Opportunities during high-interest rate and high-inflation times
It’s become common knowledge that both interest rates and inflation are high (4.75% federal funds rate at the time of this post), with no signs of stopping anytime soon. Inflation obviously affects your spending power, but it also presents an additional challenge of causing your hard-earned money to lose value over time. However, it’s not all doom and gloom. High inflation and interest rates present attractive investment opportunities to the public (meaning you!). We’ll cover a few investment options that benefit from this environment and how to add them to your investment portfolio.
Understanding interest rates and inflation
Before we get into the nitty gritty, it’s important to learn a bit of context. You hear the words “interest rates, interest rates, interest rates” repeated everywhere, almost as if people are summoning an ethereal being, but what do they actually mean and why does it affect you?
Briefly, an interest rate is the cost of borrowing money. Because banks aren’t just going to give us money for free, they’ll charge us a percentage of what we borrow as interest. Higher interest rates make borrowing more expensive, lower interest rates make borrowing less expensive.
More broadly, when people say “interest rates are high,” they’re likely referring to the federal funds rate, or the interest rate at which banks lend money to each other overnight to meet their reserve requirements. The Federal Reserve sets the federal funds rate as part of its monetary policy to influence the broader economy. When the Fed lowers the federal funds rate, it becomes cheaper for banks to borrow money, and vice versa. This rate gets passed down to you and me by influencing how much it’ll cost us to borrow from banks, but also the return on certain investments.
Increasing interest rates is one of the tools the Fed has to combat inflation (the cost of goods rising). By making money more expensive to acquire, the Fed hopes to slow down demand and eventually lower costs. However, this move takes a bit of time to affect the economy, and we find ourselves in an environment where both interest rates and inflation are sky high, and consequently with favorable investment opportunities.
T-Bills thrive in high-interest rates
T-bills, or Treasury bills, are short-term debt securities issued by the US government to raise funds. In layman's terms, if you are buying a T-Bill, you are lending money to the government. Think of them as a friend that always pays you back on time, with a little extra, no matter what. They typically have a maturity of one year or less and are sold at a discount to their face value (this is investor terminology, which means instead of earning interest, you buy them for a bit of a discount, say $95, but then get back the full amount of $100 after a year). Much like a friend that always pays you back, T-Bills are considered to be a very low-risk investment because they are backed by the full faith and credit of the US government.
During high-interest rate environments (such as now!), T-bills returns increase. Continuing with this friend analogy, it’s like when your friend suddenly gets a better job and now pays you back with even more interest.
At the time of this post, the 4-week T-bill rate is 4.52%, meaning you can get the equivalent of 4.52% annual return on an investment that can liquidate in four weeks. That’s less time than it takes to grow out a bad haircut!
Besides the 4-week rate, T-bills offer different returns for different maturity lengths. Current rates as of 3/1/23:
8 weeks: 4.63%
13 weeks: 4.73%
17 weeks: 4.89%
26 weeks: 4.96%
Generally, the longer it takes for the bill to mature, the more interest your friend will pay you when it comes time to return the money.
The additional beauty of T-Bills is the ability to build a “T-Bill ladder” and further derisk investing in this instrument. The idea behind a T-bill ladder is to create a regular source of income while also maintaining a degree of liquidity and flexibility.
Here's an example of how a T-bill ladder might work:
Suppose you have $10,000 to invest in T-bills. Instead of investing the entire amount in a single bill, you might create a T-bill ladder with the following maturities:
$2,500 in a 4-week T-bill
$2,500 in an 8-week T-bill
$2,500 in a 12-week T-bill
$2,500 in a 26-week T-bill
As each bill matures, you can reinvest the proceeds in a new bill with a similar maturity, or use the cash for other purposes. By creating a T-bill ladder, you ensure a regular source of income as bills mature and are replaced by new ones, while also maintaining a degree of flexibility and liquidity in your investments.
Bond funds perform well during high interest rates
Too lazy to build a T-Bill ladder or too annoyed by the TreasuryDirect.gov website? Bond exchange traded funds (ETFs) are an easier way to benefit from high yields during high interest rates.
Instead of investing in one specific security like a T-Bill, bond ETFs hold various different types of bonds, including government bonds, municipal bonds, corporate bonds, and international bonds. Similarly, when interest rates rise, the yields on the new individual bonds in these ETFs also increase - leading to a higher yield.
Bond funds are easier than T-Bills to invest in and track - you can open an account with a brokerage or roboadvisor like Nexus (Nexus has the added benefit of also offering fee-free ATM withdrawals and other checking features you need) and allocating bond funds like BND to your portfolio. Additionally, bond ETFs offer easy liquidation - there are no maturity dates or hold-up periods. You can sell your bond ETF holdings whenever you want.
At the time of this post, the 30-day SEC yield for BND is 4.36% - a respectable return for a easy to manage, liquid investment.
I bonds thrive in high inflation
I bonds, or series I savings bonds, is longer term security issued by the U.S. Department of Treasury. The “secret sauce” to an I bond is that a portion of the interest rate is fixed, but another portion of the interest rate is pegged to inflation - meaning when inflation is high (like right now), that portion can get incredibly attractive. Think of it like a two-part burrito: the fixed rate is like the meat, and the inflation rate is like the spicy salsa. The meat stays the same, but the spicy salsa gets hotter or milder depending on how much inflation is happening.
Well right now, this I Bond burrito is pretty darn spicy, to the tune of 6.89%. This rate does change twice a year (in May and November), but with inflation still steadily rising, I Bonds are likely to continue being a safe, attractive investment.
However, a few notes to be aware of when investing in I Bonds:
You can only buy up to $10,000 worth of I Bonds per person per year
I Bonds take at least 1 year to become redeemable
Interest is paid monthly on I Bonds, and interest compounds every 6 months (all interest that was earned is added to the old principal amount)
Redeeming an I Bond anytime before 5 years results in a penalty of 3 months worth of interest
No penalty on redeeming an I Bond after 5 years
As you can see, compared to T-Bills, I Bonds take longer to liquidate, but currently pay out a higher interest rate. Because of the rules and restrictions on how to access I Bonds and the $10,000 personal limitation, there isn’t as sexy of a strategy as “T-Bill laddering” here.
Protect your money during high inflation and interest rates
There you have it. A few ideas to park any excess cash during these times to accumulate healthy returns.
Whether or not you choose to invest in bond funds, I Bonds, T-Bills, or some other vehicle, the most important takeaway during these times is to find something that gives you returns. If your cash is sitting pretty in a low-yield checking or savings account, it actually loses value as costs go up and your purchasing power decreases.
And we wouldn’t want that to happen, do we?
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Chen-Chen is one of the co-founders of Nexus, a banking and investing product that earns market returns for people, not institutions. Chen-Chen is a self-admitted Boglehead, travel enthusiast, and will talk your off about interest rates and investment vehicles if you give him the opportunity. All views are his own and for educational purposes only.
