Did you know that diversified portfolios can help mitigate risk and inflation?
The most efficient portfolios consist of very little cash and cash equivalents. This is because cash and cash equivalents oftentimes yield substantially smaller returns over the long run. With most banks currently offering less than 1% in annual interest, cash essentially loses purchasing power every second you hold it. Cash and cash equivalents do have a very large advantage though, they do not fluctuate in value and oftentimes are FDIC insured. From a principal protection standpoint, cash is a safe investment. A properly structured financial plan will include some amount of cash and cash equivalents in order to protect against emergencies or unforeseen circumstances. It is this cash position that enables the rest of your portfolio to be invested for medium and longer term goals. If an unforeseen circumstance occurs at the same time as invested portfolio assets experience a drop in value (as is the case at this point in 2022), an investor may be forced to sell some of the invested portfolio at an inopportune time. For this reason, holding cash, despite typical low yields, is a necessary evil!
In the current environment, investors may be able to supercharge their cash position with the purchase of Series I Savings Bonds (I-Bonds). One could essentially purchase I-Bonds, hold them for 1-year, and ensure a much higher interest payment than what most banks and online high-yield savings accounts currently provide.
Interested in learning more about supercharging your cash position with I-Bonds? You’re in the right place. Read on for everything you need to know about I-Bonds and how they might fit into your financial plan.
What Is Inflation?
To understand the value of an I-Bond, you should first understand inflation. Inflation is the decreasing purchasing power of money. This is reflected by the increase in price of goods and services over time.
Inflation is usually connected to commodity prices. This includes the price of food grain, metals, fuel, and electricity. This is because once these prices increase, it has a ripple effect on almost every product and service in the world.
Businesses rely on one or more of these commodities to produce their products for the marketplace. When the price of production increases, companies will increase their sales price to maintain profit margins. This is what causes the domino effect of inflation in the economy.
Why Is Inflation Bad For Your Portfolio and Your Cash?
When prices rise, the amount of money you have does not rise along with it. This means that your money will lose purchasing power. This is the amount of power your money has to purchase products and services within the market.
When inflation occurs, and your portfolio doesn’t increase proportionately, you lose the ability to buy the same amount of goods and services as you could prior. It’s important to remember that while assets may not decrease in numerical value, they can still decrease in terms of their purchasing power.
Inflation can also cause the Federal Reserve to increase short-term interest rates in order to slow demand in the economy. When the Fed raises its benchmark rate, this can cause interest rates for all types of fixed income and cash accounts to also increase. Increases in interest rates generally cause fixed income investments to go down in value. The longer the duration of the fixed income investment (duration refers to the time until a fixed-income security matures), the more it will be impacted by movements in interest rates. As an example: Investor A purchases a $100,000 10-year bond, with a 1.5% annual interest rate (this is where 10-year Treasuries yields were at the start of 2022). Five months later, Investor B can buy that same bond and earn a 3% yield (where we are today). Investor A’s cash flows would be $1,500 per year for the next 10 years, whereas Investor B’s annual interest amount would be $3,000. In the final year, both investors would get back their original $100,000 investment. If prior to the 10-year maturity date, Investor A decides they no longer want their 1.5% yielding bond, they can sell it on the open market. However, since someone can now earn $3,000 per year buying a new 10-year bond, selling the 1.5% yielding bond would come at a heavy discount. In fact, Investor A would only receive about $87,000 at the time of sale, versus their initial $100,000 investment (a 13% loss on versus their initial investment).
Increasing interest rates also impacts stock investments. Oftentimes, stocks are priced based on their earnings. These earnings are “discounted” using a discount rate. Earnings expected far in the future are worth less than earnings derived tomorrow, because you won’t receive them for many years. Using any type of cash-flow based model, a higher discount rate will cause the current fair market value of the stock to decrease. Growth stocks are typically defined as shares from companies that are growing their revenue at a rapid rate (let’s say 20%+ per year) – and they are even more sensitive to an increasing interest rate environment. Growth stock companies often have lower, or even negative earnings in the early years. These companies are focusing a significant amount of their money trying to drive top line growth, to produce higher earnings years in the future. Growth stocks can be viewed as “long” duration, if trying to compare them to bonds.
What Is an I-Bond?
Series I Savings Bonds (commonly referred to as Inflation Bonds or I-bonds) are safe securities issued by the United States Government. These financial products are a type of U.S. savings bond designed to act as a hedge against inflation. This means that the value of the investment will grow in line with inflation, allowing investors to better retain purchasing power.
