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I bonds, TIPS, and inflation

These government bonds pay more interest when inflation rises but differ in key ways.

Key takeaways

  • Inflation poses a threat to bondholders because rising prices reduce the purchasing power of the fixed rates of interest that their bonds pay.
  • Treasury Inflation-Protected Securities (TIPS) are bonds whose principal and interest rate payments rise along with inflation.
  • I bonds are savings bonds sold by the US Treasury whose rates change depending on inflation.
  • Investors should consider whether adding inflation protection to their diversified portfolios makes sense.

When inflation awoke from its 40-year nap last year, it pushed a little-known financial product into the spotlight. After years of being overshadowed by stocks, bonds, mutual funds, ETFs, and nearly every other place to put your money, Series I savings bonds issued by the US Treasury have caught the attention of the media, savers, and investors as their yields have risen to match—or exceed—the rate of inflation.

But while I bonds’ nearly double-digit yields may deserve their moment in the sun, they aren’t the only inflation-linked bonds investors should pay attention to right now. Treasury Inflation-Protected Securities (TIPS) are another US Treasury fixed income product that delivers more yield when consumer prices rise and potentially offers more benefit to investors than I bonds.

Why inflation matters

Inflation is bad news for most types of bonds because it makes their fixed interest payments less valuable. Bonds generally offer a series of fixed interest payments that represent a percentage of the face value of the bond. When inflation picks up and prices rise, the purchasing power of the interest payment decreases, meaning those fixed payments buy less stuff.

To help reduce the risk that inflation poses to bondholders, the US Treasury created Treasury Inflation-Protected Securities (TIPS) in 1997. These are bonds whose principal and interest payments are designed to rise when inflation does. A year later, the Treasury launched Series I savings bonds, a savings account-like product that also offers inflation protection in the form of twice-a-year interest rate changes that reflect the consumer price index (CPI).

TIPS or I bonds?

Both I bonds and TIPS adjust the interest they pay based on changes in inflation and are backed by the US Treasury, which means there is little risk of defaulting on those interest payments. But those similarities also come along with significant differences. The most important difference is that while you can buy up to $10 million worth of TIPS through Fidelity at auction, and an unlimited amount on the secondary market, I bond purchases are limited to $10,000 per person per year and are only available on the Treasury’s website, not through your brokerage account. I bonds also require that you not touch the money you invest in them for a year and if you do so during the following 4 years you must forfeit the most recent 3 months of interest payments. These limits on both quantity and liquidity represent obstacles for both savers who want liquidity and for investors who want yield. While I bonds’ high interest rates may look appealing, a closer look at TIPS may reveal them to be more useful inflation fighting tools.

How they adjust to inflation

The interest rate on I bonds changes every 6 months, based on the CPI. TIPS' yields are based on their current amount of principal. When the CPI rises, the principal of TIPS adjusts higher, and the payments go up along with it. Let's look at a hypothetical example to understand how TIPS do this.

This example is for illustrative purposes only and does not represent the performance of any security. Consider your current and anticipated investment horizon when making an investment decision, as the illustration may not reflect this. The assumed rate of return used in this example is not guaranteed.

Risks

TIPS—and I bonds—pose very little risk of default because they are backed by the full faith and credit of the US government. However, they do not protect bondholders from all types of risk. If inflation were to give way to deflation, principal and interest rate payments on TIPS would adjust downward.

TIPS are also subject to interest rate risk, just like other bonds. That means when interest rates rise, the market value of bonds is likely to fall. Rate risk may be managed by holding individual TIPS bonds to maturity, as in a bond ladder. If you hold TIPS until they mature, you will receive either the adjusted principal or the original principal, whichever amount is greater.

I bonds, TIPS, and taxes

Semi-annual interest payments on TIPS are subject to federal income tax, just like payments on conventional Treasury securities—or I bonds.

Any increase in the value of the TIPS principal is subject to federal tax in the year that it occurs—even though you won't receive any income from the increase. On the other hand, when the TIPS matures or is sold, you will only pay federal tax on the final year's increase in principal while receiving the full increase in principal since the date of initial purchase. Like all Treasury securities, TIPS and I bonds are exempt from state and local income taxes. Investors should consult their tax advisors regarding their specific situation prior to making any investment decisions with tax consequences.

Finding ideas

While I bonds are only available at TreasuryDirect.gov, investors interested in diversifying their portfolios with TIPS can choose from individual bonds, mutual funds, or exchange-traded funds. The approach you choose should reflect your ability and interest in researching your investments, your willingness to track them on an ongoing basis, the amount of money you have to invest, and your tolerance for various types of risk. There are pros and cons for both individual bonds and bond funds. In some cases, it may make the most sense to own both. Learn more about the differences between individual bonds and funds here: Bonds vs. bond funds

TIPS are also used by professional investment managers to help protect portfolios from specific risks, says Lars Schuster, institutional portfolio manager with Strategic Advisers, LLC. "While higher inflation can be problematic for some bonds, TIPS exposure might help protect the value of the fixed income portion of a well-diversified portfolio," he says.

You can buy TIPS directly from auctions held by the US government and at Fidelity.com. TIPS are available in 5-, 10- and 30-year maturities, at auctions spread throughout the year. You can also buy and sell individual TIPS with various maturities and prices from other investors in the secondary market. Fidelity.com does not charge fees or mark-ups on these transactions. You can learn more at Comparison of TIPS and Series I Savings Bonds

Fidelity also offers research tools including the Mutual Fund and ETF evaluators on Fidelity.com.

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The views expressed are as of the date indicated and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments. The third-party contributors are not employed by Fidelity but are compensated for their services.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

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Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk.

Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.

Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall.

Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected.

Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product, Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

 The Fidelity Mutual Fund Evaluator is a research tool provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Information supplied or obtained from these Screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk. Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.

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