All in Favor, Say “I” (Bonds)
You’ve probably heard people talking non-stop about the new investment hotness. You can buy it online and sure, it’s going to change your financial life, right? No, it’s not Dogecoin, Pugcoin, Hippocoin, Loraxcoin or any such nonsense—it’s Series I Bonds and they’re currently paying a risk-free 7.12% annual interest rate. But, is the juice worth the squeeze?
Series I Bond 101
Series I Bonds are U.S. government savings bonds that offer a composite rate to help investors combat inflation. The composite rate consists of a fixed rate and a semi-annual inflation rate. Both adjust every six months.
I Bonds can be purchased and redeemed online at Treasury Direct and investors can purchase up to $10,000 per taxpayer ID number. These bonds will be electronic—no fun paper artifact to show off at the bar unfortunately. An additional $5,000 can be purchased with a tax refund (Why do you have one of those?), and those bonds will be issued on paper.
The I Bond will pay its composite rate for 6 months from purchase, then reset to the prevailing composite rate for the next six months. It will pay interest for up to 30 years. But you’ll only receive the interest when you redeem it. There’s no stream of income into your account every six months.
If you’ve been face-palming over CD, Money Market, and “High-Yield” savings account rates for the past few years, this probably sounds like interest rate lottery winnings. As always, the devil is in the details.
Series I Bond Pros
There are some great reasons to consider purchasing I Bonds, but plenty of drawbacks too.
Current composite interest rate. The semi-annual rate is 3.56%, which is double the 1.77% percent from the previous six-month period. Since I’m at 1 G and 0 knots, I’ll risk some math in public. A $10K bond purchased now will earn at least $356 if redeemed a year later, even if both rates reset to 0% during the next update cycle. That feels pretty good since you’d have to invest $71,200 for a whole year to earn the same amount at current “High Yield” savings account rates.
If inflation continues to rise, or the composite rate holds pretty much steady for the next six-month period, you’d likely earn over $700 on a $10,000 investment in just one year. Not too shabby in the yield famine we’ve experienced for so long.
Risk. Investors usually consider U.S. Savings Bonds to be risk-free. We all like to Chicken-Little about how “things are bad” these days, but even Congress seems to agree that defaulting on debt isn’t in our national interest.
Tax Preference. The interest earned on I Bonds is not taxed at the state and local level. Most of you have probably signature-managed state taxes by choosing TX, FL, AK, NV, WY, WA, or SD, but state taxation is a factor for many investors. Uncle Sam does tax the interest, but that bill can be deferred until you redeem the bond. If desired, you can pay tax annually, even though you haven’t received the amount to spend into your account. This might make sense if you expect a higher income tax bracket at redemption, e.g., 30 years from now.
A tax-preferenced, risk-free, 7.12% investment… what’s not to love? A good bit.
Series I Bond Cons
I Bonds are not all sunshine, lollipops, and bottomless Jack and Coke at the expense of a Snacko with bad inventory control methods. Here’s the fine print.
Variable Interest Rate. This chart shows the history of the fixed and semi-annual rates. You can see that the fixed rate has been falling for over 20 years and gravity seems to have it trapped near zero. The semi-annual rate has largely been on the rise for a bit, but you’ll need a functional crystal ball to know where it’s headed next. If inflation ends up being fairly transitory, that 7.12% rate might fade from your scope.
Nominal versus Real Interest Rate. The nominal rate is the rate before factoring in inflation. The real rate is what you earn after inflation. Inflation isn’t a unitary number; it truly depends on what you need purchasing power for in your own life. If all you plan to buy with your bond interest is healthcare, college tuition, or a new car in 2021, then 7.12% may not help you much. Series I Bonds are meant to protect against inflation, not make you rich in the face of it. The real return in the current environment is likely 0% or potentially negative. Your history book will tell you in a few years.
That said, if you hold the bond for a couple decades, I’m comfortable predicting that interest rates will change over the duration and it’s possible that your bond will generally keep up with inflation and at least deliver the purchasing power of your original investment, e.g., $10K.
Purchase Limit. Many families are sitting on a lot of cash, perhaps hoping to buy a home in the next few years. Wouldn’t it be great to get 7.12% on all that cash? Unfortunately, the $10K limit isn’t going to help with a down payment on most houses. The $10K limit is per individual tax payer. Thus, a married couple can buy $10K each… per calendar year… plus $5K more per tax return with a tax refund. Given that we’re about to switch calendars, that means a couple could sock away $45K in the next couple of months by purchasing $20K in December 2021, $20K in January 2022, and another $5K if they’re receiving a large tax refund. That could be up to $3,204 in interest if the rate holds at 7.12% for a whole year.
Other options to run up the score would include using a Trust or Business entity to purchase additional lots of $10K (electronic only—no paper via tax return). Series I Bonds can be purchased and gifted, too.
Holding Period. Series I Bonds cannot be redeemed for 1 year, full stop. If redeemed prior to 5 years, the investor forfeits the last three months of interest. For a house purchase in two to five years, this isn’t such a bad proposition for a portion of the down payment money. Additionally, if rates head back down, 3 months of interest at 0% is… wait for it… $0, so not a big penalty.
If you’re putting your Emergency Fund in I Bonds, you’ll need to schedule your emergency for at least 12 months later…
Account Management. I’m a huge fan of simplifying financial activity. One the one hand, I Bonds are not marketable. You don’t have to worry about where and how to sell them, or use a costly broker to do so. On the other hand, you can only purchase them at TreasuryDirect.gov.
That website interface leaves a lot to be desired. It’s clunky. You can’t hold your I Bonds at a brokerage or bank, so you’re inviting another account/website/login credential to your life. If you pass away, it’s one more knot for your executor to untie.
What About TIPS Instead?
While I Bonds are meant to blunt inflation, so are Treasury Inflation Protected Securities (TIPS). As financial instruments, they’re quite different. The rate on TIPS is determined at auction each time the government issues them. TIPS are bought and sold on secondary markets and if you own them, it’s probably through a mutual fund or ETF.
To combat inflation, a TIPS receives both a stated interest rate and a boost to the face value based on actual inflation. Buying TIPS does hedge inflation, but as interest rates and other economic factors change, a TIPS fund can lose value. You’ll pay an expense ratio and potentially other sales and management fees to invest in a TIPS fund as well. You can invest a lot more than $10K in TIPS, but you can lose principal too.
Cleared to Rejoin
Should you consider Series I Bonds? If you have the cash, and would like the feeling of earning some return, and don’t mind curating another set of account credentials (or two+ for a couple, a Trust, and a Partnership…), and don’t mind giving up access to the cash for at least a year… They’re probably a do-no-harm purchase.
If you had to make a (taxable?) sale of an asset to free up the cash to buy I Bonds, are bothered by the fact that inflation can easily gobble up the purchasing power of the investment, would prefer to invest in stocks, or don’t want the complexity of extra accounts… they may be a hassle for you.
When the froth about Series I-Bonds started in October 2021, I didn’t put them very high on the to-do list. I have recently gone through the process to make a purchase so that I can talk people through it and describe it, but I don’t expect I Bonds to be my family’s financial savior. Some extra diversity? Check. A sense of agency in the face of inflation? Check. A clunky website that probably makes the rollout of Healthcare.gov look like Instagram? Okay, no need to be mean.
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