While these bonds have not been very popular in the last 20 years, record-breaking inflation has brought them back into the spotlight. I-Bond are linked to the inflation rate and pay interest based on the inflation rate at the time. Currently, I-Bonds are yielding an extraordinary 9.62% in annualized interest for the next 6 months.
I-Bond’s interest rate is adjusted every 6 months (based upon when it’s purchased). The rate is based on the current inflation rate and it’s reset twice per year (May 1st and November 1st). This means a purchaser of an I-Bond today would lock in that impressive interest rate for at least six full months. After 6 months, the yield would re-adjust to the rate that was set on November 1st (this number is likely to be at least 5%, potentially higher, based on the current inflation numbers we’re seeing)
I-Bonds must be held for at least 12 months but can be held for as long as 30 years. I-Bonds come with a 20-year original maturity period which can be extended for another 10 years. This means you can effectively protect your cash from inflation for up to 30 years.
Individuals are free to purchase I-Bonds directly from the government. Individuals can purchase anything from $25 to $10,000 per calendar year. This means that you can set aside $10,000 every year to be safely hedged against inflation.
Are I-Bonds Taxed?
I-Bonds are completely free of state and municipal taxes, but the interest is subject to Federal tax. There are also a few exceptions and incentives you can leverage to decrease your tax liability. This is primarily if you plan to use the income to pay for education.
Owners can choose when they wish to pay the tax as well; tax on the interest can be paid annually, at maturity, or whenever you cash the bond.
What Are Fixed Income Investments?
I-Bonds are a type of fixed-income investment. A fixed income investment is an investment designed to preserve capital or the income that you derive from that capital. Fixed income investments offer a reliable stream of income, usually with lower risk than other kinds of investments.
Fixed savings accounts are a common example of fixed income investments. These are special bank accounts where the money you invest is locked away for a fixed period of time. You will then earn interest on your investment according to the fixed interest rate.
This kind of investment is suitable for individuals who are looking for ways to generate income from their capital. There are also securities that pool fixed income investments together. Exchange Traded Funds (ETFs) and Mutual Funds are types of pooled investments that can offer diversification by combining many individual fixed income investments into one single fund.
Benefits of Investing in I-Bonds
Diversifying your portfolio is a great way to minimize your overall risk. While the best way to diversify is to invest in different kinds of asset classes, in today’s environment, one can supercharge their cash yield by purchasing some I-Bonds. Here are some of the benefits of keeping your cash invested in I-Bonds.
Hedge Against Inflation
When it comes to investing cash, banks offer anything from 0.1% to 1.5% on capital. With typical inflation rates around the world being at least 2% a year, this means that holding cash decreases purchasing power over time.
By investing in I-Bonds, capital is guaranteed to grow in-line with inflation. This currently provides a much higher return which will adjust to maintain your purchasing power over time.
Greater Returns
As mentioned above, most banks will offer below 2% interest on cash. With inflation now reaching close to 10%, investing in I-Bonds can offer over 5-times the return! This is a simple comparison to make, as higher interest rate means higher returns on investment.
Liquidity
The point of having cash on hand is for liquidity. This means that if a circumstance arises where cash is needed, it’s available. Having cash available allows the remainder of a portfolio to stay invested and working. I-Bonds have a minimum required holding period of 12-months. In addition, if you redeem an I-Bond within the first 5 years, you’ll lose the last 3 months interest, In today’s environment, even after paying the 3-month interest penalty, an investor would have earned substantially more interest with the I-Bond than in a traditional bank savings vehicle.
Diversifying Your Portfolio
When it comes to creating an investment portfolio, it’s important to think about the future value of your savings. While many may think about allocating into different asset classes, it is also good to be mindful of the investing environment to see if it creates any unique opportunities. One opportunity that exists in today’s environment is I-Bonds. I-Bonds can be a perfect way to supercharge your cash yield.
Financial planning and investment management are often complicated. This is why it’s a great idea to have a professional help creating a portfolio for you. Experienced professionals know how to make your money work for you so that you can create additional streams of passive income.
Learn More About Diversifying into I-Bonds
I-Bonds are directly backed by the US Government. This makes them one of the most secure investments available. Diversifying an investment portfolio with I-Bonds may be a great way to deploy surplus liquid cash and capitalize on the current 9.62% yield. .
If you have any questions or want to learn more about I-Bonds, feel free to contact us today. We would be happy to answer any questions you may have and show you how fixed income investments can help strengthen your portfolio.
