By Investment Associate Bobby Adusumilli, CFA.
In the book In Pursuit of the Perfect Portfolio, MIT Professor Andrew Lo interviews pioneering individuals in the investment industry - including Vanguard Founder John Bogle as well as Nobel Prize winners such as Eugene Fama and Robert Shiller - in order to answer a question that has captivated investors for generations: what is the perfect portfolio? While each interviewee gives hints as to what they consider the perfect portfolio, Andrew Lo ultimately concludes that there is no such thing as an everlasting perfect portfolio, writing, “Our Perfect Portfolio today is really just a snapshot of what’s best for you at the moment and in the current environment. Expected returns are ever evolving…. The pursuit of the Perfect Portfolio is all about adapting to our current income, our spending habits, our financial goals, the environment, and expected returns.“[1]
Nevertheless, the interviewees do provide some investments to consider. Andrew Lo writes, “If there is one specific asset that a majority of our authorities recommended for your Personal Portfolio, it’s TIPS (Treasury Inflation-Protected Securities). Inflation in recent years has been stable and low, but there is always the risk of macroeconomic change.“[1] TIPS are U.S. government-issued securities that generally increase in value with inflation and decrease in value with deflation, as measured by the nonseasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items.[2][3]
Source: FRED, as of July 31, 2022. See Important Disclosure Information.
Since the book came out in August 2021, U.S. inflation has risen significantly. As a result of this rise in inflation, TIPS (as measured by the Bloomberg U.S. TIPS Index 0-5 Years) have performed relatively well over the past year, outperforming the U.S. stock market (as measured by the Russell 3000) and the U.S. bond market (as measured by the Bloomberg U.S. Aggregate Bond Index), as shown in the below graph. However, because TIPS are subject to market demand as well as other structural features, TIPS have underperformed inflation (as measured by nonseasonally adjusted CPI-U) over the past year.
Sources: Dimensional Returns Web, U.S. Bureau of Labor Statistics. See Important Disclosure Information.
This lends the question: are there any investments that can provide more inflation protection than TIPS? Luckily, there may be.
Series I Saving Bonds provide many of the benefits of TIPS, but may be even more beneficial during times of heightened inflation.[4][5] Offered directly by the U.S Department of the Treasury through the treasurydirect.gov website, Series I Savings Bonds are 30-year government bonds designed to pay interest that matches (or even exceeds) inflation, as measured by the nonseasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items.[4]
The interest on Series I Savings Bonds is composed of two parts: a fixed rate that lasts for the entire time that you hold the bond, and the inflation interest rate that resets every six months. The rates are set on May 1 and November 1, and you are guaranteed the stated inflation interest rate for the first six months that you hold the bond, and then you are guaranteed the next set inflation interest rate for the following six months, and so on. The interest rate on Series I Savings Bond cannot go negative (though a negative inflation rate can decrease your fixed rate for that six-month period to a minimum of 0%), which is beneficial considering that the specific CPI index includes the volatile food and energy sectors.[3][6]
You can choose to defer paying taxes on the monthly interest that you receive until you redeem the bond. The interest on Series I Savings Bonds is only subject to federal income taxes, not state or local income taxes. You can redeem Series I Savings Bonds directly with the U.S. government via the treasurydirect.gov website after one year, subject to some limitations listed below.[4]
While Series I Savings Bonds have many benefits, there are some drawbacks:[4]
Each eligible person and entity can only purchase up to $10,000 in Series I Savings Bonds per year, thus limiting usefulness for higher net worth people and entities.
Except in rare circumstances, you cannot redeem your Series I Savings Bond within the first year.
If you redeem your Series I Savings Bond within five years of purchase, you lose the most recent three months' worth of interest.
If you decide not to pay taxes on the annual interest while you hold the bond, then the year you redeem a Series I Savings Bond, you may add a significant amount to your federal taxable income, thus increasing your federal taxes in that year.
You must buy Series I Savings Bonds through the treasurydirect.gov website; you cannot buy through another custodian, and your financial advisor cannot buy these bonds on your behalf.
You can only specify one beneficiary (via the Registration List section on your treasurydirect.gov account) per Series I Savings Bond.
If inflation falls back to low levels, Series I Savings Bonds may pay little interest.
Prominent financial journalists including Jason Zweig, Christine Benz, and John Rekenthaler have written about Series I Savings Bonds in recent weeks, and it’s easy to see why given the current inflation interest rate of 4.81% for the first six months if you purchase prior to November 1, 2022.[4][7][8][9] We believe that Series I Savings Bonds can provide value for investors over the near-term as well as the long-term. Whether using for an emergency fund, saving for a big purchase such as a home, or wanting to add diversification to your overall investment portfolio, Series I Savings Bonds can provide a safe and stable way to save money while minimizing loss of U.S. dollar purchasing power. And if inflation ends up rising again in future years, then by accumulating Series I Savings Bonds over time, you can provide some stability and growth for your portfolio at a time when other investments may suffer.
Important Disclosure Information & Sources:
[1] In Pursuit of the Perfect Portfolio. Andrew Lo & Stephen R. Foerster, 2021, Princeton University Press.
[2] “Treasury Inflation-Protected Securities (TIPS)“. U.S. Department of the Treasury, Bureau of the Fiscal Service, treasurydirect.gov.
[3] “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Federal Reserve Bank of St. Louis, fred.stlouisfed.org.
[4] “Series I Savings Bonds“. U.S. Department of the Treasury, Bureau of the Fiscal Service, treasurydirect.gov.
[5] “Comparison of TIPS and Series I Savings Bonds“. U.S. Department of the Treasury, Bureau of the Fiscal Service, treasurydirect.gov.
[6] “Series I Savings Bonds Rates & Terms: Calculating Interest Rates“. U.S. Department of the Treasury, Bureau of the Fiscal Service, treasurydirect.gov.
[7] “Fight Runaway Inflation With I Bonds“. Jason Zweig, 29-Jul-2022, wsj.com.
[8] “Is It Too Late to Add Inflation Protection to Your Portfolio?“ Christine Benz, 22-Jul-2022, morningstar.com.
[9] “Run, Don’t Walk, for I Bonds“. John Rekenthaler, 10-Aug-2022, morningstar.com.
The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers.
Russell 3000 TR USD Index is a market-capitalization-weighted index that measures the performance of the largest 3000 US companies representing approximately 98% of the investable US equity market.
Bloomberg US Aggregate Bond TR USD Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS.
Bloomberg U.S. Treasury Inflation-Protected Securities (TIPS) 0–5 Year Index is a market-weighted index measures the performance of inflation-protected public obligations of the U.S. Treasury that have a remaining maturity of less than five years
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this report that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains. The performance of the indices was obtained from published sources believed to be reliable but which are not warranted as to accuracy or completeness.
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