So a year ago around this time, I put out a video on inflation and talked about using
Treasury Inflation-Protected Securities, or more commonly referred to as TIPS, as one
way to hedge against it.
In that video, I also talked about traditional bonds in general and how they differed from
TIPS.
Today, I'm going to talk more about bonds, this time specifically series I Bonds as another
way to hedge against inflation; I’ll tell you what they are, why you might consider
them, and maybe reasons why you shouldn't.
Plus, if you feel they’re right for you, I’ll tell you how you can get them; it’s
a little more limited than with other types of investments
But real quick, I want to first welcome you to Healthy, Wealthy, and Wise where talking
about our financial wellness and how to achieve it is my top focus.
My name is Kevin, and on this channel, I share my experiences and the strategies I've used
in my over 25 years of DIY investing.
And now that we're having the highest levels of inflation that I've seen in my adult life,
talking about inflation hedges makes sense.
As I talked about inflation last spring in the TIPS video, I mentioned how the Federal
Reserve rate was essentially at 0% at the time, and that eventually, the rates would
begin to rise to tamp down inflation which was already starting up.
Well, it really ramped up and now after the highest rates of inflation in 40 years, that
cycle of rate hikes has begun this year.
And with interest rates already going up with more to come, the era of cheap financing and
loans is over.
And this higher interest rate environment has been a huge factor in pushing the overall
stock market down, hammering those highly leveraged growth stocks particularly hard,
resulting in many of us having seen our stock funds drop significantly in value since the
beginning of the year.
So with all the major stock indices down, with more rate hikes on the way that will
only keep pressuring stock prices, everyone's asking where can they safely put their money.
The one thing we should realize is that a basic bank savings account isn't really all
that safe in an inflationary period.
Yes, your principal is protected, which there’s something to be said for that if you’ll
be needing your money soon, however the reason that a bank savings account is not really
all that safe is that the interest you’re paid by the bank on your money is still very
low, in fact well below the rate is inflation.
And that’s important to consider, because inflation erodes our purchasing power, meaning
that what we can buy for $100 dollars today, might cost $110 or more next year, and yet
the interest you received for keeping your $100 in the bank for that entire year might
only net you up to 50 cents or so.
So even though your principal is safe, the purchasing power of it goes down, so in a
way you’re losing money.
Put another way, your money is basically becoming less valuable because it’s not keeping up
with the rate of inflation, which means that the cost increases on things you buy is going
up faster than your money is growing in a bank account because the interest rate is
so low.
So what can you do with your money to help it grow at a level that matches inflation?
Well TIPS is one option; as I said at the beginning of this video, we’ve already talked
about them on this channel in another video, so if you missed it, you might want to check
that one out…I’ll link it for you in the description.
Another option, and the focus of this video is investing in series I bonds, or just I
bonds.
I bonds are inflation adjusted US savings bonds.
As the name implies, an I bond is designed to have a rate that adjusts by either increasing
or decreasing along with the rate of inflation.
How it works, to keep it simple, is that the I bond actually has 2 rate components, one
component that is fixed and another one that is variable.
Let’s talk about the fixed component first.
The fixed rate component of an I bond stays the same over the length of the bond, which
is for the entire 30 years that interest can accrue on it after it’s issued.
This rate is unsurprisingly pretty low; but you might be surprised to know it’s actually
been at 0% for the past 2 years.
Needless to say, nobody is buying an I bond at this time based on the fixed rate of 0%
over the next 30 years.
It's the second, variable rate component that is drawing all of the interest in I bonds
right now; this is called the inflation rate of the bond.
The inflation rate is updated every six months based on changes in the non-seasonally adjusted
CPI, which stands for the Consumer Price Index, for all Urban Consumers for all items, and
this measure includes food and energy.
This update to the inflation rate occurs two times per year: on the first business day
of May and on the first business day of November.
When we are in an inflationary period, as we currently are in now, the inflation rate
of the bond is positive meaning you’ll accrue interest.
Now in periods of deflation, where prices are dropping and the CPI is negative, the
Treasury limits the combined rates of the bond to zero, so you don’t have to worry
about a situation where you’re losing money by holding the bond, you just won’t be earning
any.
So as of this recording, we’re now in May of 2022 and the semi-annual inflation rate
was just recently set at 4.81%.
And the formula for calculating the composite rate, or the combination of the fixed and
variable rates is: the fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual
inflation rate).
So using that math which is 0 + (2 x 0.0481) + (0.0000 x 0.0481), the composite rate comes
to 9.62%.
That means that any I bond bought within this time period, May through the end of October
will have interest accrued at this rate monthly.
Now what’s important to know here is that if you bought an I bond at any time during
this time period, your I bond will pay you at that rate for the next 6 months, whether
you bought it in May when the new rate took effect or even if you bought it in October
at the end of the period.
After those 6 months, you will then accrue interest at the new rate set in November for
the next 6 months.
Again, that’s not when you necessarily will receive that rate, it will be 6 months after
you bought the bond.
So if you bought the I bond in October; you would accrue interest at the current rate
for the next 6 months, and only after that, would the most recent update to the rate in
November take effect.
This might seem a little confusing, so definitely rewind and review this to make sure you understand.
Also, keep in mind that the interest is compounded semiannually.
So every six months from the bond's issue date, the interest the bond earned in the
six previous months is added to the bond's principal value, creating a new principal
value.
Interest at the updated rate is then earned on the new principal.
The interest, and principal, are paid to you only when you cash in the bond.
So let’s take a step back and think about this composite rate of 9.62%, if you currently
have an I bond or if you buy one at any time between May and the end of October in 2022,
you are guaranteed to receive monthly interest of 9.62% for 6 months.
