A good time for inflation-protected bonds

By Elliot Raphaelson
Posted on February 09, 2022

If you had a significant proportion of your portfolio in diversified index funds or exchange-traded funds in 2021, you should have had a good return on your investments.

It is also likely that the return on the bond portion of your portfolio was not very good because of the low interest rates on most bond investments. So, if you are considering rebalancing, which I recommend at least once a year, it is likely that you would be considering taking some profits on your equities and reinvesting in some type of bonds.

Burton Malkiel, the economist and author of the celebrated book A Random Walk Down Wall Street, discussed Series I inflation-protected savings bonds recently as an excellent investment for the fixed-income portion of your portfolio.

He believes that even if inflation falls back to the 2% Federal Reserve target, a 10-year U.S. Treasury bond yielding 1.5% will still have a negative rate of return after inflation. He also points out that high quality bonds from other countries currently have negative returns.

As long as inflation remains high or increases, then bond prices are likely to fall as the Fed is forced to increase interest rates. Bond prices have an inverse relationship to interest rates; as interest rates increase, bond prices decrease.

Safe but high return

For all of these reasons, Malkiel offers his case for purchasing I bonds for a portion of your bond portfolio. I bonds pay a fixed rate of return for the life of the bond plus the annualized interest rate of 7.12% through April 2022.

This return is far above any return for safe investments. You can never receive a negative real yield, and the combined interest rate can never be less than zero even if price level declines.

If inflation rises, the rate paid will increase when it resets in April. In other words, Malkiel points out that you are safe from the economy’s current problems and any actions the Fed takes to deal with them.

Interest from I bonds is exempt from state and local taxes. If you use the proceeds for qualified higher-education expenses, the interest is exempt from federal taxes as well.

Interest is deferred until maturity, or when the bond is cashed. Maturity is 30 years, but you can cash them in after one year for a small penalty (equivalent to three months interest). After you hold the bonds for five years, there is no penalty.

If you do purchase I bonds, you will be protected against any market downturn or an increase in inflation.

Easy to purchase

As long as you have a Social Security number, you can purchase I bonds directly from the U.S. Treasury at its website (treasurydirect.gov). Each individual is limited to a maximum of $10,000 in electronic bonds per year, plus up to another $5,000 in paper bonds that may only be purchased with an IRS income tax refund.

Malkiel knows it is tempting to simply “ride market optimism,” maintain your equity portfolio, and watch your stocks rise. But because of existing inflation, there is now significant investment risk.

Although it’s unlikely that we will be facing the double-digit inflation we faced in the early 1980s, monetary authorities agree inflation is not likely to disappear quickly. So, rebalancing is a wise choice in order to minimize your risk and insulate yourself against possible market volatility.

For these reasons, I bonds offer a good alternative — and an opportunity for small investors that is not available to large institutions.

There is no question that equities are a useful long-term inflation hedge. But market falls are inevitable and can easily be initiated by Fed monetary policy.

I bonds are safe and stable, and they offer inflation protection. For these reasons, you should consider purchasing I bonds.

You can obtain more information regarding I bonds at the Treasury site (treasurydirect.gov), as well as information about the purchase of Treasury Inflation Protected Securities (TIPS), which also offer inflation protection.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.