Over the last year and a half, investors and consumers alike have dealt with some of the worst inflation rises in recent times. In June, the Consumer Price Index rose to 9.1%, the largest increase in the last 40 years.
Since then, the Consumer Price Index has been consistent, although incrementally, declining. But investors may still want to look into adding different inflation protection vehicles to their investment strategy. Below is a quick guide on investing in inflation-indexed bonds to hedge your portfolio against inflation rises and meet your investment objectives.
How Do Inflation-Indexed Bonds Work?
Inflation-indexed bonds are bonds where the principal is indexed to the inflation rate. When the inflation rate rises, the principal amount also changes to reflect this rise. Inflation-indexed bonds still pay a fixed rate of coupon. However, since this rate is applied to the adjusted principal, the actual amount of interest payments also changes when the inflation rate changes.
Let’s look at what happens when if you were to invest $5,000 in an inflation-indexed bond with a real return of 2%:
If the inflation rate is 5%, the adjusted principal on your investment a year later would be $5,250, and you would receive 2% interest on this adjusted principal. Your total nominal return would be $5,355. As you can see, not only does the purchasing power of your investment stay intact, but you’ll also earn a 2% real return (after adjusting for inflation-eroding purchasing power).
Risks and Challenges of Investing in Inflation-Indexed Bonds
As with any investment, inflation-indexed bonds come with their own set of risks and challenges. Below is a quick rundown of what you can expect before investing in inflation-indexed bonds.
1. Returns can be lower than expected when inflation is low.
When inflation comes in below expectations, the returns of inflation-linked bonds are worse than the returns of nominal bonds because inflation-linked bonds payout in terms of the actual inflation. This is why investing in inflation-indexed bonds is recommended when inflation is on the increase.
2. Not a perfect measure of inflation.
The Consumer Price Index is the most commonly used measure of inflation for United States inflation-indexed bonds. The problem is that the CPI isn’t a perfect metric, and some experts warn that you can expect a degree of uncertainty with how well inflation-indexed bonds will protect your investment from inflation rises.
3. Investment returns are fixed
Unlike other securities like stocks, which can offer investors many times the returns on their investments, inflation-indexed bonds are more comparable to fixed-income investments because they provide a fixed rate of returns.
4. They’re affected by deflation
While inflation-indexed bonds may provide a good hedge against rising inflation rates, when it comes to deflation, investors stand the chance of losing money on their investments since returns are directly related to the rate of inflation.
What Is the Right Portfolio Allocation?
Portfolio allocation with inflation-indexed bonds should be based on several factors that should all be considered before deciding to invest.
Your age, risk tolerance, and overall diversification matter when you invest in inflation-indexed bonds. Besides, you should always diversify with other major liquid asset classes.
Investing in Series I Savings Bonds
Series I savings bonds (or i bonds) are investments issued by the government to protect your money from losing its value due to rising inflation rates. The interest rates of i bonds are adjusted regularly to keep up with rising prices. Interest on i bonds is also exempt from state and local taxes, making them an even better option for low-risk portfolios.
Advantages of I bonds
1. High-interest rate
I bonds benefit from higher interest rates while inflation rates are high.
2. Low risk
The U.S. Treasury Department has never defaulted on its debt, meaning you’ll almost certainly get your i bonds interest payments on time and receive back your principal at the end of your ownership.
3. Portfolio diversification
Most financial advisors recommend balancing your portfolio between riskier, more aggressive investments like stocks and less risky assets like government bonds. i bonds are an excellent option for diversification that hold low risk.
4. Inflation hedge
The interest of i bonds will grow at around the same rate as inflation, meaning your savings won’t lose their buying power.
1. Variable rate
The initial rate on i bonds is only guaranteed for the first six months of ownership. After that, the i bonds rate can fall, even to zero.
2. One-year lockup
Money can’t be withdrawn from your i bond for the first year of your investment.
3. Early withdrawal penalty
If you withdraw money from your i bond after one year, but before five years, you will lose the last three months of interest on the i bonds.
4. Opportunity cost
Between 2015 and 2019, the combined interest on I bonds never exceeded 2% annually, while the S&P 500 had several years of double-digit annual gains. Investing too heavily in I bonds can mean missing out on larger returns in the stock market.
5. Annual investment limit
The maximum amount you can invest in I bonds is $10,000 per person annually. If you and your spouse both invest $10,000 in i bonds, that’s your maximum until a year later.
6. Interest is taxable
The interest on I bonds is subject to the Federal income tax, which depends on your income. For many investors, the Federal income tax rate is higher than the capital gains tax rate.
7. Not allowed in tax-deferred accounts
Because I bonds are limited to taxable accounts, you can’t buy i bonds in an Individual Retirement Account (IRA) or 401(k) plan. And if you’re saving for your kids’ college education, you can’t put i bonds in a 529 plan directly. But if you’re buying i bonds under your child’s Social Security Number, their interest will be taxable at their rate, which is typically relatively low—zero if they don’t earn more than the lowest marginal tax rate.
Can I Invest in Mutual Funds or ETFs for I Bonds?
Yes, you can. An i bond mutual fund or exchange-traded fund allows you to achieve a higher level of diversification when investing in i bonds for the exact investment cost. Income payments are made monthly and reflect the mix of all the different i bonds in the fund and the payment schedule of each.
A Mutual fund or ETF managing i bonds usually has to fluctuate monthly income distributions, while individual bonds are considered fixed-income securities or fixed-income investments.
Investing in Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. government that offer protection against inflation and modest interest payments.
1. Great hedge against high inflation
TIPS can significantly outperform traditional government bonds or treasury securities during periods of high inflation. During these periods, they provide excellent inflation protection.
2. U.S. Government backing
TIPS are the only investments guaranteed to outperform inflation rates over time while offering all the benefits of standard treasury bonds.
1. Poor performance during deflation or low inflation
During deflation or low inflation periods, the par value of Treasury Inflation-Protected Securities is reduced, lowering interest payment amounts. During low-inflation periods, TIPS can’t keep up with market interest rates.
2. Unpredictable cash flow
Payments depend on inflation, so it’s hard to predict your income.
3. Anticipatory taxes
Any increase to the par value will be taxed, meaning that you can end up owing “phantom taxes” on the money you won’t earn until your Treasury Inflation-Protected Securities mature.
TIPS Mutual Funds and ETFs
TIPS mutual funds and exchange-traded funds allow you to achieve a higher level of diversification for the exact investment cost. Income payments are made monthly and reflect the mix of all the different bonds in the fund and the payment schedule of each. Bond funds usually have fluctuating monthly income distributions, while individual TIPS have fixed rates.
Using inflation bonds to hedge your portfolio against rising inflation rates can be a very successful, low-risk strategy. Both i bonds and TIPS usually perform best during periods of high inflation, so keep inflation rates and projections in mind before investing.
As with any investment, inflation-indexed bonds like i bonds and TIPS come with their own risks and challenges. And it’s essential to understand them before you decide to invest.
When creating an investment strategy, you must consider the risks and advantages against the investment goals of your portfolio. This way, you can stay in line with your long-term goals without carrying too much trouble while creating better inflation protection.