Let’s say that again, 9.62% on a US bond, a bond that is backed by the full faith and
credit of the US government, that up to this period in time, the US government has never
defaulted on its debt, which makes it about as safe as you can get.
Now consider what your bank savings account rate is, what CDs are paying, what money markets
are paying…nowhere near 9.62% right?
Now in a good year, stocks can definitely beat that rate, but the question we have to
ask ourselves is, do we think the market will do that this year?
It’s often said, and very true, that it’s really hard to predict how the stock market
will perform in the future, particularly during shorter time horizons such as 12 months…it
could go up or it could go down.
Having said that, with the headwinds of more interest rate hikes coming and inflationary
pressures on companies’ expenses and the overall economy in general, there’s a lot
of sentiment that the market might be flat at best in the upcoming year.
In this situation, you have to ask yourself: do you take the chance on the uncertainty
of the market vs a guaranteed 9.62% interest over 6 months?
The guaranteed 9.62% sounds very tempting in this current economic climate, doesn’t
it?
Well, before you move forward in buying an I bond, which I’ll tell you how to do in
a minute, I do want you to be aware of a couple of reasons that may make you want to think
twice before jumping in.
Probably the biggest reason to consider not investing in an I Bond is that once you buy
one, you can’t cash it in for at least 12 months.
There’s just no way around it.
So if you were to need that money, you won’t be able to access it for a full year.
Because of this, an I Bond is not where you would want to put your emergency funds or
money you may need within the next year.
Now after a year passes, you can sell it anytime afterwards, but something else to keep in
mind: if you cash it in before holding it for less than 5 years, you would have to forfeit
the last 3 months of interest, so that’s an important consideration as well.
After 5 years, there is no penalty where you have to forfeit any interest when you cash
the bond in.
To me losing that last 3 months of interest by cashing it in after holding it under 5
years is a lesser problem, particularly if you’re getting a much better rate than you
could elsewhere over the course of a year, but again, the biggest issue is if you need that money within the first 12 months of buying the I Bond, you just can’t get to it.
The other big consideration is if you buy the I bond now, from May through October,
you’re only guaranteed to get that 9.62% interest rate for 6 months, but as I just
said, you have to hold the I bond for at least a year.
Once again, that rate sounds good, right?
Well that’s only because inflation is high right now, but there’s no guarantee that
the interest rate will stay that high when the rate is reset in November.
In fact, as the Fed continues to hike the Federal Reserve Rate throughout the summer,
it’s likely to start slowing the rate of inflation, which would mean that the variable
inflation rate component of the I bond will be lower than it is now leading to lower interest
that will be accrued.
And to that point, many analysts and economists believe that this might be the peak of inflation.
So if that’s the case, and the inflation rate is reset lower in November, your money
is no longer making 9.62%.
Now in a completely hypothetical, worst-case scenario, let’s say that inflation rate
drops to 0% or even if it goes negative where deflation occurs; even if that were to happen,
you still would have a 4.81% return for the 12 months, which would still be better than
any interest-bearing bank savings account.
Of course, the main issue being that you don’t have the access to move your money into something
else within those 12 months.
Another thing to consider is that in a calendar year, you are limited to investing up to $10,000…in
most cases.
I’ll tell you what I mean by that in a minute.
If you are married, your spouse can also invest up to $10,000, so a couple could invest up
to $20,000, 10 thousand per person.
Now $10,000 is nothing to sneeze at, but if you’re someone that has a fairly substantial
amount of savings, this just means that I bonds won’t be able to fully hedge your
investing capital against inflation.
So let’s say you have $200,000 in brokerage or bank accounts, you would only be able to
park 10,000 of that, or 5% of portfolio in I bonds, so you’re just limited in how much
of your capital you can hedge against inflation using I bonds.
That doesn’t mean you shouldn’t consider it, but just to realize it’s not the answer
for fully protecting your money.
Now as I alluded to a second ago, there is one other way to buy additional I bonds over
that $10,000 limit; but that only can occur if you have an income tax refund where you
can request up to $5,000 dollars in paper I bonds.
Otherwise, you’re limited up to $10,000 in I bonds and those can only be purchased
electronically.
And unlike other types of investments such as TIPS where you can buy them from banks
and brokers on the secondary market, you can only buy series I bonds directly from the
US Treasury at the TreasuryDirect website, which is at www.treasurydirect.gov.
Because the bonds are electronic, you have to open up an account at TreasuryDirect where
your bonds will be held.
You’ll also have to link a bank account where you can transfer your funds back and
forth.
Setting up the account isn’t difficult, but it is another account that you have to
keep track of, and I know a lot of people like to keep all of their savings and investments
in one place.
As far as how much you can buy them for, you can buy them starting at a minimum of $25
up to the annual limit of $10,000.
So let’s say you decided to buy an I bond, what does that mean for taxes?
Well first of all, the income earned is taxable on your federal return, however it is not
taxable for your state and local tax returns.
Although you can choose to report your interest income every year, the majority of people
defer reporting the interest until the year they cash in the bond.
I think this a good time to remind you that while my videos are meant to be informative,
they should not be seen as a recommendation for you to take any action based on the information
or the personal opinions I share—you should always do your own research or consult with
your own financial advisor when making any investment decision, and considering taxes
is a big part of that, and how it relates to your individual situation.
So I think that about covers the basics on series I bonds …what do you think?
Are they something you’re going to consider?
Or do you have another strategy to hedge against inflation?
Let us know in the comments.
We’re always looking to learn from each other here.
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Until next time, thank you for watching…and have a great day!