With inflation rates hitting a 40 year high in 2022, many investors are looking for investments to hedge against high inflation, or ways to take advantage of the high inflation rates. Many clients have asked us about investing in series I bonds, and if they are a good investment.
A series I bond is a type of savings bond that is issued by the federal government, and the interest rate is determined by the consumer price index (or CPI), that is issued every May and November of each year. The CPI is a measure of the average price increase paid by consumers for a market basket of consumer goods and services. In simple terms, it shows the increase in the cost of living (or inflation) from the previous year. In May of 2022, the CPI hit a 40-year record high, and was announced at 8.6%.
Interest paid out on a series I bonds is called the composite rate and has 2 parts that determine it. The first is a fixed interest rate that is fixed for the life of the bond (has ranged from 0%-3.4%). The second component of the composite rate is determined by the inflation rate announced by the CPI. These two are added together to determine what interest rate is paid to the I bond.
Any person can purchase a maximum of $10,000 per calendar year in series I bonds (there is a way to purchase an additional $5,000 but must do so through tax refunds). These bonds must be held for a minimum of 12 months and are issued in terms of 30 years. However, if you cash out your I bond before the 5-year mark, you lose the last 3 months of interest.
Interest on the bonds is taxed at the federal level but exempt from state and local taxes. There are 2 ways of reporting your interest.
With the inflation rate hitting a 40-year high, the current composite rate for a series I bond (as of May 2022) is 9.62%. Generally, if something looks this good, it is worth looking at the pros and the cons:
For example, if an investor purchased $10,000 worth of series I bonds, and the composite rate was 9.62% again in November of 2022, they would be paid 9.62% for the first year they held the bonds. If held for over 365 days, they would receive $721.50 (after losing the last 3 months of interest). And after paying taxes (23.8% long term capital gain, assuming the highest tax bracket), would receive $549.58 interest.
This could be a great investment if the inflation rate continued to be high and the interest paid on the bonds continued to be over 9%. But historically since 1914, inflation has averaged 3.27%. If I bonds paid an average of 4.27% per year (generously estimating 1% higher than the average inflation rate), the $10,000 investment would be worth $35,920 after 30 years. After paying capital gains taxes (assuming 23.8%) in this example, the bond would be worth $29,751.51 at the end of the 30-year term.
If you had put $10,000 into the S&P 500 for the same 30 year time period (assuming average of 10.49% per year, which is since 1926 inception), you would have $177,260 after taxes.
Although not apples to apples, it is worth putting this in perspective when you see an equity return of 9.62% offered in something safe. Is this really sustainable, and worth the time and headache of setting up?
Since it is backed by the US government, this is one of the safest investments that an investor could make. But when making a “safe” investment, one of the main benefits is for it to be accessible when the equities markets are down. An I bond cannot be accessed for 12 months and a penalty is paid on the interest if they are cashed in before 5 years, making them not very easily accessible. And looking at historical inflation numbers, it is historically unlikely that the returns would continue to be this high.
If you do decide to purchase one, the last factor comes into play which is adding another layer of tracking, logins, and another place where your money is spread out. Sometimes simplicity and saving time can go a long way. Especially when $10,000/year is only 1% of a $1,000,000 portfolio so regardless of returns being high, this would be on a very miniscule amount of total net worth for most investors liquid enough to purchase these in the first place.
Is $962 of taxable interest (on a 10k bond) that will likely not continue at this level, worth the time of setting up especially when you cannot hold these where your other money is already held?
These can be purchased through:
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
Stock markets are volatile, and the prices of equity securities fluctuate based on changes in a company’s financial condition and overall market and economic conditions. Although common stocks have historically generated higher average total returns than fixed-income securities over the long-term, common stocks also have experienced significantly more volatility in those returns and, in certain periods, have significantly underperformed relative to fixed-income securities. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the Fund. A common stock may also decline due to factors which affect a particular industry or industries, such as labor shortages or increased production costs and competitive conditions within an industry. For dividend-paying stocks, dividends are not guaranteed and may decrease without notice.
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