Hugh F. Wynn
When Battling Inflation Consider Bonds, I Bonds
With the start of a new year, I revisit I Bonds and Rainy Day Funds and how they can work together to serve you well during inflationary times. We need all the help we can get when battling the ravages of this monster! NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Rainy Days and Inflation
I obsessively recommend that folks set aside a minimum of 4-6 months of equivalent salary in a "Rainy Day Fund" to handle unforeseen emergency expenditures. And because I DON'T recommend tapping into retirement funds for Rainy Day money, I suggest that folks save up the necessary dollars and place this money in safe, but liquid assets. An FDIC-insured bank savings account is an example of safety and liquidity. However, bank savings accounts are like thieves in the night, paying 0.10%-0.15% on your hard-earned money. And, after you factor in inflation, this miniscule return is not just nothing but less than nothing in terms of salvaging purchasing power.
For that reason, it's worth exploring a little-used option which is almost, but not entirely, risk-free. I talked about this about six months ago, and with inflationary times upon us, I want to bring it up again!
No one enjoys earning low yields on their savings, particularly with inflation gobbling up all of a minuscule yield and more. U.S. Treasury I Bonds offer a (possible) way of enhancing yields on Rainy-Day Funds, and alternatively, as a safety net against Jerome Powell’s overly-stimulative Federal Reserve monetary policies – excessive bond buying and low interest rates – and Congress’ Cares Act fiscal money dump, both of which were destined to create more inflation. Well, here we are in inflationary times, and here we may stay for some time to come. The current surge in prices has long since lost its “transitory” aura, and for those with portfolios heavily weighted in equities, this trend is creating a significant elevation in investment risk. Therefore, exploring inflation-reducing risk options is in order, and one such option is the I Bond.
I Bonds are devised to help smaller investors deal with the consequences of inflation…and as a possible alternative to those low bank savings rates. I Bonds have a fixed rate that remains the same for the 30-year life of the bond and an inflation rate that adjusts semi-annually. The variable inflation-indexed rate for I Bonds bought from November 1, 2021 through April 30, 2022 is 7.12%. Every I Bond will earn this rate for six months, depending on the initial purchase month. At the sixth month…and at later 6-month increments…that rate resets, that is, unless the “official” government rate of inflation remains unchanged.
I typically preach “highly liquid” emergency funds, and the I Bond's 30-year term doesn’t sound very liquid. But why not salvage as much purchasing power as possible in today’s low interest rate environment?
How I Bonds Work
The variable portion of an I Bond's interest rate is set every six months, based on the consumer price index. The CPI is the U.S. government's measurement of price changes in a typical "basket" of goods and services bought by urban consumers. The basket represents the prices of a cross-section of goods and services commonly bought by urban households.This variable rate is paid out in addition to a fixed rate (if any), which is determined when the bond is issued.
I Bond rates are the sum of the fixed rate (guaranteed for the 30-year bond life) and the variable inflation-indexed rate, which adjusts semiannually. As of November 1, 2021, the fixed rate is 0.00% and the variable rate is 7.12%. They can’t be sold until 12 months after purchase so are not liquid that first year. Further, if you redeem them before you’ve owned them for five years, you’ll forfeit three months' interest, which impacts your yield a bit. But you CAN redeem them after 12 months. and - perhaps best of all - the government pays interest for 30 years if you keep your money there and protects you from both inflation and deflation.
An example. If you had bought an I Bond at the current fixed rate of 0.00% and the variable rate of 7.12%, and if you needed to sell it after that one-year required holding period, you will have earned 5.34% (7.12% less the three-month forfeiture penalty of 1.78%), assuming the variable rate doesn’t change. Sounds a whole lot better than your local bank’s savings rate of 0.15%, doesn’t it?...about 36 times better.
I Bonds and TIPS
I Bonds are available exclusively from the U.S. government with a government guarantee that your original capital investment plus any increase in the cost of living during your ownership is secure. And, no, they aren’t Treasury Inflation-Protected Securities (TIPS)…but similar.
Both I Bonds and TIPS are inflation-related government bonds that offer principal and purchasing power protection. They both combat inflation risks, but in subtly different ways. Currently, you can only buy $10,000 of I Bonds per individual family member during a calendar year with a $25 minimum per bond. An additional $5,000 can be acquired if you direct your tax refund toward the purchase. Old Sam likes to hang onto every dollar he can, even if temporarily.
On the flip side, you can buy up to $5 million in TIPS at any single auction using Treasury Direct. I myself prefer the more doable minimum purchase of I Bonds.
Interest on I Bonds is subject to federal income tax…no surprise there…but typically they are exempt from state and local taxes. NOTE: Interest is added to the value of I Bonds and only taxed upon redemption. And as mentioned, should deflation occur, the value of an I Bond never goes below that bond's value in the prior month.
In short, any upward inflation adjustments already received can't be eroded by later occurring deflation.
Why not conduct an experiment this new year? Place 50% of your emergency funds in an FDIC-insured bank savings account and the other 50% in I Bonds. After one year, the I Bond half of your money will be immediately available, allowing you to buy I Bonds with the other 50%. Yes, you’re subject to the three months of forfeiture, but look at the HUGE improvement in yield on those I-Bond invested dollars.
For risk-averse folks like me but who don’t wish to store their dollars with a bank at a loss - a pitiable interest rate of 0.15% eroded by inflation rates of 2%...3% …4%...or more - consider negotiating a line of credit with your friendly banker (perhaps using your I Bonds as collateral) if you happen to need some quick money. During this first year of exposure, try to avoid a bank maintenance fee on the hopefully untapped credit line and a variable interest rate during its term.
For you risk takers, knowing that government-guaranteed I Bonds offer some assurances against the high probability that some of your other bets will sour will provide comfort. Give it some thought.