Where do I-Bonds fit into personal finance plans?

Question

I'm mainly interested in a finding a medium-term, low risk savings vessel. Bank and Credit Union savings accounts available to me at the moment are all < 1% APY, so inflation-protected securities are attractive to me right now.

First of all, it would be helpful if someone could clarify the difference between TIPS and I-Bonds. There are 3 previous questions on this site tagged with TIPS. There is no separate tag I can find for I-Bonds, although there seem to be a few questions and answers that fit them. The Treasury site has this helpful comparison between TIPS and I-Bonds, but doesn't answer some fundamental questions.

1. Are I-Bonds a type of TIPS?

They're Treasury issued and somewhat inflation protected and they're a bond, so a type of financial security. Is this just a case of overlapping names? Naming things is hard.

2. Are I-Bonds earnings & interest superior to TIPS?

TIPS imply that they can go down if deflation occurs. Can I-Bonds ever depreciate in value? Also, I-Bonds impose buying limits per person and appear to be non-transferable, implying they have significant benefits over the unlimited, transferable TIPS, which also seem to be available through 3rd-party investment funds.

3. Do TIPS and I-Bonds rate fluctuate over the term of the bond?

The current rate for I-Bonds seems to be 1.48% while TIPS recently auctioned for a max of 0.842%. I understand that the two account for inflation in different ways: I-Bonds vary the rate while TIPS vary the principle. How much of this is 'locked in' when I purchase the bond for each? Or are both capable of losing money if significant deflation occurs?

4. If I want to hedge some savings against inflation, should I own both I-Bonds and TIPS?

Alternatively, should I buy I-Bonds up to the $10k/year limit and only put excess in TIPS?

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Now, what I'm thinking of doing is putting a portion of my cash savings into I-Bonds every year. This savings is currently a small (admittedly undersized) emergency fund that I would like to grow. I've just paid off some credit card debt so I have some funds to start a new investment. Psychologically though, I have hard time justifying growing a savings when the interest rate is so low.

Since I-Bonds are not redeemable for 12 months, I obviously wouldn't want to tie all my emergency funds up in it right away. If I were to gradually move the account to I-Bonds, similar to a CD Ladder, would that be able to double as an emergency fund (fixed dollar amount equal to 3-6 months living expenses) and long-term cash savings (10-20% of non-retirement investments)? Would TIPS be a better vessel for this strategy?

If you don't think that's not a good use of I-Bonds, then where would I-Bonds and TIPS fit into your investment portfolio?

Answer 1

edit: Updated (2022) as my answer here was out of date. Updates in bold.

First the questions (succinct reference):

1. No. The names are weird I agree. I-Bonds are not really securities as they are not tradable.
2. As of 2021 short term inflation has increased and the interest rates on I-bonds has increased massively. I-Bonds rates are probably one of the best deals out there for bonds currently though that could change in the future
3. I-Bonds have a fluctuating rate. TIPS have a constant rate, but a fluctuating yield (effective rate) as the price and principle amount both change from the original price and principle.
4. No, you should generally own equities as a long-term inflation hedge though there can be short-term pain and perhaps some TIPS or commodities which have some inherent inflation protection but also have some downsides. The high yield of I-bonds is amazing currently but they have no inherent inflation protection.

I-Bonds are not generally good for personal investment as they are not marketable when necessary, however currently (in 2021/2022) the rates are so high that I believe they are worth this trouble. While most generally good investments (equity and bond ETFs/Funds) you can buy and largely not think about, I-bonds are currently great in the short-term but they will likely reset to below market rates again in the future. You will have to watch the rates carefully and you can't take the money out freely. Still the rates are so high right now that for many people they are worth that trouble.

Inflation protection is in general an interesting problem. While inflation-protected bonds sound like they are great for inflation protection (after all it is in the name), they may not be the best instruments for long/medium term protection. TIPS really protect against large inflation changes less so sustained inflation. It is really important to remember that inflation protected bonds have significantly lower returns and one form of inflation protection is to just have more money in the future. The short term use of I-Bonds at these very high rates can help here as well as the general long-term higher returns of equity.

When you own a stock you own part of a company and inflation will increase the value of the company relative to the inflated currency. Foreign stocks can give even more protection if you think inflation in your local currency is going to be higher then the foreign currency. Stocks in the past have had significantly higher return overall than inflation protected bonds but have higher risk as well.

As a medium term, low-risk portfolio, it is worth looking into some combination of TIPS, normal bonds and a small to medium allocation of local/foreign stocks all done through low-fee mutual funds or index ETFs.