For years, my inbox has served as a great barometer of the financial aspirations and fears of everyday investors. With all due respect to all the great PR professionals out there, we’re not talking about work email.
Everyone around me knows that I’m a personal finance expert. So when something happens in the market that causes excitement or fear, my phone rings. When the stock market crashed due to COVID-19, they asked me if they should sell (no). During the meme stock boom, they wondered if they should go all in on GameStop (no). At the height of cryptocurrencies, they hatched a plan to get everyone rich with an altcoin tied to the Spanish soccer league (no comment).
Not surprisingly, given last week’s headlines about rising inflation, a friend reached out to ask about savings. “What is the consensus on TIPS these days?” he asked. “What will happen to i-bond?”
I told him that Treasury Inflation-Protected Securities and Series I Savings Bonds are both backed by the full faith and credit of the U.S. government, meaning there is virtually no risk of default. I added that whether they are suitable for him depends on his specific goals. “But, I’d be happy to ask a financial expert,” I added.
Ultimately, the consensus among them was that assets aimed at preserving purchasing power during inflation can be a useful portfolio tool. But they found that making large changes to a portfolio in response to short-term news is usually a volatile idea.
“Just because inflation is in the headlines in the morning, people shouldn’t suddenly start building inflation protection into their portfolios,” said Jacob Cuthbert, a certified financial planner in Washington, Pennsylvania.
TIPS and I How bonds can protect against inflation
No one is saying my friend was wrong to ask about these investments. Both TIPS bonds and I bonds are designed to protect your savings from the negative effects of rising costs.
“TIPS and I Bonds are not broken tools, only to be dusted off every time CPI hits the headlines and then forgotten about again. This is exactly the opposite of their usage,” says Jeff Judge, a CFP based in Forest Hill, Maryland.
Instead, he says, you need to factor inflation into your financial plans from the beginning. And depending on your goals, both TIPS and I-bonds can be useful. Typical behavior is:
tips
The principal value of these bonds increases in line with the government’s main inflation measure, the Consumer Price Index. TIPS pay interest twice a year based on this fluctuating principal and receive the greater of the inflation-adjusted price or the original price at maturity. You will never get less than your investment.
For a given period of time, the difference between the interest rate you receive for holding a government bond until maturity and the interest rate on TIPS of a similar date is known as the break-even interest rate. Currently, the interest rate on 10-year government bonds is 4.48% and the interest rate on 10-year TIPS is 2.13%, a difference of 2.35%. If the average inflation rate exceeds 2.35% over the next 10 years, you will be better off owning TIPS.
The latest inflation statistics show that prices rose 4.2% in May compared to the same month last year. This is up from a 3.8% year-on-year rise in April and is well above the Federal Reserve’s annual inflation target of 2%.
i bond
These government-backed bonds pay a fixed interest rate over the life of the bond, plus an inflation-based interest rate that is adjusted every six months based on changes in CPI. New I bonds purchased between now and Oct. 31 will pay a total interest rate of 4.26%, which is a fixed rate of 0.90% plus an inflation-adjusted rate.
Unlike many other types of bonds, I bonds cannot be bought or sold on the secondary market. This means that they are less susceptible to price fluctuations based on changes in investor demand or interest rates.
However, these securities have some characteristics. It cannot be redeemed within one year of purchase, and if you redeem it within the first five years of purchase, you will pay a penalty equal to three months’ interest.
You can purchase up to $10,000 of I Bonds electronically in a calendar year (although you can use your federal tax refund to purchase an additional $5,000 in paper bonds). I Bonds typically have to be purchased through the Treasury Department’s website, which can be difficult, especially if you don’t already have an account. TIPs can be purchased directly from Uncle Sam, through a brokerage firm, or held through an exchange-traded fund.
How to adjust your financial plan for inflation
How you protect against inflation depends on what you save for.
“For the average person, the bigger question is not, ‘Should I add an inflation sleeve today?’ It’s better to ask, ‘What will I use this money for and when will I need it?'” Cuthbert says.
Financial experts generally recommend stashing money you need immediately, such as an emergency fund, in a high-yield savings account.
Steve Ripley, global co-head of the iShares Bond ETF, says that for funds you want to use in the short term, such as a down payment on a home you want to build within the next three to five years, it’s worth considering adding some inflation protection, but that may mean talking to a financial professional about your inflation expectations.
For example, if you’re worried that inflation will remain high for the next few years, “buying a two-year TIP (ETF) will pretty much match your expectations,” he says.
Pros say I-bonds can be a reasonable investment for short-term savers who know they won’t need the money within a year. The current I bond rate is 4.26%, which is higher than the interest rate on most high-yield savings accounts and short- and intermediate-term government bonds.
For long-term investors, Cuthbert says it’s important to remember that inflation mitigation strategies aim to protect short-term cash from inflation.
“There’s another role for money looking forward to the next 10, 20, 30 years. It’s not just about avoiding volatility. Its role is to maintain and expand purchasing power. Historically, stocks have done the heavy lifting,” he says.
In other words, if you’re adding TIPS or I bonds to your 401(k) because of the latest CPI results, you’re probably missing the point that stocks have done a good job over the long term of outpacing stock price gains.
“Inflation is important, but for most long-term investors the answer is usually not to build a new inflation sleeve after the fact,” Cuthbert says. “The answer is to have a portfolio that is already designed to take into account your time horizon, liquidity needs, risk tolerance, and the reality that long-term purchasing power generally comes from owning highly productive assets.”
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