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I bonds thrive in a high inflation environment, so what does the future hold?
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Everyone knows the saying “high risk, high reward,” the rule that is almost a law of investing. However, in 2022 some investors seemed to invert the rule. Typically-high-yielding stocks had an abysmal year. But some bond holders got a great return on their investment while putting their money in one of the safest bonds available. How is that possible, and can investors still take advantage of I bonds?
What are I bonds?
In the case of a series I savings bond, or I bond for short, the name informs the meaning. At its core, an I bond is simply a bond whose interest rate is adjusted for “I,” or inflation. And in a high-inflation environment, an I bond can give investors the best of both worlds, yielding high returns without exposing the underlying principal to much risk.
I bonds are some of the least-risky investments available on the market, thanks largely to the issuer: the United States Treasury. The Treasury, which has never defaulted in its two-century history, is fully backed by the credit of the federal government and widely considered to be one of the most creditworthy institutions in the world. Barring an extended debt ceiling crisis this year, the Treasury is expected to honor its debt obligations for the foreseeable future.
Typically, low-risk investments like I bonds yield low returns, but just the opposite happened in 2022. While most bonds make payments according to a fixed rate, I bonds are subject to a variable rate which increases when inflation rises and decreases when inflation falls. For a year with rapid runaway inflation like 2022, the rates offered on I bonds quickly rose to nearly 10%, a previously unimaginable return for one of the safest bets on Wall Street.
Consider this…
For the average investor, I bonds may seem like an incredible buying opportunity. However, like any other investment, I bonds come with some limitations. Before you buy, consider two things: holding periods and investment maximums.
While I bonds may be easy enough to buy, they can be trickier to sell if you don’t pay attention to the fine print. Once you buy an I bond, you’re locked in for a year before you can sell it again. And after that first year, you still need to hold on for another four years in order to avoid the heavy surrender charge of three months of interest. So, if you buy an I bond today, you could be stuck with that investment until 2028, regardless of how inflation, and the bond’s interest rate, change over those five years.
Another drawback of I bonds is the relatively small amount you can buy. At first glance, you might be tempted to put all of your savings into a low-risk, high-return investment like I bonds. But unless your savings amount to under $10,000, you’ll hit the buying ceiling. The Treasury only allows consumers to buy up to $10,000 of I bonds each year, so while I bonds might make up part of your portfolio, they aren’t likely to make or break your personal finances.
The future of I bonds
In 2022, buying an investment indexed to inflation sounded like a great idea, and even more so when that investment was backed by the full faith and credit of one of the world’s largest governments. However, with inflation now being reigned in, investors might have second thoughts.
The interest rates offered on I bonds are recalculated every six months based on inflation rates. So while you might buy an I bond yielding 6.89% annual interest today, that rate is far from guaranteed. The Fed appears to be succeeding in its fight against inflation, which is good for the economy but bad for I bond holders. Should the Fed succeed in reducing inflation to a more typical 2% interest rate, I bond holders could see their returns halved.
I bonds grabbed headlines throughout 2022 as a low-risk, high-return investment for the average American. However, variable rates coupled with downward trending inflation and restrictive holding periods may be enough to dissuade potential investors.
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