U.S. consumer prices rose 6.2% in October, marking their sharpest increase since 1990. While economists believe temporary factors, like supply chain disruptions, are at fault, the massive influx of cash from stimulus payments and rising wages could turn inflation into a long-term problem that could take years to resolve.
For investors, rising inflation presents a unique problem. The S&P 500 Shiller P/E ratio stands at a lofty 40x, suggesting that stocks may be overvalued at current levels. On the other hand, most fixed-income yields remain low and inadequate to keep up with inflation. As a result, investors are left with few good options to keep their savings from dwindling.
Let’s take a look at an underappreciated government bond, known as an I-Bond, that can help everyday investors hedge against inflation and realize a surprising yield in today’s environment.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
What Are I-Bonds?
Series I Savings Bonds, or I-Bonds, are a low-risk product that helps to protect your savings from inflation and supplement retirement income. Unlike a conventional bond, they combine a fixed rate and an inflation rate to adjust yields to inflation levels. They are available in $25 increments to $10,000 per individual per calendar year.
The variable inflation rate component is calculated twice per year based on changes to the non-seasonally-adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy. The composite rate calculation considers both rates, but the combined rate will never be less than zero (although it may be zero).
| Fixed Rate | 0.00% |
| Semi-annual Inflation Rate | 3.56% |
| Composite Rate = (Fixed Rate + (2 x Semiannual Inflation Rate) + (Fixed Rate x Semi-annual Inflation Rate)) | (0.00 + ( 2 x 0.0356) + (0.00 x 0.0356)) = 7.12% |
Example of I-Bond Composite Rates from the Treasury – Source: Treasury
I-Bonds earn interest for 30 years unless you cash them out. But, while you can cash them out after one year, they lose the previous three months of interest until you’ve held them for at least five years. So, for example, if you cash an I-Bond after 18 months, you’ll only receive 15 months’ worth of interest, although that may still be better than savings!
Why Consider I-Bonds?
The initial interest rate on new I-Bonds is 7.12%, and these rates will be available through April 2022. While the interest rate may change after April 2022, there are few places where you can realize a risk-free 7.12% yield in today’s environment. Even if you sell after one year, you still realize nine months of interest, including five months at 7.12%!
The relative benefit of I-Bonds is even higher if inflation continues to rise—a theory that’s no longer fringe. Federal Reserve Chairman Jerome Powell recently warned that inflation could continue to grow next year due to the impact of the Omicron variant, which could further disrupt supply chains and exacerbate current challenges.
I-Bonds are also superior to other inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS). Since I-Bonds have a guaranteed real (e.g., inflation-adjusted) yield, you will always earn at least as much as CPI inflation. By comparison, TIPS are trading at negative real yields thanks to low Treasury yields.
Investors may want to consider I-Bonds for some of their emergency funds since they’re 100% safe and completely liquid after a year. Of course, they also offer a better yield than a savings account and protect your emergency funds from the ravages of inflation. Other investors may use them for part of their fixed-income retirement portfolio.
Click here to learn more about TIPS.
Risks to Keep in Mind
Here are some risks you should consider:
- You cannot cash in I-Bonds for the first 12 months after purchase. And if you redeem them within five years, you will pay a penalty equal to three months’ worth of interest.
- The I-Bond interest rate resets every six months. If inflation is a lot lower in April next year, you could earn a lower interest rate than other securities for at least one year until you can sell.
- You can’t purchase I-Bonds in an IRA. However, you don’t pay tax on I-Bond interest until you redeem it, which provides a benefit similar to that of an IRA.
- You’re limited to purchasing $10,000 per year per Social Security Number. However, you can buy another $5,000 per year with your tax refund if you desire.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Bottom Line
I-Bonds represent an effective yield in today’s environment, particularly given that they are risk-free. While there’s no guarantee that inflation will remain high, the bonds may still make a lot of financial sense since interest rates are only reset every six months. You can also sell them at any time after one year, making them exceptionally liquid.
Make sure to visit our News section to catch up with the latest news about income investing.
