Want a Hot Tip? The inflation-indexed Treasuries known as TIPS have been having a great run--but I Bonds may be a better choice for you
(MONEY Magazine) – Just as the Yalies and Princetonians have their invitation-only societies (they're too well known to be called "secret" anymore), so do financial advisers. Theirs is called the Alpha Group and includes some 15 high-profile planners, whose names you'll often find in MONEY.
At the group's most recent gathering, the topic of TIPS--Treasury Inflation-Protected Securities, also known as Treasury Inflation-Indexed Securities--came up. TIPS have been selling like hot cakes, racking up a market capitalization of $216 billion in seven years. Why? Low volatility and strong returns--since its inception in 1997, the average return of the TIPS index (7.9%) is higher than both the Lehman Treasury index (7.4%) and the S&P 500 with dividends (6.7%).
I was nodding when Ross Levin of Accredited Investors in Edina, Minn. whispered in my ear, "For many investors, I Bonds [savings bonds with inflation protection] make more sense." I made a note to take a closer look. Here's what I learned.
I Bonds and TIPS are similar in many ways. I Bonds have a fixed interest rate (set when you buy the bond) and a variable one (tied to inflation) that protects your purchasing power. With TIPS, it's the principal that's adjusted. Both are guaranteed by the U.S. government and free from state and local taxes. And because they don't move in lockstep with stocks or traditional bonds, both are good for diversifying your portfolio.
But they also have some important differences--and it's these differences, not the yields, that determine which is a better fit for you.
TAX ISSUES If you're buying for a taxable account, I Bonds are the logical choice. You can purchase up to $30,000 in I Bonds each calendar year and pay no taxes until you redeem them. TIPS, on the other hand, pay phantom interest, like zero-coupon bonds; you don't get the money, but you have to pay taxes on it anyway. So it makes more sense to go with TIPS or a TIPS fund for a tax -deferred account.
LIQUIDITY If interest rates go up, once you've held I Bonds for five years you can turn them in for their face value and invest the money in an I Bond with a higher yield. If you cash out in less than five years, you'll pay a penalty of three months' interest. But if I Bond rates move up as fast as they fell (about a percentage point a year from 2001 to 2003), you'll still come out ahead.
It will likely be cheaper to get out of I Bonds than out of TIPS, which have a 10-year maturity. You can always sell TIPS on the secondary market, but the price fluctuates with interest rates. "The problem is knowing whether or not you got a good execution," says Morningstar analyst Eric Jacobson. "Stock prices are extremely easy to get. You pick your stock, look it up on the Internet. That's almost impossible to do with bonds."
TIPS mutual funds--Vanguard, T. Rowe Price and Fidelity offer low-priced ones--are easier to sell. You get the benefit of savvy managers who know what the underlying bonds are worth and cash out when it's advantageous to shareholders. As with all funds, you run the risk of losing principal, which can't happen if you buy the bonds and hold them to maturity. If your 401(k) offers no TIPS funds but lets you buy stocks, the iShares Lehman TIPS Bond Fund, an exchange-traded fund, is a good alternative.
A FINAL THOUGHT TIPS have done extremely well in the past two years. If you're wading into TIPS or a TIPS fund now, make sure it's for the right reasons--asset protection and diversification --and not to chase hot money. Though the long-term case for these securities is still good, TIPS may under-perform regular Treasuries in the short term if interest rates spike faster than inflation. In July 2003, when the bond market as a whole fell 3.4%, the average TIPS fund dropped 4.8%. If that kind of risk rattles you, do something else with your fixed-income allocation. An idea from Levin: Pay down your mortgage.