I bonds, TIPS and T-bills: how each handles inflation

The Treasury borrows from savers in several forms, and each treats inflation differently. This guide explains how they work, not which one to buy.

I bonds

Series I savings bonds are bought directly from TreasuryDirect and are not traded. Their rate has two parts: a fixed rate set when you buy and kept for the life of the bond, and an inflation rate reset every May 1 and November 1 from the six-month change in CPI-U. The combined rate can’t fall below zero.

Interest is added monthly and compounds every six months. You can’t cash an I bond in its first year, and cashing it before five years costs the last three months of interest. Federal tax on the interest can wait until you cash the bond, up to 30 years; there is no state or local income tax on it. Treasury limits how much one person can buy each calendar year; TreasuryDirect lists the current limit.

TIPS

Treasury Inflation-Protected Securities are marketable bonds sold at auction in 5-, 10- and 30-year terms. Instead of a changing rate, their principal goes up and down with CPI-U. The fixed interest rate is paid every six months on that adjusted principal, so payments rise with inflation. At maturity you get the larger of the adjusted principal and the original amount.

Because TIPS trade, their market price moves with interest rates, and selling before maturity can mean a gain or a loss. Each year’s increase in principal is taxable federally even though you don’t receive it until the bond matures or is sold. TIPS interest is exempt from state and local income tax.

T-bills

Treasury bills run from a few weeks to a year. They are sold below face value and pay face value at maturity; the difference is the interest. Nothing in a T-bill adjusts for inflation. Its yield is set at each auction and moves with what investors expect short-term rates, and the Fed, to do. Because bills are short, savers who roll them over pick up a new rate every few weeks or months. The interest is exempt from state and local income tax.

Side by side

An I bond’s inflation adjustment comes in steps every six months and trails prices by several months. TIPS principal follows CPI-U with a lag of about three months, but the bonds’ market price moves with interest rates until they mature. T-bills offer no inflation adjustment at all, only a short horizon that lets their yield catch up when rates move.