How I Bonds Can Hedge Against Inflation

There’s a plethora of concerns when it comes to the current state of the market and economy, inflation being one of the biggest. In addition to things costing more for consumers, inflation also can cause a slowdown in growth and business activity.

For years, there has been little or no inflation. However last year and into this year, we’ve seen a sharp uptick. There’s a lot of debate over whether the high inflation numbers are transitory and will go away, or if they will be long-lasting, potentially causing the Federal Reserve to change their monetary policies sooner than projected.

Naturally, the next question is: What can you do to protect your portfolio against inflation? 

There are certain sectors in the stock market that usually prosper during periods of inflation — such as Energy and Financials. Anyone can see that the price of gas has increased sharply. Not surprisingly, companies in the energy sector will profit by higher gas prices. And with inflation comes higher interest rates, so financial companies will profit by lending money at those rates.  

In the chart below, you can see the gap year-to-date in Energy and Financial stocks when compared to the S&P 500.

Stocks are not the only hedge against inflation. Here are 9 assets that can potentially hedge against inflation.

Most investors don’t think of bonds during periods of high inflation because of interest rate risk — the price of bonds usually decreases as interest rates go up. But there is one type of bond that investors may want to consider.

An I bond is a security that earns interest based on both a fixed rate and a rate that is set twice a year based on inflation. The bond earns interest until it reaches 30 years or you cash it, whichever comes first. If they are sold after fewer than five years, the holder sacrifices the last three months’ worth of interest. I bond purchases are restricted to just $10,000 per year per Social Security Number. They are considered low risk since they are backed by the full faith and credit of the U.S. government and their redemption value cannot decline.

No interest is paid during the life of the bond. The interest gets added back to the value of the bond and earns interest on interest. Interest income for I bonds is taxable at the federal level, but not at state and local levels. The bondholder has the option of selecting one of two methods of taxation: The cash method — tax is only applied when redeemed — or the accrual method — taxes on the imputed interest earned are applied every year. If an I bond is sold and the proceeds are used to pay for qualified higher education expenses, then the interest is exempt from federal income tax.

Below are details on some of the common questions that come up related to I Bonds.

How Do I Purchase An I Bond?

I bonds can only be bought directly from the Treasury. There are two ways to purchase: 

1. Buy them in electronic form. Electronic I bonds come in any amount to the penny for $25 or more. For example, you could buy a $50.23 bond. In the calendar year, you can purchase up to $10,000 in electronic I bonds. One strategy could be to purchase $10,000 of I Bonds in November when the rates reset and another $10,000 in January 2022
2. Purchase them using your Income Tax refund to buy paper savings bonds. Paper bonds are sold in five denominations; $50, $100, $200, $500, $1,000. In the calendar year, you can purchase up to $5,000 in paper I bonds. 

How Does Interest On An I Bond Work?

The interest rate combines two separate rates:

1. A fixed rate of return, which remains the same throughout the life of the I Bond.
2. A variable semiannual inflation rate, based on changes in the consumer price index (CPI). Rates reset each May and November.

How Do I Sell An I Bond?

You have to hold an I Bond for at least one year. If you sell it before holding it for five years, you give up the last three month’s worth of interest. When you redeem your bonds, you receive your original purchase price plus interest earnings. The value of your I Bonds can never be less than what you paid for them.

How Are I Bonds Taxed?

You will owe federal tax, but are exempt from state and local taxes. The bondholder has the option to select one of two methods for taxation:

1. Cash Method – Tax is only applied when redeemed.
2. Accrual Method – Tax on the imputed interest earned is applied each year.

How are TIPS different from I bonds?

Treasury Inflation-Protected Securities (TIPS) are another type of US Treasury security whose principal value is indexed to inflation, but they are more complex. 

Here are six differences: 

1. When inflation rises, the TIPS principal value is adjusted up. If there’s deflation, then the principal value is adjusted lower. Therefore, unlike an I Bond, the return on a TIP can go negative.
2. TIPS can be bought in much larger amounts and can be purchased in a brokerage account. I bonds are limited to a $10,000 max annual purchase and must be purchased through the US Treasury.
3. With TIPS, the principal is adjusted for inflation, and with I bonds, the interest rate is adjusted for inflation.
4. TIPS can be sold without any penalty. I bonds have an interest penalty if sold in the first 5 years.
5. Holders of TIPS will have taxes due each year. Holders of I bonds have the option of paying tax each year or deferring the tax payment until the security is redeemed. 

If you’re looking to diversify some savings and get an inflation hedge, I Bonds may be worth looking into.

Disclosure: Before making any investment decisions please consult with a financial professional.