103.75 today.
You can buy savings bonds or Treasury bills, notes
and bonds using TreasuryDirect, but you can't use TreasuryDirect
as an individual to buy savings bonds for retirement accounts. Using
TreasuryDirect as an individual to buy Treasury securities for a
retirement account may be possible with the permission of the Internal
Revenue Service, or a custodian can set up a TreasuryDirect account
to hold these securities. The Treasury
Direct Web site has more information about registration choices.
There's an argument that the TIPS have performed so
well that there's not much room for continued price appreciation.
If that's true, and past history makes it a pretty convincing argument,
then a mutual fund is a better place to hold TIPS because of the
fund manager's ability to actively manage the portfolio.
The announcement May 1 of the change in interest rate
for the Series I savings bond brought an increase in the fixed-rate
component from 1 percent to 1.2 percent. It was interesting to watch
that change trigger changes in the price in the five-year TIPS to
make it competitive with the Series I savings bond. As I write this,
the five-year TIPS is priced to yield 1.35 plus inflation adjustments.
The next rate change is Nov. 1.
I suggest you let where you plan to hold the
investment and your tax situation dictate which type of inflation-protected
security you own. I'd lean toward a mutual fund for retirement
accounts. I'd compare the fixed component on the Series I savings
bond with the yield to maturity quoted on a TIPS security over your
desired holding period and make your choice based on that, coupon
reinvestment and tax deferral for taxable accounts. Remember that
you can defer taxes on the Series I bonds. Bloomberg
is the most convenient place to see how the TIPS issues are trading.
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