As I stated in my last newsletter, due to rapidly rising interest rates, bond prices have plummeted in 2022. While we cannot know for sure, it appears that rates will continue to rise until the Federal Reserve is convinced that inflation is under control. However, this likelihood does not mean that investors cannot benefit from the highest interest rates in two decades.
There is a silver lining for income seeking investors as a result of the carnage in the bond markets. As an example, short to intermediate term investment grade bonds now accrue interest in the 4% range with limited downside risk from rising interest rates. For bond investors who are on the prowl for opportunities in long term bonds discounted from rising interest rates, investment grade fixed income including corporate bonds and mortgages now offer extremely attractive yields often approaching double digits.
Despite this huge spike in rates, bank interest has been a disappointing laggard. Banks are slowly increasing the Annual Percentage Yield (APY) they pay on deposits, money markets, and certificates of deposit but they remain very low. There has been no direct correlation between the so-called federal funds rate dictated by the Federal Reserve and the deposit rates offered on savings. Typically, savers can receive higher bank rates from online banks and other online financial institutions who are much more aggressive in their attempt to attract depositors.
With the dual rise of inflation and interest rates, there has been a lot of buzz from savers/investors about investing in I Bonds which are issued by the Treasury Department. The bonds have a 30 year maturity that is broken down into a 20 year original maturity plus a 10 year extended maturity. The safe and high interest represents the primary reason for this surge of attention. The interest in I Bonds is a combination of fixed interest for the duration of the bond and inflation which is adjusted every six months. This combined interest rate has been 9.62% from May 1, 2022 to October 31, 2022 and is paid semi-annually. Another benefit is that all interest is exempt from both state and local income taxes.
There are several restrictions that individuals must consider before investing in I Bonds. First, an investor may only purchase $10,000 annually ($20,000 for spouses), plus an additional $5,000 from a tax refund. Second, I Bonds issued after February 2003 must be held for at least one year before they are eligible to be redeemed. Third, in order to receive all the interest that has accrued, the investor must hold the bond for at least five years. If the bond is redeemed prior to the five year hold, interest earned during the three months prior to cashing out will be forfeited. Finally, I Bonds can only be purchased directly from the Treasury and cannot be held in custodial accounts such as an IRA.
A benefit for astute homeowners who took advantage of historically low mortgage rates is to maximize the spread between their mortgage interest and available interest in fixed income. Conventional advice for individuals approaching or attaining retirement has been to eliminate all debt. Typically this would mean paying off a mortgage. But if a retiree had refinanced their home over the past couple of years, from a pure financial perspective, it does not make sense to pay off the mortgage. For these homeowners, bond interest is likely higher than the existing mortgage rate and the deductibility of mortgage interest effectively reduces this rate thus enhancing the net financial benefit.
History has taught us that market corrections create opportunities from which prescient investors can take advantage. The decline in the price of bonds this year has been excruciating but to those investors who look forward rather than backward, there are opportunities that may result in rewarding returns.
Clifford L. Caplan, CFP®, AIF®CLC