I Bonds-a Safe Heaven from Inflation

High volatility in the stock market in recent months would normally spur more physician-investors to think about increasing their investment in bonds. But a spurt in inflation amid slowing economic growth early this year and recent tumult in the bond markets are, at least for now, changing the yin-yang dynamic of stock versus bond investing.

“Historically, physicians have been big buyers of savings bonds. But many still aren’t aware of I bonds and their key advantage of inflation protection.”— Daniel J. Pederson; author, Savings Bonds: When to Hold, When to Fold and Everything In-between

High volatility in the stock market in recent months would normally spur more physician-investors to think about increasing their investment in bonds. But a spurt in inflation amid slowing economic growth early this year and recent tumult in the bond markets are, at least for now, changing the yin-yang dynamic of stock versus bond investing.

“Expectations of inflation are built into a bond market,” says David Wyss, an economist with Standard & Poor's. Because of this, Wyss and other experts agree that refugees from stocks and corporate bonds might consider an often-overlooked safe haven from inflation: a US savings bond called the “I bond.”

Aren’t savings bonds obsolete? Some might ask. Hardly, especially in these troubled times. Savings bonds are a sure-fire way to preserve principal, inflation notwithstanding.

Two-Way Protection“Nobody, absolutely nobody, who has cashed in any savings bond has ever received less than they paid for it as long as they waited the required year after purchase,” explains Daniel J. Pederson, who operates a consulting service on savings bonds for individual investors and publishes The Savings Bond Informer.

Yet with traditional savings bonds, it has historically been possible for investors to lose money to inflation. But not with I bonds, a relatively new bond product that was introduced in 1998. This is because the federal government guarantees that investors won’t lose a time to inflation—a restful financial concept for busy physicians who want to safeguard assets without spending time to do so.

The “I” stands for inflation-indexed. I bonds pay an interest rate composed of two parts: the inflation-adjusted rate, which goes up and down with government inflation figures, and the fixed rate, which is assigned at the time of purchase and remains fixed for the life of that particular bond.

The variable inflation rate is recalculated every six months based on the Consumer Prince Index for urban consumers (CPI-U), and is published every May 1 and November 1. Every six months, the government takes whatever six-month change occurs in inflation, annualizes it and plugs it into a formula to calculate the composite rate for that period. Thus investors are insured that they’ll received interest on the fixed rate as the spread over inflation.

Returns aren’t huge. Over the past few years, the fixed has varied between 1 and 2% annually, and currently stands at 1.2%. The composite annual interest rate for I bonds purchased during the six-month period ending May 1, 2008: 4.28%.

Dependable Turtles“I bonds—like any savings bond—are like the turtle,” says Pederson, a former official with the Federal Reserve Bank. “They only have a place in the conservative end of a portfolio. But for turtles, they’re not bad.”

So these turtles can be viewed as a slow-earning yet ultra-safe hedge against inflation with a little real interest income as gravy. And, as is the case with other savings bonds, no taxes are due until they the bonds are cashed in at maturity.

Another advantage: Within limits, gains from savings bonds are tax-free when used for education expenses. So I bonds can be viewed as a way to protect tuition nest-eggs from inflation while adding to them.

In limited amounts, this amphibian investment has great appeal for conservative portfolio diversification among the self-employed—including physicians—who lack access to the array of payroll-deduction-based investment opportunities afforded by large companies. “Historically, physicians have been big buyers of savings bonds,” says Pederson, “But many still aren’t aware of I bonds and their key advantage of inflation protection.”

The other type of savings bond that’s available to new purchasers is the EE. This is a classic, secure investment, only it doesn’t offer any guarantees against the ravages of inflation. Instead, these pay a single interest rate. Experts agree that, in these troubled times, the I’s have it over the EE’s. “Economic conditions are tough on bonds in general,” says Wyss. “But right now, the best course is to buy bonds with inflation protection.” Neither I bonds nor EE bonds can be sold under any circumstances during the first year after purchase.

No State Income Tax

With savings bonds, tax is due only when cashing them in—typically, between five and 30 years from the date of purchase. (A three-month interest penalty applies when savings bonds are sold in less than five years. Interest payments freeze after 30 years, so there’s no point in holding them longer.)

With I bonds, investors get long-term inflation protection along with tax deferral—typically until retirement, when investors are in a lower tax bracket. Further, interest on all savings bonds is exempt from state and local taxes, while interest earned from CDs and most money market funds is not.

And unlike other forms of government debt, savings bonds don’t require holders to find a buyer if they want to sell them before they reach maturity. Nor do investors have to pay any commissions. All they need do is to head to the nearest bank that acts as an agent for the government regarding savings bonds.

The government offers another inflation-fighter in the form of Treasury Inflation-Protected Securities (TIPS). Yet unlike I bonds, these don’t offer the advantage of tax deferral; those holding them outside of interest-deferred instruments such as IRAs must declare annual gains on these as income from the time of purchase. And holders of TIPS must go to the trouble to find a buyer if they choose to sell them before they reach maturity.

Because savings bonds don’t generate commissions, salespeople don’t pester investors about them. Instead, investors must seek them out by inquiring at their bank—many banks and other financial institutions offer them—or by establishing an account with the government at TreasuryDirect, a site that carries rates and other information on all US Treasury offerings.

How great an investment in I bonds is appropriate for a given investor? The treasury department doesn’t let investors get overly invested in any savings bond. Inexplicably, the heavily indebted United States government recently greatly reduced the annual dollar amount of savings-bond purchases allowable by individuals to a total of $10,000 ($5,000 online and $5,000 on paper). But married couples can invest $10,000 annually in the name of each partner.

Within investment these limits, says William Reichenstein, a professor of finance at Baylor University, “people with a low risk tolerance should consider placing more of their total bond allocation in savings bonds than those with a higher risk tolerance.”

And for Treasury-product investors who want both tax-deferral and inflation protection, experts agree, I bonds are far and away the best choice.

Richard Bierck, a widely published financial writer, is a contributing editor for Preferred Lifestyles magazine.

5%—Annual return for an average US bond mutual fund in 2007.(Wall Street Journal, 2008)