leaf check-circle cross-circle Lifted Logic Web Design in Kansas City clock location phone play chevron-down chevron-left chevron-right chevron-up facebook checkbox checkbox-checked radio radio-selected instagram google_plus pinterest twitter youtube send linkedin plus checkmark minus

The case for fighting inflation with I-Bonds

Back to Blog

For the first time in decades, inflation has become a very stubborn problem for nearly all developed economies around the world, including the US. While most economists agree that it is not likely to remain this high in the US going forward, it may take years for inflation to return to more normal levels – historically, roughly a 1-3% per year range (vs the current 9.1%). 

In the meantime, investors are faced with making major adjustments to spending, driving habits, savings priorities, and wondering where to park their cash reserves. With inflation approaching 10% over the last year in the US, holding cash practically guarantees that cash will have lost 10% of its purchasing power, given that you’re lucky to get even a fraction of 1% interest at most major banks for a savings account.

Importantly, despite the loss of purchasing power, there is a very specific reason just about everyone should still make sure to hold a certain amount of their assets in cash reserves at all times – your emergency fund

Cash can be accessed quickly and easily, generally without tax implications, and therefore should be held in a savings account (preferably an online bank with the highest rates available) for life’s expected “unexpected” financial moments. 

That said, many individuals and families may find themselves in the relatively fortunate situation of having significantly more than the recommended 3-6 months worth of living expenses, in their emergency cash reserves. If this is you, it might be time to consider taking advantage of the current inflation situation, by purchasing some I-Bonds, via the US Treasury

What is an I-Bond and how does it work?

While you may have heard of the typical savings bond, issued by the US Treasury, you may not have known that there is a unique type of savings bond, designed to protect the investor specifically from the risks of inflation. I-Bonds were created to essentially guarantee that an investor’s money will keep pace with inflation, whatever the inflation rate may rise to.

These bonds can be purchased online and each individual is limited to a total of $10,000 per year in purchases. As with any bond, there is a stated interest rate for the I-Bond you purchase. That interest rate consists of two separate components – a fixed rate for the life of the bond (can receive interest payments up to 30 years), plus a variable interest rate that is tied to the inflation rate. The variable rate adjusts every six months (every May and November) to match the inflation rate at that time. With inflation currently over 9% in the US, any I-bonds issued between May and November 2022 are now earning a rate of 9.6%. Depending on the inflation rate in November, this total interest rate will adjust up or down to match at that time.

For the last decade or so, inflation has remained in the 0-2% range and the Federal Reserve in the US has held interest rates close to 0%. Until now, this has meant I-Bonds have offered relatively unattractive interest rates for most investors and most situations, given some of the drawbacks. So, what are those drawbacks?

Things to consider before purchasing I-Bonds

As we’ve already mentioned, individuals can only purchase $10,000 of these savings bonds per year. For those with significantly high excess cash sitting around, that limit may not provide enough benefit to be worth the hassle of setting up the account with the US Treasury Direct website. In addition to the annual limit on purchases, you cannot withdraw this money for a minimum of 12 months after purchase. So, you need to make sure any cash used to purchase an I-Bond is truly excess cash you have and not money you may need to use in the next year. 

Another drawback of these bonds is that, while you can “redeem” (withdraw) them after one year, any redemptions prior to holding the bond for 5 years will result in an interest penalty equal to three months of interest. With rates approaching 10%, we would argue a three month interest penalty is still worth considering I-Bonds as an alternative to excess cash earning 1% (if you’re lucky) in a savings account. 

Some additional benefits to consider

In addition to the relatively high, virtually guaranteed rate of return backed by the US Treasury, these savings bonds are also exempt from state income tax, meaning your interest cannot be taxed as income by your state. Federal tax does still apply though. 

If you purchase an I-Bond and decide to hang onto it for the long-term, it’s good to know that they can also be redeemed to be used to pay qualified education expenses, tax-free. This is similar to a 529 education savings plan. Although, we would generally recommend the 529 over I-Bonds for long-term education savings.

The bottom line

With inflation hitting its highest levels in a generation, I-Bonds provide those fortunate enough to have excess uninvested cash sitting around, a short-term arbitrage opportunity. It can be argued that there is no better risk/reward opportunity available to investors at the moment, given that these bonds pay interest that is backed and guaranteed by the full credit and faith of the US government, with rates currently nine times higher than even the highest yield savings account around. 

Since such an opportunity will likely be short-lived, as inflation expectedly returns to more historical levels in the coming years, it’s important not to alter your overall long-term investment strategy or to place your emergency cash reserves in these bonds. I-Bonds should NOT be viewed as an alternative to your long-term stock/bond portfolio investments, especially those held in retirement accounts. I-Bonds should only be considered as an alternative to cash you have sitting in a bank savings account, in excess of your 3-6 month emergency expense needs. A great example might be a short-term savings goal (longer than one year away), like a house down payment.

Although stocks are experiencing a bit of rough patch in the current environment, it’s important not to confuse the purpose of I-Bonds (maintaining cash purchasing power) vs the long-term wealth building purpose of investments like stocks in your retirement accounts. If you have questions about whether or not I-Bonds could be appropriate for you and your situation, please reach out to us. Our advisors are happy to talk through your situation and see whether or not it makes sense to look further into this alternative for some of your shorter-term savings goals. 

The information is provided for discussion purposes only and should not be considered as advice for your investments. Past performance is no guarantee of future results. Please consult an investment advisor before you invest.

Published on July 28, 2022