Options for "Solid" Cash: TIPS, T-Bills and I Bonds

After checking out TIPS in ETF form (to mixed results), I now turn to how they work if you want to buy and hold them directly. I consider them a type of “solid” cash, and compare them here to T-Bills and I Bonds. But, selecting the best of these really depends on the situation.

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This is the seventh post in my "RPC Investigates" series on Treasury Inflation-Protected Securities (TIPS). The first post introduced them and what I'm trying to do in this deep dive; the second was a Risk Parity Basics post explaining them from the ground up; the third differentiated between TIPS purchased individually and TIPS in funds. The fourth assembled five sources for more learning on TIPS. The fifth presented results from two backtests (21 years and 13 years) of TIPS. The most recent post zeroed in on TIPS performance during inflationary stretches.

One of the nice things about starting your own blog is that you have a forum for when you need to invent a word or concept. Excuse me if someone out there has already coined one, but I need a term for cash-like assets in your portfolio that aren’t liquid. This is not cash you’d need to pay an emergency car repair bill or to pay off the ransom to get your prize Pekingese back.

Borrowing from chemistry, then, in this post I’ll be talking about “solid” cash - the assets in your portfolio that behave somewhat like cash, and perhaps could be made liquid in a pinch, but you’re not expecting to need to. In case you were wondering what “gaseous” cash is, something likely to evaporate and maybe toxic, I would say crypto, but that might be giving it too much credit.

Ba dum dum...back to “solid” cash… low returns and illiquidity certainly don’t sound very good. This isn’t a “must have” element in an investor’s portfolio, Risk Parity or otherwise. I don’t have any original portfolios with a dedicated allocation to solid cash. In real life, I have some I-Bonds that I bought at the beginning of 2022 when the advertised rate was 9.62% and I think I’ll probably invest a little this way in 2023, as well, but this has been part of my already existing bond allocation.

Yet, there are some occasions and situations where solid cash would have a dedicated place in a portfolio.

For the extremely risk averse, cash is about the best ballast you can have. It will definitely stabilize your portfolio and provide the dry powder to purchase other asset classes when they lag or crash. Liquidity is nice, but once you have an emergency fund in place or, otherwise, just have a large enough checking account, you can commit funds to cash-like vehicles that can bring a little return in the form of interest, hence the right time for "solid" cash.

Of course, inflation is a concern. If you leave cash in a checking account, it melts in real terms month after month, especially recently. Ideally, you’d have some amount of growth with your "cash" to off-set inflationary decay.

Cash can also be a part of an explicit Risk Parity strategy, especially those that give a nod to one of RP’s original gangsters, Harry Browne. His permanent portfolio recommended 25% each in equities, nominal bonds, gold and cash. To me, this is a bit too safe, but Risk Parity is an investing approach with fuzzy edges and different people view the concept of balanced risk differently. In Browne’s case, he might have meant for the cash to literally be in paper form, under the mattress, but you could modernize that by pursuing a “solid” cash alternative.

So, what are the options? In this post, we’ll go over the merits and demerits of three:

  • Short-term bonds (technically, these are Treasury Bills, or T-Bills)
  • I Bonds (technically, Series I savings bonds)
  • And of course, Treasury Inflation-Protected Securities, or TIPS

For this post, I’ll be covering each of these in stand-alone form, meaning specific individual securities bought either through the Treasury or via a brokerage, and not in fund form. I’ll assume the intention is to “buy-and-hold” until maturity, though I will cover the basics of how they can be unloaded on the secondary market.

I will generally leave off the question of whether an investor should have an allocation to solid cash. Although I may come back to that in a later post, for now, we’ll assume that a given allocation to one of these makes sense for you, and we’re just trying to figure out which.

Criteria

This won’t be one of my typical backtests, since I don’t have apples-to-apples data on them, but I’ll go over their merits and demerits to try to get a sense of each.

To evaluate, I’ll be using the following criteria:

  1. Expected Return (while you hold them)
  2. Expected Return at Maturity
  3. Ability to Resell Before Maturity
  4. Taxation
  5. Inflation protection

T-Bills (Short-term, nominal Treasuries)

These usually have pretty low returns since they have essentially no default risk (the risk that you won’t be paid back), and very low duration risk. Current returns are higher than they have been for as long as I can remember - as I write this (12/28/2022) the 1-Month Treasury rate is 3.87% and the 1-year is 4.71%. That’s really not bad at all - almost four percent with extremely low risk (or rather, if these bills do default, you/we probably have other problems to worry about!).

Of course, this figure is in nominal terms, so with current annual inflation running at 7.1%, these “high” rates are actually losing ground, like walking the wrong direction on a people mover at the airport.

