By Dr. James M. Dahle, WCI Founder
I Bonds are back in the press! The last time I wrote about I Bonds (2014), I had zero interest in investing in them and neither did anyone else. That has all changed recently—mostly because the annual inflation rate soared in the back half of 2021 (and because by April 2022, it had jumped to 8.3%)—so it's a good reminder that asset classes periodically rotate in and out of favor. Let's take a look at I Bonds once more.
Who Should Consider I Bonds?
While I do not actually own any I Bonds, they can make a lot of sense for some investors. The ideal purchasers of I Bonds:
- Want to put some of their portfolio into bonds,
- Want to put some of their bond allocation into inflation-indexed bonds,
- Have a taxable investing account (i.e. cannot fit all of his or her investments into retirement accounts), and
- Are not TOO wealthy.
If any of these are not true, then I Bonds probably are not for you.
I vs EE Bonds – US Government Savings Bonds
The US government issues two types of Savings Bonds: “Series EE” and “Series I.”
What Are EE Bonds?
The EE Bonds have been issued since 1982 when they were yielding 13.05%. Unfortunately, they now yield 0.10% (and have since my original post on I Bonds in 2014). While it is hard for me to get excited about a savings account yielding 0.60%, it's six times better than the current yield on EE Bonds. EE Bonds are not indexed to inflation in any way.
What Are I Bonds?
I Bonds, however, are similar to Treasury Inflation Protected Securities (TIPS) in that there are two components to the yield. One component is fixed at the time you purchase the bond. It is set for new bonds every six months. If you had bought an I Bond at any time in the past several years, the fixed rate was 0.00%. If you bought it in 2000, you could have gotten 3.6%. The other component varies with inflation and changes with the Consumer Price Index (CPI-U) (non-seasonally adjusted, includes food and energy). It is changed every six months and then combined with the fixed rate of your particular bond in an interesting but not straightforward way.
The combined rate can be lower than the fixed rate, but never lower than zero. It changes every six months on the first day of the month you bought the bond (January 1 for bonds bought in January) and the first day of the month six months later (July 1 for bonds bought in January). The current inflation rate is a whopping 3.6%, dramatically higher than the 0.59% the first time I wrote this post back in 2014. But it has varied from 2.85% to -2.78%. Keep in mind that is a “six-month inflation rate” so the calculation to get your composite rate actually doubles that. There is one other factor in the calculation (the fixed rate multiplied by the inflation rate), but it rarely affects things much so you can essentially ignore it, at least these days.
Here is the calculation:
Composite Rate = Fixed Rate + 2 * Inflation Rate + Fixed Rate * Inflation Rate
So, on an I Bond issued in the first few months of 2022
7.20% = 0.00% + (2 * 3.60%) + (0.00% * 3.6%)
And on an I Bond bought back in 2000
10.89%= 3.60% + (2 * 3.60%) + (3.60% * 3.60%)
I'm not sure I really understand the point of that last factor since it only adds a basis point or two to the yield, but that's the formula. So, the fixed rate when you buy I Bonds is all important to their eventual return. You get to keep up with inflation (at least inflation as defined by the government), but that's it unless you buy a bond with a halfway decent fixed yield. However, inflation right now in the fourth quarter of 2021 (as measured when calculating I Bond yields) is pretty high, so the overall yield is pretty high, even without a decent fixed rate. If you can combine it with a high fixed rate, it's downright awesome!
As of May 1, 2022, the interest for an I Bond rose to 9.62%, up significantly from the 7.20% in the previous six months. The I Bond rate remained at 9.62% until November 1, 2022 (with the demand so high in late October 2022 to get that interest rate before it fell, it was tough to actually log in to the TreasuryDirect website and purchase the bonds). By November 1, the new rate was 6.89%, though interestingly, the fixed rate had moved from 0.0% to 0.4%.
