“Should I be investing in I bonds?” has become a popular question these days. With inflation hitting four-decade highs, investors are looking for ways to protect their money from inflation. I bonds were created to do exactly that: help provide a hedge against inflation.
On the surface, they can seem like a slam dunk, given how elevated inflation is. The reality is the net benefit for most people won’t amount to much because of the bond limitations.
What I Bonds Are
A good place to start is understanding what I bonds are. They are a U.S. savings bond designed to help protect cash against inflation. The U.S. Treasury issues and guarantees them, which means that unless the federal government completely folds, your principal is not at risk.
I bonds are issued as 30-year bonds and combine two sources of interest income:
Fixed rate: This rate is determined upon purchase and never changes over the bond’s life. The government establishes the fixed rate every six months, and currently, it is at 0%. You can view the historical fixed rates for I bonds here.
Inflation rate: This rate is variable and adjusts every six months (on the first business day of May and November), based on changes to the Consumer Price Index (CPI).
The rates above are combined to calculate your actual rate of interest, sometimes called the composite or earnings rate. It is important to note that unless the inflation rate has been increasing over the prior six-month period, it could provide little to no value, as witnessed from 2009 to 2020.
The good news is the combined rate will never be less than zero, even if the six-month inflation reading is negative, dragging the combination of both rates down to negative territory. The U.S. Treasury won’t allow you to “lose.”
Pros
Guaranteed: The U.S. Treasury fully backs and guarantees your principal, so the risk of loss is negligible.
Taxes: You are not responsible for paying tax on the interest until the bond is sold or matures (30 years). This allows compound interest to work its magic but could stick you with a hefty tax bill down the road.
State tax: Interest earned from I bonds is not subject to state taxes.
Education: Under certain circumstances, the interest earned may be excluded from federal income tax when used for higher-education expenses.
Cons
Several limitations to I bonds prompt many people to pass on them.
Purchase restrictions: An individual can ONLY purchase up to $10,000/year. Individuals can purchase an additional $5,000/year in paper bonds using their federal tax refund (if applicable). This means that unless inflation remains extremely elevated, you are not likely to make much interest
Liquidity: I bonds CANNOT be sold for the first 12 months from purchase. In addition, there is a three-month interest penalty if liquidated before five years.
Hassle: To purchase and redeem I bonds, you must open an account through Treasury Direct. You cannot buy them through a financial advisor or any other institution. It should be noted that any paper bonds must be cashed in at a local bank.
Interest: The interest from I bonds is not paid until you cash the bonds in. This means you can’t collect the interest to “supplement” your other sources of income. While it likely won’t amount to much, it is something to keep in mind.
Can I bonds earn more interest than cash sitting in a bank account? Absolutely, but the question is whether the juice is worth the squeeze. The limitation of $10,000/year puts a damper on how much you earn. Plus, the actual “gain” is minimal for those with higher net worths. Let’s look at an example:
Bob has a net worth of $1 million. He purchases $10,000 of I bonds and ends up earning a composite rate of 5% (above historical returns) over the next 12 months. Bob’s return would be ~$500, which increases his net worth by .0005%.
The maximum purchase of $10,000/year makes it difficult to earn anything of substance. The strategy could be more effective over 30 years, but that begs the question of whether you should invest in something as conservative as I bonds if you have a long time horizon.
In the end, I bonds should be viewed as a cash alternative investment. This cash should be money that you don’t need immediate access to and don’t want to subject to market volatility. The fixed rate has been below 2% for the last 20 years, so unless inflation remains extremely elevated, I suspect the composite rate will revert to its historical average.
Does that mean you should always pass on I bonds? No, but they likely won’t add much to your bottom line.
If you are wondering whether I Bonds are right for you, we encourage you to discuss your situation with a fee-only financial advisor.
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