How to Hedge Against Inflation Using I Bonds
What are I bonds and how do you buy them?
Few investments have kept pace with inflation as consumer prices rise at the fastest rate in 40 years. But what if there was a way to guarantee your returns adjusted with the change in prices?
As many popular inflation hedges and safe stores of money tremble under pressure, there is one vehicle that can: I bonds. These are U.S. savings bonds whose interest payments include a variable rate that changes with inflation.
With the rapid rise in prices over the past year, I bonds purchased before November 1 will pay 4.81% for the first six months (or 9.62% on an annualized basis), then a new rate in November based off the inflation reading in September.
I bonds purchased before April 30, 2022 will pay out at an interest rate of 8.5% over the next year (which is a blend of the inflation reading in September and March). Since I bonds are offered by the federal government they are seen as an extremely safe investment.
I bonds have some quirks that makes investing in them not as simple as stocks, bonds, or funds. You can’t sell them for a year after buying them, and they must be purchased through the treasurydirect.gov website, which can be clunky. With most asset class posting losses this year it may be worth the extra effort for many investors. Major U.S. stock and core bond indexes have lost more than 5%, and other investments designed to protect against inflation, such as TIPS (Treasury Inflation- Protected Securities), have struggled (find a comparison of I bonds versus TIPS here). The rates offered on other near-guaranteed safe stores of money don’t offer competitive rates. Relative to the current opportunity set, I bonds look attractive, says Morningstar strategist Alec Lucas.
U.S. government Series I-Savings Bonds pay a fixed interest rate, which is set at the time of purchase, and an additional interest rate indexed to inflation, which adjusts to reflect the past six months' level of inflation as measured by the Consumer Price Index. Interest accrues monthly for up to 30 years if you hold the bond to maturity.
I bonds carry some important caveats. They cannot be sold for one year and if they are redeemed before five years you must forfeit three months of interest. After five years, I bonds are fully liquid, risk-free securities.
Investors are limited purchase as much as $10,000 per calendar year online, and up to $5,000 of paper bonds through your tax refund.
If you purchase an I bond before November 1 you will receive an annualized 9.62% interest rate the first six months you own the bond, and then a new rate based off the inflation rate from April to September. The worst-case scenario is that inflation plunges to 0%, and you only receive a 4.81% return for the year.
So if prices rise 3% from April-September, you will receive 4.81% yield the first six months on your I bonds, and 3% for the next 6 months. For the year that totals 7.85% when compounding after the first six months.
If you decide to withdraw after one year, you would have to forgo three months of interest, giving you a 6.28% return on the investment if you sold after one year.
There is also a chance the fixed rate will increase in the future. The current rate is at 0%, but in the past it has been set as high as 3.60%. Investors who purchased I bonds at this level are reaping the benefit. Investors who purchased I bonds in 2000 when the base rate was 3.60%, are now receiving a 13.39% annual rate for the next six months.
I bonds cannot be purchased through a brokerage account. They must be bought through the treasurydirect.gov website.
I bonds are ideally suited as a way for an investor to progressively build up a rainy-day fund, Morningstar's Lucas says. He uses the example of an individual who wants to build up a rainy-day fund with $50,000. They could buy $10,000 worth of I bonds per year for five years.
After the first year, the $10,000 allotment purchased from the prior year would become liquid and available for an emergency use if need be, Lucas says, with a three-month forfeiture of interest as the only impediment to spending that money. After each allotment passes the five-year mark, there would be no penalty for taking the money out. If a new series of I bonds later offers a more attractive rate than one currently held, the investor can always sell the older bonds to buy the new one.
For investors needing a source of steady income or as a substitute for other fixed-income options, I bonds may not be a perfect fit. Morningstar’s Director of Personal Finance Christine Benz says, “Because I bonds don't make regular interest payments but instead pay you your income when you sell, they're not a good option for those looking to fund any part of their living expenses with the current interest from the bonds.”
However, I bonds could be a smart move for another group--parents saving for their children’s education. You can avoid paying federal taxes if you use I bonds for education expenses, so an investor can use them as another way to save for college, Lucas says. You don’t have to use I bond money for college but if you do you will pay no taxes on it, he says.