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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

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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.

Bankrate.com's corrections policy
-- Posted: June 21, 2005
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