Protecting against inflation - How about an I Bond?
Submitted by S. F. Ehrlich Associates, Inc. on May 17th, 2022
May 15, 2022
Inflation has been lifting prices lately, and with that comes a barrage of news articles, TV talk show segments, and social media posts about how best to beat inflation in your portfolio. One of the hottest tools on the market currently is Series I bonds. They're "hot" since they currently have a published rate of 9.62%. With a rate like that, who wouldn't want to invest?
First, a few facts on Series I bonds:
- What is a Series I bond? - I bonds are variable rate bonds issued by the Federal government that pay interest based on a) a fixed rate, determined by the Treasury and b) a variable rate that is reset every 6 months based on current levels of inflation. Per the TreasuryDirect website, I bonds are currently paying a fixed rate of 0% plus a variable rate of 9.62%. Series I bonds have 30-year maturities. During the time you own the bond, you don't receive interest payments; rather, the value of the bond goes up every 6 months by whatever inflation rate is assigned to the investment by the Treasury. At the end of the 30-year holding period (or if you sell prior), you receive what you initially paid plus whatever inflation occurred during the holding period.
- Each individual taxpayer is capped on annual purchases. If you file a joint return, you and your joint filer can purchase up to $20,000 per year (a single filer can purchase up to $10,000 per year). In addition to these caps, you can also elect to receive your Federal tax refund in the form of I bonds, up to $5,000 per filer.
- I bonds can only be purchased and held directly through TreasuryDirect’s website.
- I bonds are subject to redemption penalties. They can only be cashed out after 1 year of ownership; at that point, you’ll still incur a penalty of three months’ interest if you try to sell the bond prior to owning it for five years.
A few thoughts on including I bonds in a portfolio:
- Purchase Limits: The cap on purchases makes it difficult to build a meaningful initial position. For example, if you have a $1 million portfolio, are joint tax filers, and purchase $20,000 of I bonds this year, you've established a 2% position. Repeat the same process next year, and you're up to 4%. During the time it takes to build this position, the variable inflation component of the bond can fall, which means you're no longer earning 9.62% interest. The primary driver of return on this investment is inflation expectations. After three to four years of diligently building an I bond position in your portfolio, inflation may no longer be an issue.
- Holding Period Requirements: As mentioned above, an investor needs to hold their I bond for at least a year before they can sell; and even then, there's a penalty of three months' interest if they try to sell before holding it for five years. By purchasing these bonds, you’re not only committing to high inflation now but for an extended period of time. If that scenario plays out, there may be better ways to protect against inflation (leading to the next point).
- More efficient ways to combat inflation: By purchasing I bonds, you're investing solely in future inflation (i.e., if there's inflation, the investment has solid returns; if not, it doesn't). If you truly want to protect against inflation there might be better ways to do so:
- Within equities - Over extended periods of time, equities have outperformed inflation. Companies have quite a bit of flexibility in passing cost increases along to customers (translating to higher revenues) while also managing rising costs of inputs, all resulting in stable and/or increasing profits down the road. Much of the downturn you see in the equity markets over the past several months is a function of the cost of capital going up and concerns over a coming recession. But if you stretch out the time horizon and compare an equity portfolio’s ability to outpace inflation, the equity portfolio compares favorably.
- Within fixed income - As we've seen play out on the bond side of the portfolio this year, one of the greatest threats to bond returns is inflation. If you purchase a bond today paying $200 per year for the next 10 years, rampant inflation can make that bond payment worth a lot less than $200 as you get closer to year 10 of the bond's life. When faced with potentially inflationary times, it's better to keep bond portfolio maturities short so that when bonds mature they can be reinvested at higher rates, which will eventually pay higher interest payments down the road.
- As a replacement for emergency funds?: For non-retirees, we typically recommend keeping anywhere from 6 to 12 months of monthly expenses in liquid cash for emergency savings in the event someone loses a job or suffers some other form of hardship. While having this cash stash can offer peace of mind, it can come at the cost of foregone investment earnings. Should I bonds be considered a place to park your emergency fund? Not quite. The emergency fund needs to be available at a moment's notice; cash in the I bond can't be accessed for at least a year from the initial purchase. Even then, it's subject to withdrawal penalties if not held in the I bond for more than 5 years.
Bond investing has changed considerably over the last 20 years. You used to be able to rely on bonds paying a solid 4-6% annually. Nowadays, we must be diligent and patient when investing in bonds. While a 9%+ rate of return is attractive, it's important to recognize it comes with potential pitfalls and unintended consequences, all of which should be understood prior to investing.