You can resell these, if you wish, though for the very short durations, it’s way more likely that you’d just wait until maturity to save yourself the hassle. If you buy them from Treasury Direct, you’d have to move them over to a brokerage in order to put them on the secondary market. This seems like a pain to me, so maybe the better way is to buy them through your brokerage from the start. Of course, every time the brokerage helps you with a transaction, there is a fee (1% at Vanguard, for example).

The price on the secondary market depends a lot on the prevailing interest rates when you sell, so it may or may not be worth it. If you’re planning on moving in and out of this market from the start, you’re better off with a bond fund from the start as they are much easier and cheaper to trade.

At maturity, you get your principal back, no more, no less, and no capital gains tax since there will be no capital gains. The income you receive as you hold them is taxable at the federal level, though exempt from state taxes (like all Treasury securities).

If you’re in a very high tax state, you could go for a version of these issued by a state, called municipal bonds or “munis,” though in mathematical terms, these usually pay out interest roughly equal to what you would get by federal securities minus a tax-rate. The decision of whether to go with Treasury bonds or munis is a complicated one that depends on your given situation - I’d get advice from an accountant on this.

Short-term Treasuries have no explicit inflation-protection, but it’s worth noting that any time a bond is traded, there is a type of implicit prediction of inflation embedded in the rates offered. Treasury bills, with no inflation adjustment, will carry a higher interest rate to reflect a rough estimate of future inflation when compared to a TIPS of similar length.

Simple example: Suppose a 10-Year Treasury’s rate is 4%, while a 10-Year TIPS is 1% plus, of course, the promise to keep up with inflation. That means the market’s expectation of inflation over the upcoming decade is 3% (per year). If it actually comes in at 2% per year, then the regular 10-Year Treasury would have been the better buy (as the market overestimated inflation), and if the actual inflation rate is 4%, then the market underestimated future inflation and TIPS would have been better.

Predictions are hard, especially about the future, so it is impossible to predict whether the prevailing sentiment about inflation is accurate or not. It would seem most logical to buy nominals and TIPS simultaneously to cover yourself for both eventualities.

I Bonds

These have garnered a lot of attention lately as advertised rates have risen to meet inflation. I invested in some when the 9.62% rate was announced in the spring of 2022. Now the rates are at 6.89%, guaranteed for six months, and will then reset at an inflation-adjusted rate for the next six months and so on.

Like with TIPS (and as I argued, implicitly in regular Treasuries, as well), there is a fixed rate and an inflation rate that tracks changes in the Consumer Price Index. These aren’t “inflation-protected” exactly, since the six-month lag means they are not perfectly responsive to quick changes in inflation. But, they will stay pretty close to it.

They differ from TIPS in one key regard: the inflation interest rate is what changes, not the principal amount, so there is no “phantom income” to worry about. Their tax situation is straight-forward and flexible. There is no capital appreciation on the bonds, as a $4,000 bond, for example, will be the same amount when cashed out.

With the accrued interest, you can choose to pay tax every year (which you might want to do if the bond is in a child’s name whose interest rate is lower), or you can defer the taxes on the interest until you cash out. This is what most people do and is easy to report. One last little bonus: the I Bond’s interest can be tax-free if the bond is used to pay for higher education expenses.

There are limits to how much in I Bonds you can purchase in a given year: $10,000, and then, if you have a large tax return, you can purchase up to $5,000 more using that money. You can also buy I Bonds as gifts for people, though since you need their Social Security number and the recipient is subject to the same yearly maximum, this essentially means close family members. It does get complicated, but here is a great video tutorial explaining more about buying I Bonds as gifts.

Besides the purchase limit, the resale of I Bonds is another restriction. You can’t resell them on the secondary market. You can cash out the bond with the government (at face value) once you have held them for one year. If you do this before five years have passed, though, you surrender the three most recent months of interest. If you have held the bond for longer, there is no penalty and you will receive all the interest that has accumulated.

TIPS

Now we turn to the star of the show. How do TIPS stack up?

In terms of expected return, it is impossible to say whether they will be the highest or lowest of the three, but they will be the security to match inflation most closely. There is not the lag that there is with I Bonds, and there is a more explicit mandate to match inflation, unlike with regular Treasuries where it is just the market’s future expectations.

Interestingly, though, this doesn’t mean that TIPS will have the highest return of the three. I Bonds might be a better bet if inflation spikes over 6-12 months and then quickly declines from there: you’d have the higher inflation-adjustment for about a year with an I Bond, and then could sell them when lower rates returned.

