I Bonds Are an Excellent Hedge Against Inflation

By Jane Young, CFP, EA

Inflation has become a major concern for investors after a rise in annual inflation of 6.8% in November. The stock market has historically been a good hedge against inflation, but most investors keep a portion of their portfolio in fixed income as a buffer against stock market fluctuations. Returns on fixed income investments have been earning significantly less than inflation with money market accounts and certificates of deposits earning between zero and one half of a percent.

Until inflation returns to a more reasonable level, I bonds may be an excellent option to keep pace with high inflation. I bonds issued between November 2021 and April 2022 are paying an annual rate of 7.12%. I bonds are securities issued by the U.S. government that pay two components of interest. They pay a fixed rate that remains the same for the life of the bond and a variable inflation rate that is adjusted every six months. The variable rate is based on the Consumer Price Index for all Urban Consumers CPI-U. The current fixed rate is zero and the current variable rate is 7.12%.

I bonds have a maturity of 30 years, but you are not required to hold them until maturity. You must hold them for at least 12 months and if you sell them after twelve months but before five years you will forfeit the last three months of interest. This may seem restrictive, but inflation is unlikely to drop dramatically over the next 12 months. If it drops significantly over the next five years, it may be time to sell the bonds and the loss of three months in interest at the lower rate will be less impactful.

Due to the required holding period of 12 months, I bonds are not a good option for your emergency fund which should be readily accessible.

An individual is limited to the electronic purchase of up to $10,000 in I bonds within a calendar year. A couple can electronically purchase a total of $20,000 per year. With year-end approaching, you can purchase $10,000 by December 31st and another $10,000 in January. A couple can purchase a total of $40,000 in I bonds between now and the first week of January. Additionally, if you receive a tax refund, you can purchase an additional $5,000 in paper I bonds with the refund.

I bonds can be electronically purchased by establishing an account at Treasury Direct, www.treasurydirect.gov. Once you create a Treasury Direct account, money can be transferred directly from your bank account to purchase the bonds.

Interest on I bonds is compounded semi-annually, and the value of your bonds increase on the first of every month. The interest is subject to federal tax but not state and local tax. The interest is tax free if used for qualified education expenses. Interest can be reported to the IRS on an annual basis or when you sell the bonds.