Should Series I Savings Bonds Be Part of Your Inflation Protection Strategy?

  by Shelley Seagler

In March 2022, the year-over-year consumer price index (CPI) reached 8.5%, the highest rate since 1982. By June, the stock market had officially growled its way into bear territory. The current economic climate has retirement investors looking for ways to hedge against rising inflation and volatility.

Series I bonds for inflation protection

For the right investor, Series I savings bonds offer a moment-in-time opportunity to augment an inflation protection strategy.

What Is a Series I (Inflation-Linked) Savings Bond?

As with any investment, there are pros and cons of I bonds.

One of the first things to know is that Series I bonds are not a way to shelter a cash war chest. The annual maximum purchase is $10,000 per Social Security number, purchased electronically via an account with TreasuryDirect.

You can also buy $5000 worth of paper Series I bonds if you use your tax refund, a good reminder to file away for your tax strategy. If you use your income tax refund to purchase U.S. savings bonds, complete and file IRS Form 8888 with your tax return.

Secondly, Series I bonds are not a place to park cash you will need soon. You can’t get to your money for a year. You can’t sell your bond. It is a non-marketable, interest-bearing savings bond. 

If you cash in the I bond in less than 5 years, you lose 3 months of interest. I bonds have a 20-year initial maturity, plus a 10-year extended period. 

Because of the mild penalties for early withdrawal, some advisors see the I-bond as an option for not only long-term but mid-term investment strategies. 

It’s also difficult to predict the long-term interest rate of an I bond. Let’s take a look at why.

Free Download: Bond Selection Fund Worksheet

How Does Treasury Calculate I Bond Interest Rate?

I bonds have two rates – a fixed rate for the life of the bond, and a variable inflation adjustment. These two rates make up the composite rate for the current six months. 

Fixed-rate for Series I Savings Bonds

The Secretary of the Treasury determines the fixed rate for I Bonds at the beginning of May and November. That fixed rate is applied to all bonds for the next six months. It is compounded semiannually throughout the life of the bond. 

Semiannual Variable Inflation Adjustment for I Bonds

Like the fixed interest rate, Treasury announces a semiannual inflation rate in May and November. The Consumer Price Index (CPI), which tracks inflation, influences this rate. 

Unlike the fixed-rate, which does not change, the inflation rate is applied to the bond every six months from the bond’s issue date. So that means the two rates combined, or composite, create a variable interest rate for each bond This makes it challenging to forecast the values of the bonds a few years out or at maturity. If inflation drops, the interest rate of your I bond is likely to drop as well. Looking at the formula shows us how this works.

What is the Formula to Calculate the Composite rate for Series I Savings Bonds?

Treasury calculates the actual I bond rate by combining the fixed and inflation rates. For example, the May 2022 fixed rate is 0% and the inflation rate is 4.81%.

The formula for calculating the I bond composite rate is:

Composite rate = fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)

0.0000 + (2 x 0.0481) + (0.0000 x 0.0481)

0.0000 + .0962 + 0

= 9.62%

The composite rate for May 2022  to October 2022 is 9.62%.

The 9.62% interest rate that I bonds are paying is the highest amount paid since 1998. In an average year, the stock market returns about 10%. So far, 2022 has not been an average year and stocks continue to show volatility.  

How to Buy a Series I Savings Bond

The minimum purchase for an I bond is $25, and the maximum is $10,000 per Social Security number per year, purchased electronically via an account with TreasuryDirect.  You can also buy $5000 worth of paper I bonds if you use your tax refund. In that case, the IRS mails the paper bonds to you. 

Don’t forget – free download: Bond Selection Fund Worksheet

Tax implications for I-Bonds

The series I bond is a zero-coupon bond, meaning that the holder receives no interest during the life of the bond. The interest is added to the value of the bond and earns interest on interest. Bondholders may pay taxes on the bond using either cash or accrual methods. 

Series I bond Interest is not taxable at state or local levels, which makes the bonds attractive to residents of states with high tax rates. 

Individuals may purchase bonds as a gift. If the I bond is cashed in to pay for higher education, the interest is exempt from federal income tax. This could introduce some interesting options for college tuition savings strategies. Be sure to check with your accountant for conditions regarding eligible institutions and other considerations.

Inflation Protection Alternatives to Series I Savings Bonds

As we’ve seen, at the current time I bonds are one tool to consider as part of an inflation protection strategy. However, with a 10K cap per individual, I bonds may not have much of a ripple effect on a larger portfolio. 

Other strategies to consider include: 

  • Covered calls provide investors with extra income from their equity portfolios, offsetting a decrease in real income (e.g., inflation-adjusted income) from fixed income. 
  • Dividends are the most common way to generate income from an equity portfolio.  Historically, dividend growth has exceeded the long-term inflation rate.  This means that dividend-focused portfolios can provide an income that keeps pace with or exceeds the inflation rate. 

The Bottom Line

So are Series I Savings bonds a good investment for 2022?

With a composite rate of 9.62%, approximating the stock market average return, and none of the risks, the I bond could be a good option for investors with a solid emergency fund who don’t need a chunk of cash right away.  

The downside is the relatively low $10,000 cap on total investment. 

If you are interested in learning about additional prudent retirement portfolio strategies to ride out the inflation, such as covered calls, Snider Advisors provides free e-courses and asset management services. Contact us today.

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