Nominal Treasuries would be your bet if the market overestimated inflation, even if the actual inflation were objectively “high.” TIPS would offer the best return if the market has underestimated inflation.

The biggest drawback with TIPS, in my opinion, is how they are taxed. Since their principal changes to match inflation, this is considered income by the government, and so it is taxed, even though you can’t actually do anything with the added principal (unless you sell the TIPS, of course). This is the “phantom income” mentioned above, and then on top of that, you’d of course be taxed on the interest payments you receive. But these cannot be deferred, as they can with I Bonds, so unless you really need the cash, you’d be generating regular taxable events.

The common wisdom has been that holding TIPS in a tax-advantaged account makes sense, but I’d argue this is a waste of valuable space. I would rather protect the capital gain on my equity index funds than use that room to save me from the hassle of TIPS taxation. Your mileage may vary, of course, but all in all, TIPS are a hassle from the taxation side.

In terms of liquidity, they follow the same rules and process as nominal Treasuries. They can be resold, at a price determined by prevailing interest rates, and through a broker, which of course will attract a fee. There is no practical limit on how much in TIPS you can buy in a given year (technically there is, but it’s in the millions).

Quick Diversion: Laddering

One popular technique to make TIPS and nominal Treasuries (but not I Bonds!) more user-friendly and more lucrative is to build a “bond ladder.”  Since fixed income securities tend to pay higher interest rates the longer the duration, what you are basically doing is buying a staggered series of bonds that will mature on a continual basis. You buy a 3-month and 6-month T-Bill initially, paying 3 and 3.5% respectively, and then when the first 3-month T-Bill matures, you immediately buy another 6-month T-Bill with that money. When the original 6-month T-Bill matures, you buy another 6-month T-Bill, and so on. You now have money becoming available every 3 months, but are earning the higher 6-month rate.

Bond ladders definitely are great if you are planning on having a permanent allocation to solid cash in a portfolio, as they give you relative liquidity and relatively higher interest rates. They are not that difficult to set up as long as you are dealing with a brokerage that allows you to automatically purchase another bond when each one reaches maturity. Otherwise, you’d have to remember the maturity dates and remember to repurchase.

If you want even more automation, you can of course buy a bond fund (either in mutual fund or ETF form). Essentially, these are large, rolling bond ladders that you can easily hop in and out of, though as we have covered in this series, this does make them perform a bit differently than the buy and hold securities we are talking about in this post.

Keeping Score

In sum:

Conclusion

This is a classic situation where there really is no one method of solid cash that is best in all circumstances. It depends on what you need exactly, and what your primary concern is.

I bonds are great for general purposes, but the yearly limits and restrictions on cashing out mean they are not suited for strategic trading or for large positions. They would probably work best for someone wanting higher returns for as long as inflation lasts, but who will look elsewhere when/if inflation lowers.

I Bonds are the only one of these three that I own in real life, and my position is fairly limited since my first purchase was in 2021. I am using a simple guideline: if they pay more than 5%, I’ll purchase them, and when they offer less than 3%, I’ll sell what I can. Between 3 and 5, I’ll just hold tight. Right now, they offer 6.89%, so I'll try to use up my 2023 allotment, though I may wait until April in order to get the full six months at the high rate, as the next rate looks to be a bit lower.

If you want more solid cash than the $10,000 or so limit for I Bonds and you have a lot of time and energy for managing your purchases, then I think the best strategy is to build a bond ladder, using both nominal Treasuries and TIPS in equal measure. This means assembling two parallel bond ladders, with the two taking turns as the better choice depending on whether the market was either Pollyanna-ish or Eeyore-ish about inflation.

It may be tempting to outsource this effort to a financial advisor, but this would come with a lot of fees for what is actually pretty simple to do on your own. I would look for a brokerage that offered automatic repurchase for expiring securities, and also configure the ladder with the right maturities to take advantage of this feature (automatic repurchase may be available for 1-year securities, but not for 2-years, for example). Once your bond ladder is set up this way, monthly or yearly management is pretty easy, and you’d get higher returns and easier access.

If you had to choose between nominal Treasuries and TIPS, I think nominals are the better choice just because of taxation issues. The “phantom income” problem is just another step I’d need to deal with every year, and even if all things were even in terms of how much you paid, I’d rather go with the straight-forward situation of regular Treasuries.


Resources

There are a lot of great YouTube videos out there about breaking down all three of these options, and then the differences between them. Here are some good ones:

I Bonds and TIPS compared” by Healthy, Wealthy and Wise

TIPS vs. I-Bonds” by Wealthion

And so many from my go to source on this type of investing, Jennifer Larmer (as Diamond NestEgg on YouTube):