Rising inflation has been cause for concern after the most recent June consumer price index reading increased 5.4% from a year earlier. This was the largest jump since August, 2008. Investors therefore are seeking a hedge against inflation as speculation grows that this may be more than transitory. A sector investment into commodities, specifically a commodities exchange traded fund (ETF), is a pointed, tactical approach. Another tactical tool for investors is to purchase government products such as Treasury Inflation-Protected Securities (TIPS) and Series I (Inflation) bonds.
Series I bonds are currently paying slightly more than 3.50% in interest (3.54% rate annualized is good through October 31, 2021.). This rate exceeds current inflation, which is targeted at 2% by the fed. The interest for Series I bonds is significantly higher than the interest rate for savings accounts and clearly higher than that for online bank savings accounts. The yield on I bonds is also superior to those of TIPS. Series I bonds pay a fixed rate for the life of the bond plus adds an inflation-based rate premium. Consumer Price Index measures inflation and is the component used to determine the inflation-based rate. The inflation-adjusted variable rate is double the semiannual inflation rate. The fixed rate for the Series I bonds resets twice a year.
Investors receive the initial investment, or bond’s face value, and the overall rate cannot fall below zero. Therefore, unlike TIPS, Series I bonds will never fall below zero if we experience deflation. Series I bonds also protect against inflation, and they make sense in an elevated inflationary environment. Investors bought ten times the total of I bonds in May when compared to what they bought last year in May 2020. January is usually the peak month for buying Series I bonds.
Series I bonds have their limits and drawbacks however. The limit per person, per year to buy I bonds is $10,000, and these bonds are digital only. To purchase, one has to go to TreasuryDirect.gov and set up an electronic TreasuryDirect account. Because no commissions are involved, there are no brokers to go through. One could go over this $10,000 limit and buy an additional $5,000 in I bonds if using an income tax refund, or receiving Series I bonds as payment instead of a tax refund. These additional bonds are paper only. For example, a married couple can purchase a total of $30,000 in Series I bonds, with $20,000 digital and $10,000 paper. Additionally, Series I Bonds are not liquid. The holding period for any Series I bonds is a minimum of 12 months, and you cannot redeem it any earlier. The last three months of Series I bond interest is taxable if you cash out before five full years. To compare, TIPS have a much higher purchase limit and are available on the secondary market. With respect to taxation, the federal government taxes Series I bonds at the federal level but not at the state or local level. Investors owe taxes at the time of Series I bond redemption, unlike TIPS for which investors owe taxes as interest accrues. Series I Bond investors have the option to pay taxes as they accrue. The taxes are potentially fully avoidable if the investor is in a lower tax bracket and is using the proceeds to pay college expenses (tuition and fees only). One can earn interest on I bonds for up to 30 years. One can redeem the Series I bond at 30 years, and all the taxes up to that moment of redemption are tax deferred. Series I Bonds pay interest monthly, and this interest compounds every six months.
Keep in mind that with a zero base rate, I bonds would earn less if inflation falls, rates reset, and the Series I bond’s variable rate falls. Owning Series I bonds can be risky because of the minimum 12-month holding period. The influx into Series I bonds occurred recently based on concern about inflation and on anticipation of a rate increase. One scenario is that rates may not change, inflation does not hit 2%, and Series I bond investors have to hold onto their bonds for ten more months if they bought in May. We do not know with certainty where interest rates and inflation will be later this year. The 10-Year Treasury yield peaked in March of this year and his since come down, leaving many wondering how big of a concern inflation really is. While it remains to be seen, it is important to have these tools at your disposal if they become necessary. Always consult a tax or investment professional before making these important decisions.