Where can we park our money, take zero pricing risk and protect it from inflation? The U.S. federal government offers an investment that does all three, explains Rida Morwa, editor of High Dvidend Opportunities.
I-Bonds Make A Great Inflation Hedge
Series I Savings Bonds are bought directly from the U.S. Treasury. Similar to regular savings bonds, they are designed to help ordinary people save money. They pay interest that combines a fixed rate and an inflation rate. Additional details are available at this link to Treasury Direct.
Electronic I-bonds are available in any amount, to the penny, from $25 to $10,000. You are limited to buying $10,000 in any one year, with an additional $5,000 that can come from your tax refund. This limit is per person so that a married couple could double these amounts.
The bonds are meant to be held for the intermediate to long term. So avoid them if you want access to the money in a few months. The bonds must be held for a minimum of 12 months. In addition, if you redeem a bond before five years, you lose the last three months of interest payments. This discourages shorter holding periods.
How The Interest Works
Currently, I-Bonds are offering a higher yield today than in the past: 9.62% for bonds purchased in May through October 2022. This consists of a 0% fixed rate and a 9.62% annualized variable rate. The variable rate resets every six months from the month the bond is issued. At the end of 6 months, the rate will be reset higher or lower based on inflation.
The interest is accrued and then added to the principal every six months. So you will not receive cash payments. Instead, the interest owed to you will be added to the principal at the end of 6 months.
So at 9.62%, if you buy $10,000, you will receive approximately $481 in interest at 6 months when the rate is reset. Then the next 6 months, you will earn the new rate on $10,481. This will continue every 6 months until it matures in 30 years or you decide to redeem them.
How To Buy I-Bonds
There are two ways you can purchase I-Bonds.
1) You can also purchase I-Bonds electronically from the Treasury Direct website. You can also set up a payroll purchase program. The directions are here. The electronic version of I-Bonds is available in any amount (up to the penny) in values from $25 to $10,000. You can purchase up to $10,000 a year of electronic I-Bonds. This limitation will force those who want a very large allocation to I-Bonds to purchase regularly over several years.
2) You can purchase them in paper form using your income tax refund when you file your tax return. Instructions can be found here. You can purchase a maximum of $5,000 of paper I-Bonds each year (using any tax refund you get). This does not include any paper I-Bonds you have purchased during the year. Paper I-Bonds are less flexible than the electronic ones and are only available with face values of $50, $100, $200, $500, and $1000.
Redemption
I-bonds carry no principal risk. After 12 months, you are free to redeem at any time, and you will receive your face value plus accrued interest. You can request redemption through Treasury Direct, or if you have paper I-bonds, you can redeem them at any bank.
Since these are backed by the U.S. Government, there is no worry about defaults. With no market trading them, there is no variation in prices. You know exactly what you will get and you can check the precise amount at any time through Treasury Direct.
If you are redeeming within 5 years, there is a penalty of the most recent 3-months interest. After 5 years, there is no penalty at all.
I-Bonds Pros Vs. Cons
Let's take a look at the pros and cons of I-Bonds:
Pros:
- The principal is super safe and guaranteed by the U.S. Government.
- I-Bonds pay variable interest based on CPI-U, a broad inflation metric.
- Today, inflation is high, and I-Bonds bought in May will receive the current 9.62%+ rate for 6 months.
- No matter how high inflation goes, you can rest easy knowing the bond's rate will keep up.
- You can redeem I-Bonds whenever you want after 12 months. Redemption is relatively quick, from immediate cash in a bank to a couple of days if redeemed electronically.
- The penalty for redeeming I-Bonds before 5 years is lower than for CDs (and the rates are better too).
Cons:
- The fixed-rate portion is 0%, so your return will match inflation but will not exceed it unless inflation drops significantly before the next reset.
- Returns will come solely through interest payments since the bonds can only be redeemed through the government at face value. No chance of capital gains.
- To avoid the 3-month penalty, you must hold for 5 years. If you sell within 5 years, your total return could be slightly lower than inflation.
- Interest accrues, and you won't receive any cash until you redeem them. The good news is that interest is compounded.
Conclusion
With the yield on I-Bonds at more than 9%, they are very attractive as a mid to long-term parking spot. Note that if inflation slows down in the next 6 months, the future yield will be reduced. So unless inflation keeps accelerating, your actual yield will be lower. These are designed just to keep pace with inflation, not to profit from it.
You can even set up a payroll deduction purchase of I-Bonds for convenience. Investors are limited to just $15,000 in purchases a year. For most, that is a healthy little cash reserve, and you can choose to add more next year. It provides the same benefit of ultra-safe principal you get with U.S. Treasuries while providing inflation protection.
After the first year, I-Bonds can make a great emergency reserve since they can be quickly cashed in any economic conditions. This allows you to hold a near-cash position that is significantly hedged against inflation.
I-Bonds are a great option to hold cash that you don't need for at least a year and want to protect that cash from inflation. We expect that inflation will remain elevated over the next few years. I-Bonds are currently a very safe inflation hedge.
