The I Bond: A Hedge Against a Rise in Inflation

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Like a '60s-era fallout shelter, I savings bonds are a product designed to address a threat that's lain dormant for a while now.

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The "I" in I bond stands for inflation, and I bonds are engineered to protect fixed-income investors from having their savings eroded by a leap in prices, in other words, for inflation protection.

But that hasn't been much of a problem lately, says Chris Philips, a senior analyst in Vanguard's Investment Strategy Group of Valley Forge, Pa.

"Inflation itself is actually running at pretty modest levels," he says.

On Nov. 1, the Treasury will announce the fixed rate for I bonds issued over the next six months and the inflation rate (also known as the variable rate) that will determine how much all existing I bonds are compensated for inflation.

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How I-Bond Yields Work

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Two components determine an investor's return on an I bond. One is a fixed rate that lasts the life of the bond. The fixed-rate component fell to zero percent on Nov. 1, 2010 and has been there ever since.

The other is the inflation rate, which is based on the change in the U.S. Consumer Price Index and reset every six months. As of May 1, that number is 2.2%, but it will change again Nov. 1.

0% Fixed Rate Likely to Hang Around

You may not want to count on an exciting new investing opportunity with the I bond. Both I-bond components have been on a downward slide lately. If you're wondering why the Treasury would be offering a goose egg on its savings bonds, keep in mind that, like any reasonably savvy borrower, the Treasury never pays more than it has to in order to borrow money, and many global investors are eager to lend money to the U.S. government right now, says Michael Falk, a CFA with Focus Consulting Group in Long Grove, Ill.

"Treasury debt is still a safe haven on the global stage. Because the dollar is still the reserve currency in the world, the dollar-denominated Treasury debt is still considered among the safest of places that you can stash your money in times of stress," Falk says.

Philips agrees.

"The Treasury is not going to issue something that has an attractive rate when the rest of its bonds are zero percent, particularly on the cash side, and very close to zero even a little bit further out on the curve, especially when you account for inflation," Philips says.

Inflation Protection Still a Selling Point

Investor interest in the I bond with a zero percent fixed rate reflects demand for inflation protection, Falk says.

"Because of all the various forms of stimulus that have been put into our economy since 2008, there's a great fear that so much money has pumped in that it will actually result in high inflation somewhere down the line," he says.

But even if demand wasn't pushing the fixed rate downward, it's unlikely the Treasury would want to increase its exposure to the risk of higher inflation by trying to sell more I bonds, Falk says.

"If there is a risk of higher inflation, why on Earth would they want to issue more of this debt right now?" he says. "It's hard to see that they're going to make the base rate any higher."

I Bonds for Inflation Protection

Fixed rate component 0%
Inflation component 2.2%
Total I bond rate 2.2%

Inflation Rate Component to Stay Low

As if a zero percent fixed rate weren't enough to push investors away from I bonds, the inflation rate component has also been relatively low lately as well, reflecting the slow growth of prices following the Great Recession. Leaving out food and energy prices, annual inflation has remained less than 4% since 2009.

If it feels like inflation has been worse than that in your household, it illustrates a serious weakness of I bonds. The inflation index often differs from the inflation that individuals experience because they're buying things, such as medical care, with prices that are rising faster than the index, Philips says.

"You have this mismatch between what an individual's inflation rate is, and what the economy-wide inflation rate is," Philips says.

Philips says signing up for a return guaranteed never to exceed inflation can put investors at risk.

"There's very little room for growth outside the inflation rate," Philips says. "You're getting very little growth over time. That's the primary concern with using a savings vehicle as an investing vehicle."