Bonds have long been used as a primary way to diversify a portfolio and hedge against inflation. Now, bonds not only hedge against inflation, but also can actually help you beat it and realize a profit.
The U.S. government began extending inflation protection to a new series of bonds when the Treasury introduced the Series I Inflation Savings Bond (I Bonds) in September 1998. The goal of the I Bond is to provide investors with a real rate of return above inflation. How is this achieved? Rather than paying one fixed interest rate, the Series I Bond yields a combination of two rates. One is a fixed interest rate announced by the Treasury Department that remains the same for the life of the bond. The second is a rate of inflation that is adjusted semiannually (May 1 and November 1) by the Bureau of Labor Statistics to reflect changes in the Consumer Price Index for all Urban Consumers (CPI-U). Added together, the two rates produce a total yield, which is typically higher than the fixed rate offered by traditional savings bonds, such as the Series EE Bonds. If inflation rises, which erodes the value of fixed investments, the Series I Bonds will be increased in value to compensate. In this way, Series I Bonds could continue to exceed bonds that are pegged to the Treasury Bill yields.
Here is an example of how I Bonds work:
An investor buys an I Bond for $1,000 with a 3% yield. The 3% fixed rate stays the same for the entire 30-year life of the bond. In May, the government announces that the inflation rate (CPI-U) is 2%. This 2% is then added onto the 3% fixed rate, bringing the I Bond's yield up to 5% for the next six months until the next CPI-U announcement in November.
The I Bond provides tax advantages as well. You may recall that an Inflation-Indexed Treasury Bond (T-Bond) was offered in 1997. The Series I Bond is different from the T-Bond in that T-Bonds required you to pay taxes on the interest earned each year. Taxes on interest from I Bonds can be deferred until the bonds are redeemed, and interest earned on the I Bond is exempt from state and local income taxes all together. Plus, all or part of the interest earned may be tax-exempt if it is used for college tuition and fees at eligible post-secondary educational institutions, when certain income qualifications are met.
As with most savings bonds, I Bonds should be viewed as a long-term investment. I Bonds can be redeemed after twelve months; however, if you hold the bonds for less than five years, you will incur a three-month earnings penalty. I Bonds are also affordable to most investors since they can be purchased in seven different denominations: $50, $75, $100, $200, $500, $1,000, and $5,000. Each calendar year you can purchase up to $5,000 of electronic I Bonds at www.treasurydirect.gov. You can also purchase up to an additional $5,000 worth of paper I Bonds from your bank or broker. You should check bond purchase limitations, which change from time to time, at the TreasuryDirect® site. I Bonds are sold at face value, unlike paper Series EE Bonds, which are sold at half of face value.
The Series I Bond can be an attractive investment for the long term. It provides an inflation hedge in your overall portfolio as well as a way to exceed inflation if it rises, allowing you to protect your purchasing power with a portion of your assets. And Series I Bonds offer the security of being government issued and government backed. I Bonds can be purchased from your local financial institution. When considering ways to diversify your portfolio and protect against future economic changes, I Bonds may be one answer.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.