‘I Bond Solution’ offers inflation hedge for small investors
Ijust learned about an investment tool designed to protect the small investor from inflation. It’s a timely discovery as inflation is hitting the U.S. economy hard enough the Federal Reserve has stopped calling it “transitory.”
In other words, inflation is likely to be with us for a while.
Now, I don’t give investment advice here, nor should you ever take investment advice from a stranger who writes a newspaper column. So this is not something you necessarily should do. Rather, I think it’s worth knowing about tools that may solve an investing problem, particularly given that it’s been nearly 40 years since we’ve actually experienced broadbased inflation.
Let’s call it the I Bond Solution.
I learned about it from Burton Malkiel, who wrote about I bonds in the Wall Street Journal recently. He is best known as the author of one of my all-time top five investing books, “A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing.”
So for me — like those E.F. Hutton commercials the over-50 crowd will remember — “When Burton Malkiel talks, people listen.”
In his column, Malkiel introduced the U.S. Treasury Series I Savings Bond as a tool investors should consider as part of their overall portfolios.
Here’s the part that makes I bonds sexy: Because the consumer price index jumped so much this fall, the yield on the bonds is 7.12 percent. I bonds purchased in January will enjoy this fixed rate until July 1. That’s the highest interest they’ve offered since May 2000.
The semiannual yield reset tracks the consumer price index in the future. After the next reset, the yield could very well go down if inflation goes down.
If it stays high, the I bond will keep a very nice yield, which is why it’s a plausible hedge against inflation. No matter the inflation rate, the yield on I bonds cannot go negative.
Institutional investors — big funds, insurance companies and banks — typically have
looked to TIPS, or Treasury Inflation Protected Securities, when they worry about inflation. Since 1997, investors have been able to buy these bonds, which pay a fixed rate but adjust their principal upward in response to inflation, also as measured by the consumer price index.
The little guy has typically only been able to access TIPS through mutual funds, though. Because inflation has been so tame since 1997, TIPS have rarely been high yielding but have offered a hedge against the “what if ” scenario. And that “what if ” has hardly shown up — until recently. Returns over the past 10 years on a TIPS fund have been in the 3 percent annual range, before taxes, with the biggest boost to that performance in the past two years.
Unlike TIPS, you would buy I bonds online directly from the U.S. Treasury without a brokerage company or mutual fund. They’re not salable by a brokerage, nor by you. You buy them in increments of $25 up to $10,000 maximum per Social Security number per year. They register in your name only, or the name of the trust or partnership buying them.
I bonds are designed for retail investors with a long time horizon and do not work as well for a short-term trade. That’s because you will pay a three-month interest penalty if you redeem after one year. Although they can’t be traded and are intended to be held for 30 years, you can redeem an I bond after five years without penalty.
Because interest accrues until maturity or redemption, you will pay income tax on the interest only at the end. The following fact is irrelevant for Texans, but the interest earned on I bonds is exempt from local and state income taxes, like traditional municipal bonds.
Speaking of traditional bonds, U.S. Treasury or corporate bonds are the last thing you want to buy in an inflationary environment. In addition, Treasury bonds offer a measly 0.5 percent to 1.8 percent right now. Even a basket of high-risk corporate bonds (what we’ve impolitely called junk bonds since the 1980s) only get about a 4.5 percent annual yield. That’s unacceptable unless you enjoy locking in losses against the current observed rate of inflation.
Maybe another concluding thought about this particular investment tool is in order. I, personally, will not be purchasing inflation bonds, neither TIPS nor I bonds. I’m not that worried about inflation in my life or in the economy. I think my combination of real estate (my home!) and stocks (my retirement accounts!) will serve me fine under medium-level inflation. But I have a different risk appetite from most — my appetite is quite high. And I have a longish time horizon. I’m turning 50 this year, so I have another 80 or so years to live (if my math is correct).
I’m not deviating from my plan (buy 100 percent equity index funds, never sell) but I mention the I bond product so you’re a more informed investor.
Also, you should read Malkiel’s “A Random Walk Down Wall Street.” That is my strongest investment recommendation. I wouldn’t recommend any particular stock or bond, but reading a classic like this one is likely to make you richer in the long run.