Fighting inflation: I-bonds vs. TIPS

Investors who want to hedge against inflation while still earning a decent return on their investment got some unhappy news Friday: The U.S. Treasury announced that buyers of its Series I U.S. Savings Bonds – 30-year bonds whose returns are adjusted for inflation – will earn nothing on I-bonds issued between now and October 31 of this year. That’s right: nada, zilch, zip. This marks the first time that I-bonds have had a zero rate of return for any six-month period since I-bonds were created in 1998.

Blame inflation or the lack of it: Consumer prices have plummeted since the economy ground to a halt last fall and the U.S. remains mired in recession. The Consumer Price Index plunged 5.6% from September through March, according to the Treasury. I-bonds have two components: a fixed rate of return, which is 0.1% on newly issued bonds (down from 0.7%) and an inflation adjustment, which thanks to negative inflation wipes out the fixed return for the next six months.

Of course, low prices can be a good thing. Cheap gas, less costly heating oil and lower food prices ease some of the strain of the recession on consumer wallets. But longer-term, there are a lot of folks who are worried that the government’s massive spending to battle the recession will ignite inflation in the next few years and they want to hedge their portfolios against that scenario.

So, what should you do to protect your savings if you’re worried about inflation roaring back in the not too distant future but can’t stomach the thought of a zero return on an investment? If you already own I-bonds, hang onto them. Prices will pick up soon enough and you can wait out a six-month period of zero returns (rates on I-bonds are adjusted twice a year in May and November). Remember, you can never lose your principal investment in I-bonds. And if you do cash in your I-bonds and have held them less than five years, you’ll pay a penalty of three-months interest.

But if you’re looking for a way to hedge against future inflation and aren’t already sunk into I-bonds, Treasury Inflation Protected Securities, or TIPS are a better strategy now. As a good piece on Motley Fool points out, the real rate of return on I-bonds has been steadily declining over the past decade, as high as 3.6% but just 0.1% today. As my colleague Janice Revell points out in this video on TIPS, TIPS are historically cheap, yielding a real, after-inflation return of 2%. Not a bad return for an ultra-safe investment that can protect you against future inflation. You can buy TIPS directly from the Treasury so you don’t have to pay any commission. One tax consideration to keep in mind: You can defer interest on I-bonds for the life of the bond, which means you can earn interest for up to 30 years without paying income taxes on that interest. But the interest on TIPS is taxed every year, so you’re best off holding TIPS in a tax-deferred account like a 401(k) or IRA. – Donna Rosato

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