With inflation continuing to rise, there is increasing interest in a type of savings bond called the I bond. But are they as good as they appear?
Investing in I Bonds
I bonds are bonds sold by the U.S. government. Their full, formal name is Series I Savings Bonds.
Series I savings bonds were first issued by the U.S. Treasury in September of 1998 but have flown under the radar until recently. I bonds were designed to offer Americans a way to protect the purchasing power of their money in a safe investment backed by the U.S. government. The bonds aim not only to keep up with inflation but offer a return slightly above the rate of inflation.
I bonds are safer than typical investments. US Government bonds do not have the same default risk as corporate bonds, so there is significantly less concern about losing access to principal or interest payments.
How do I Bonds work?
To offer a return above and beyond inflation, the interest on I bonds has two components: a fixed rate and an inflation rate. The fixed rate paid never changes over the entire 30-year life of the bond and is set at 0%.
The inflation rate is adjusted every six months, in May and November, based on non-seasonally adjusted CPI-U. However, the interest rate changes don’t go into effect for all I bonds at the same time; if you bought an I bond in January, the rate will not change in May but in July (six months from the date of issue), and every six months going forward.
This means if you expect rising interest rates, it is better to purchase I bonds right after new interest rates go into effect in May and November rather than before. That way, you get rate increases right after they are set and don’t lock in lower rates.
If you expect falling interest rates, it is better to purchase I bonds right before new interest rates are announced (instead of after) so you lock in higher rates for six months. If you plan on holding I bonds long-term it doesn’t matter when you buy them, because you’ll receive the same interest rates, although you might get them six months sooner or later than others.
Even if inflation is lower in November 2022 (and then again when it is reset on May 1, 2023) it’s likely I bonds may still offer a very competitive yield.
Short-term bond funds have a current yield of approximately 2.5% annually. Halve those yields and compare them to an I bond interest rate, and I think you will see what a big advantage you can have with I bonds.
Now that you see why people think I bonds are incredible, here are some things to consider before purchasing them:
- I Bonds are for investing, not saving.
The biggest drawback with I bonds is they are illiquid. When you purchase I Bonds from the Treasury, you can’t touch the money for the first 12 months. Period. So that means I Bonds are not a good investment for your emergency savings account where you need instant penalty-free access to your money.
This makes I bonds a poor choice for an emergency fund. An emergency fund needs to be readily accessible when you need it. If you had an emergency within 12 months of moving your emergency fund to I bonds, you’d be out of luck.
- Withdrawals between years 2-5 years have a penalty fee of 3 months interest.
You are allowed to withdraw your money after the first year. But between the start of year two through year five, every withdrawal will be reduced by 3-months of interest, based on the current interest rate when you take out the money. Starting in year six you can take out your money without any penalty fee.
- You will owe federal income tax when you make a withdrawal.
There is no tax bill while your money stays invested in I Bonds. When you make a withdrawal, you will owe federal income tax on the interest you earned. There is no state income tax on I Bonds.
- I Bonds are purchased directly from the U.S. government.
You can’t purchase I Bonds from your brokerage account or through your advisor. The only way to buy an I Bond is to set up an account at treasurydirect.gov, and then you will purchase I Bonds directly through that site. There are no fees to purchase I Bonds at treasurydirect.gov.
- The minimum investment is $25. The maximum is $10,000 per person, per calendar year.
The annual purchase limit is $10,000 per person. If you have a living revocable trust, you can also open an account in the name of the trust and save another $10,000 per calendar year. If you have a business, you can also have an account for the business that entitles you to an additional $10,000 per calendar year
- You will need to document and track your purchases.
I Bonds are not sold by banks for brokerages. So, you are not going to get great reporting tools. You need to carefully print your paperwork and keep track of the investment yourself.
Although they currently offer a good return, they are well hidden assets. You get no paper trail so make sure you document your account well.
- They cannot be purchased with assets in a retirement account.
You are not allowed to purchase I Bonds with funds from an IRA or employer-sponsored savings plan, such as a 401(k) plan. You will need to buy I Bonds with money that you have saved outside these programs.
The reason I Bonds are paying such a high return is inflation. And, inflation is definitely an overall disadvantage. Remember, when inflation starts dropping, so will your returns.
I bonds have a fluctuating rate. Although the current rate is good for six months and six months only; afterwards, the rate on I bonds could still be high or it might be more comparable to other cash-equivalent accounts.
Investing in I bonds won’t make you rich, but in unique times like we are in now, they could make your dollars stretch a little bit further. In inflationary times, they can be an option worth considering for medium-term savings goals.
So yes, although I bonds looks pretty good right now due to the increasing inflation rate, as inflation returns to long term averages, your returns will also be affected.