Inflation readings reached four-decade highs of 7.5%, the Bureau of Labor Statistics reported on Feb. 10, and the potential of further erosion of real purchasing power has everyday consumers and investors worried. Over 70% of participants in a recent USA Today/Suffolk University study indicated that inflation is their main economic concern, versus just 24% who cited jobs. Many investors are asking themselves how they might insulate their portfolios.
Gold, commodities, Treasury inflation-protected securities (TIPS) or maybe bitcoin come to mind when thinking of inflation hedges. While all tend to work to some extent, each has its own quirks, and none cleanly moves in lockstep with inflation.
Enter I bonds
Series I savings bonds, or I bonds, are issued and backed by the full faith and credit of the U.S. government and pay an interest rate directly tied to inflation. In short, as prices rise, so does the interest earned. Series I bonds are different from other bonds, so it’s important to understand how they work when deciding whether they are a good fit for your personal savings or portfolios. It’s also worth noting that I bonds are subject to interest rate and market risks.
Distinctive rate structure
One of the things that sets I bonds apart from other investments is their rate structure. There are two components that help determine the Series I bond rates: the fixed rate and the inflation rate. The fixed rate is set at issuance and persists for the life of the bond. The second component resets semi-annually based on the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U) for all items, including food and energy. The inflation rate and the fixed rate, adjusted for inflation, are combined to get the overall interest rate.
The bonds accrue interest monthly until they reach their 30-year maturity or you cash them, whichever comes first. For the current period running from November 2021 to April 2022, the fixed rate is 0.00% and semiannual inflation rate is 3.56%, amounting to a composite rate of 7.12%. Rates will reset again in May, and with the way inflation has been going investors can expect yields on I bonds to likely stay elevated.
They’re also tax efficient. You can defer tax reporting on interest until the bonds are redeemed, expire or some other taxable disposition. Interest is subject to federal income tax, but not state or local taxes. Check with a tax professional to see what makes sense for your situation.
Any gotchas?
Kind of. An investor must hold an I bond for at least 12 months before redeeming it. After the first year an investor can redeem their bond, but redemption before five years have elapsed will result in a penalty worth the interest of the previous three months. For example, if you redeem a bond after 18 months, you will receive the principal plus the first 15 months of interest.
Purchases are limited to $10,000 per person per year and only available through TreasuryDirect.gov. You can buy up to $5,000 additional bonds using your federal income tax return for a total annual purchase amount of $15,000.
Deployment within a financial plan
Investors with larger portfolios will quickly run into the annual purchase limit if they try to use I bonds to hedge inflation entirely. Such investors may want to consider using I bonds with other inflation-hedging strategies, such as TIPS or a broad-based commodities basket. An investor may also consider swapping out low-yield cash savings for I bonds, particularly those past their 12-month lock up period, as part of their emergency fund.
Amid volatile markets and escalating inflation, I bonds can help investors achieve a higher yield with the safety of a bond backed by the U.S. government. I bonds can hedge your portfolio against inflation, but it’s important to remember the money invested is tied up for the first year. When in doubt, check in with a financial adviser or professional who can help guide you.
Series I bonds can be a good fit for some investors, and are especially worth exploring in an inflationary environment.