By Scott Burns

Q. Are I Savings Bonds better to have than TIPS? They are paying me about 4.5 percent. —G.F., Austin, TX

A. Although both I Savings Bonds and TIPS offer inflation protection (as measured by the increase in the Consumer Price Index) there are some important differences. TIPS (Treasury Inflation Protected Securities) are issued in 5, 10 and 30-year maturities and the yield premium over inflation is determined at auction. Today, the shorter term TIPS are priced at a large enough premium over par that the effective yield over inflation is negative. This works to reduce the benefit of the CPI adjustment to the principal value of the security. Your net yield is something less than the inflation rate. Only by going to longer term TIPS can you get a premium over the inflation rate.

Treasury I Savings Bonds are different. They enjoy the same inflation adjustment to principal but the yield premium over inflation is reset by the Treasury every six months. Since the November 2010 period, that rate has been set at zero. This means new buyers are parking their money and getting a "yield" that is equal to the rate of inflation. The income is also tax-deferred until maturity. This can be a significant benefit over the purchase of TIPS whose coupon and adjustment are both deemed taxable income each year even though one isn't paid in cash. This is why most advisors suggest that you hold TIPS in qualified accounts.

Both securities provided premiums over inflation greater than 3 percent in their first years of issuance. So if you bought your I Savings Bonds or TIPS when the yield premium over inflation was higher, you could still be getting a very nice interest rate.

 But that was then. Today new inflation-protected securities are selling with a guarantee of inflation protection… and nothing else. The big limit for I Savings Bonds is that you can only purchase $10,000 in a year. Purchases of TIPS are unlimited.

Inflation protection is better than what is currently offered on conventional coupon Treasury securities. Recently, for instance, the yield on a 5-year Treasury note was about 0.8 percent, well under the 3.5 percent trailing rate of inflation. As a consequence, even recent buyers of I Savings Bonds and TIPS are getting better yields than with conventional Treasury securities. The only way this will change is if future inflation rates fall pretty dramatically.

Q. My question concerns what is the better source of dividends from a long-term investment viewpoint. I am well diversified in my total portfolio. I am invested in Vanguard LifeStrategy Moderate Growth Fund and some fixed-income funds.

I also like blue chip dividend-paying stocks. I have some money invested in Vanguard Dividend Appreciation Index Fund and Vanguard Dividend Growth Fund (Managed).  A friend argues that I should seek dividends not by sector investing but by total market index funds.
He points out that the yield on my two sector funds is about 2 percent--similar to the yield on the LifeStrategy Moderate Growth Fund. He believes, from an investment perspective, the LifeStrategy Moderate Growth Fund is vastly superior to the two sector funds.  He acknowledges that the current tax code favors qualified dividends, but he insists that the use of the three total market index funds in the Life Strategy fund is a wiser investment strategy. —M.J., Beaumont, TX

Q. Your friend makes good points. Here's the difference between these funds. Vanguard Dividend Appreciation Index fund and Vanguard Dividend Growth fund are 100 percent equity funds. They have no fixed income holdings. They are, however, diversified across many sectors of the economy so I would not call them "sector" funds. 

The Vanguard LifeStrategy Moderate Growth fund is a traditional balanced fund. It has about 40 percent of its assets invested in fixed income securities. The equity portion is spread over three major total market indexes. The fixed income portion is why its income yield is about 2.3 percent, while the yield on the dividend funds is about 2 percent.

Over the (very) long term, the expected return of the 100 percent equity funds should be somewhat higher than the return of the balanced fund. The long term, however, is a lot longer than any of us can hold our breath. In addition, the dividend income of the dividend funds is currently taxed at no more than 15 percent while the tax rate on the balanced fund will be a mixture of 15 percent taxes on dividends and full income tax rate on interest.

There is no doubt that you will enjoy far broader diversification in the LifeStrategy Moderate Growth Fund; It will also be less volatile than the dividend oriented funds, so you'll sleep better.