Now you see why there is so much interest in I Bonds right now. Who wouldn't want a very safe investment with a yield in the 7%-11% range? Note that the yield compounds semi-annually—not daily like most savings accounts, which has the effect of slightly lowering your return.
Pros and Cons of I Bonds
Benefits of Savings Bonds
There are some minor tax benefits to buying savings bonds, both EE and I. First, the income grows in a tax-deferred manner for up to 30 years. There are no distributions like with a CD, a savings account, or a typical bond. They're a little bit like “zero-coupon bonds” that way, except you don't have to pay tax on phantom income like you would with a Zero or even a TIPS in a taxable account.
When you finally do redeem the bond, the interest is taxable at your usual federal marginal tax rate but free of state or local income tax, just like all treasury bonds. However, if you use the entire proceeds (both principal and interest) to pay for qualified educational expenses, the interest is also federal income tax-free. Unless you're a doctor. Then you're probably out of luck because your income is too high to get that tax break, which is phased out completely at a 2021 modified adjusted gross income of $98,200 ($154,800 married).
You can't even just let your kids buy the bonds, because they have to be purchased by someone at least 24 years old to get the educational expense tax break. However, if for some reason you have I Bonds and you are below the income limits this year but don't expect to be later, you can redeem them now and put the money into a 529 plan, which is considered a qualified educational expense.
Downsides of I Bonds
The main issue with using savings bonds is that they're a pain to buy and to redeem. This is why I say you need to be wealthy enough to need a taxable account but not so wealthy that the low amounts you can invest into I Bonds are comparatively irrelevant to your portfolio size.
You used to buy “paper I Bonds” at a local bank. You just walked in the door, plopped down 50 Benjamins, and walked out the door with $5,000 in I Bonds.
As of 2012, you can't do that anymore. One of the only ways to get paper I Bonds is as part of a tax refund. You can deliberately overpay your taxes by $5,000 (per person) and then get the refund as an I Bond. If you don't want to do that, your only recourse is to buy I Bonds directly from Treasury Direct. You can purchase E Bonds, TIPS, and other treasuries this way too if you like. Personally, I find it well worth the 10-20 basis points that a well-run, passive mutual fund or ETF will charge to take the hassle of buying and selling individual bonds away from me.
Unfortunately, there are no savings bond mutual funds, so if you want them, you have to buy them individually. So you open an account at Treasury Direct and buy up to $10,000 in I Bonds per year per person. You can actually open a bunch of trusts if you want and each of them can buy $10,000 of I Bonds each year, but that seems like more hassle than it is worth to me. If you actually wanted $200,000 of your portfolio in I Bonds, it might take you a decade or more to get there. If you have a $2 million portfolio and want 10% of it in inflation-indexed bonds ($200,000), I Bonds just aren't going to do it for you.
You can also redeem your electronic I Bonds at Treasury Direct (remember to do so before they hit 30 years old, since they stop earning interest then). You may also redeem your paper I Bonds at many local banks. However, you cannot redeem bonds in less than one year, and if you redeem them in less than five years, you lose three months worth of interest.
Remember to always buy savings bonds at the end of the month and to sell them at the beginning of the month to maximize your returns. (You get credit for owning them for the whole month, even if you only own them for a day.)
TIPS vs I Bonds
The natural question an educated reader will have is “What about TIPS?” TIPS work a little bit differently than I Bonds, but the same basic principles apply. There is a fixed portion and an inflation-linked portion. Both are linked to CPI-U. Both are state and local income tax-free. TIPS do not have the tax-deferral feature of interest, and they can also generate phantom income—on which you owe real taxes, so they're generally best held in a tax-protected account.
It is relatively easy to compare TIPS to I Bonds to determine which is the better deal. Since both are indexed to CPI-U, you just have to look at the fixed rates. Since you can hold I Bonds for up to 30 years, you can just compare a 30-year TIPS to an I Bond. As of this writing, a 30-year TIPS yields -0.27% real, and an I Bond yields 0.00% real. That was an easy decision, although the first time I wrote this article the comparison favored TIPS, not I Bonds!
