A couple of years ago I wrote a post on savings bonds. At the time my focus was on achieving a higher risk-free rate of return than the current bond environment. Times have changed, these days most investors are more worried about inflation. So today I am going to write about the real and perceived benefits of I-bonds and TIPS for inflation protection.
I-Bonds are the Superior Long Term Choice
For those that read that fateful post on the 3.5% guaranteed return, you may recall I wrote my MBA thesis comparing TIPS and I-Bonds. I-bonds came out on top in that analysis over the long run. The primary reason was that TIPS can have a negative return while I-bonds are guaranteed not to go negative. As such this post will focus on i-Bonds as the superior investment opportunity. Remember though that you are limited in the amount of I-bonds you can purchase in a year to $10K per individual. You are not so limited for TIPS.
So how do I-Bonds adjust for inflation?
Well I-bond returns are based on 2 components.
The first is a variable component (I) determined by the current semiannual inflation rate that is recalculated twice a year. This inflation rate is calculated based on the CPI-U or Consumer Price Index for Urban Consumers. These rates are adjusted to a given bond every six months from the bonds issue date.
The Second is a fixed component (F) determined at time of sale. This rate changes for new offerings on May 1 and November 1 of each year. At present this rate is 0.5%. When I-bonds were first released this was as high as 3%. However, 0.5% is actually not that bad, when I wrote my first post it was actually at 0%. At the time of my original post, I ignored I bonds for EE bonds in that post because of that fixed component. There was little to no inflation and no return beyond inflation, so what was the point. These days a .5% at least seems to indicate the bond will return 1/2 a percent beyond inflation. With people worried these days about inflation perhaps now is the time for these investments?
I-Bond Total Return= IFixed+Fixed x Inflation+2 x Inflation
The I bond returns an overall rate equal to the fixed rate (F)+ the fixed rate multiplied by the variable half year inflation rate+ two times the variable half year inflation rate.
So with today’s 0.5% fixed rate the return is 2.83% or 2 times the semi-annual inflation rate of 1.16%. Fairly similar to other current fixed income issues, but the return is equal to the rate of inflation +.5% so in theory you’re guaranteed to preserve the value of your cash. Or are you?
The Problem with The Inflation Component of I-Bonds: Hyperinflation
Well, the problem is that pesky inflation component. Firstly it calculates only once per every six months. The issue is pricing changes do not follow a strict calendar. In a slow-moving interest rate environment, this is fine. But picture the rampant inflation we had back in the 70s, a situation where a 30-year mortgage peaked at 18.6% inflation. This type of inflation is often referred too as a milder form of what is called hyperinflation in other parts of the world. In some places in the world, this type of inflation can reach 100% or greater a year. In these cases, an adjustment every 6 months may not be fast enough. As a result, an I bond might still lag the CPI-U in a fast moving inflation environment.
The Problem with The Inflation Component of I-Bonds: CPI Calculations
Now I’d be remiss if I didn’t mention these types of hyperinflation environments have been rare in US history and are probably unlikely in the near term. But there remains another issue. In this case, the issue lies with the way the inflation index is measured each period. The CPI-U index used to calculate I-bonds inflation-adjusted rate is determined by viewing the changes in a basket of goods over time. In this particular case, the basket of goods is made up of what the government believes urbanites consume.
The problems with CPI-U, like all CPI measurements, is that basket may not be your basket. Inherently inflation is just a measure of how prices you pay change and what that means for the value of your money. So if your basket is not the CPI-U basket then the measure may not keep up with the price changes that you experience.
An Example of CPI-U Versus Your Own Basket
For example, you might spend less as a percentage of income on something like housing once you own your home than someone renting in an urban environment. That difference might mean you experience changes in prices for say food differently then measured since food might be a larger percentage of your expenses.
So say food prices increased by 10 percent. No other changes occurred. Hypothetically, let’s consider housing as 50% of CPI and food as 10 percent of CPI, not actual percentages. For you as a person with a paid off house the percentages may be reversed, 10% for housing and 50% for food. In this scenario, the index experienced a change of (10*.10)1% in prices. But your experienced inflation is now 5% (50*.10). I bond return would not account for your experienced price change, instead tracking the 1%. In this case, much of their value to you would be lost as your own money would devalue by 5% relative to your existing purchases.
The Problem with The Inflation Component of I-Bonds: CPI-U Weighting Adjustments
Furthermore, CPI-U adjusts the weighted impact of each item in its basket only once every 2 years. So any adjustments to that weight may lag consumer taste change or economies of scale. So it may be both an inaccurate measurement of users following its basket as well as your own expenditures since costs and utility of different areas of expenditure can change quickly with time.
The Problem with The Inflation Component of I-Bonds: Substitutions
Finally, there are many critiques of how CPI handles substitutions. Substitutions are a situation where we replace something with something else of similar form. The problem with substitutions is the scenario where we may substitute something of lower value due to cost constraints. In that case, CPI may discount the inflationary impact in a specific category. That lower value item may substantially impact your quality of life, thus reflecting again a loss in value of your money not accounted for by CPI.
In Light of Inflationary Component Problems Should We Abandon I-Bonds?
Do the critiques above about the inflationary measure of I-Bonds mean we should abandon the idea of using them as an inflation peg? Well, maybe not. As you can see above they are an imperfect investment for keeping up with inflation. But in reality, they also are one of the best we have. (though not the only, perhaps a post for another day)
Stocks as an Inflation Hedge?
I’d be remiss if I didn’t finish up by referencing the off-stated point that stocks are a better inflation hedge. Stocks have a higher implied return than bonds and other safe investments. This can, if achieved, offset some of the risk of inflation. But stocks do not automatically adjust to higher returns when inflation is present. So even when ignoring return risk, something I-bonds lack, depending on the amount of inflation the impact of stocks as that peg can be muted.
What About Gold as an Inflation Hedge?
Even hard asset investments like real estate and gold don’t necessarily track inflation depending on how it is experienced (if the inflation is not focused on housing expenses for example). And of course cash and bonds meanwhile decline in value in relation to inflation.
So perhaps there is a place in your portfolio for I-bonds. Do you own any?