I bonds look even better right now when compared to a 5-year TIPS (-1.66% real) or a 7-year TIPS (-1.26% real). You can also compare them to commonly held TIPS mutual funds (which tend to hold shorter-term TIPS), and they look great.
TIPS are easier to buy in any amount and you can hold them within a mutual fund or ETF. However, if rates go up, you can redeem your old I Bonds and buy new ones, whereas you'll take a hit on the principal of the TIPS. (Of course, if rates fall, you get a boost on the principal of the TIPS.) Note that if you decide to redeem your old I Bonds and buy new ones, you're still limited to just $10,000 per person per year (plus the $5,000 from your tax return).
Are I Bonds A Good Investment?
There are really four ways people use I Bonds. When today's low fixed rates are combined with a low inflation rate, none of them are particularly wonderful. But that's not the case right now.
#1 Educational Savings Plan
The first is as an educational savings plan. This is kind of silly, however, since 529s give you the exact same federal tax treatment, plus a possible break on your state taxes. If you have already maxed out your 529 contributions per year ($15,000 per spouse, per child), it is unlikely that you have an income low enough that you'll get the educational tax break on your I Bonds. So that's not a very good reason to buy I Bonds.
#2 Emergency Fund
The second use is as an emergency fund. Instead of earning 0.6% at Ally Bank or buying some CDs yielding 1%-2%, the investor figures, “Hey, why not put some of my emergency fund into I Bonds?” It gives you some inflation protection and the possibility of higher yields. The downsides are that you can only buy a limited amount each year (and can't buy back the ones you sell), and you can't redeem them for at least a year. If you redeem them in less than five years, you forfeit three months of interest. Plus, they're a pain to buy and redeem, compared to a simpler solution like a savings account. Besides, the point of an emergency fund isn't to get a maximum return on that money. Not a great reason to buy I Bonds, but if you have some you bought a few years ago, sure, feel free to use them as part of your emergency fund.
#3 Expand Your Tax-Protected Space
The third use is to “expand your tax-protected space.” Many investors have a large taxable account in comparison to their tax-protected accounts. Since I Bonds grow with the interest tax-deferred, some investors figure that owning them is a lot like having more tax-protected space. This is a little bit silly. You can always expand your tax-protected space by using a non-deductible IRA, making after-tax (not Roth) contributions to a 401(k), or buying a variable annuity. Each of those can then be used to buy asset classes that are a pain to hold in a taxable account, like REITs and TIPS. But don't think you're getting some huge benefit for doing so, since just like buying I Bonds, you get no upfront tax break for contributing to them and your withdrawals are fully taxable. These types of “tax-protected space” are very much inferior to a 401(k) or Roth IRA and, in many situations, inferior to a simple taxable account. You just get tax-deferred growth, which is a pretty limited benefit by itself.
#4 Inflation-Indexed Bond Portion of Portfolio
The fourth use is as part of the inflation-indexed bond portion of your portfolio. As I see it, this is really the only good reason for most doctors to bother with I Bonds. Given today's low yields on bonds (and thus low expected returns), it is fine to hold some or even all of your bonds in taxable. If you wish to own inflation-protected bonds, it therefore makes sense to buy some I Bonds in that taxable account. There is still the issue that you can't buy very many of them, but that's no reason they can't at least be part of the solution. You can buy as many I Bonds as they'll sell you and make up the rest of that portion of your asset allocation with TIPS.
Overall, Series I Bonds can make up a valuable portion of your fixed-income asset allocation. But don't feel like you missed out on a great deal any time recently. It has been 12 years since they had a fixed rate of at least 1% and 19 years since they had a fixed rate of at least 2%. But if you ever see them going for 2%-4% again, back up the truck. Those who bought in 2000 and still own them are loving the current yields!
What do you think? Do you own I Bonds? Does the recent rise in inflation make I Bonds a good investment? Comment below!
[This updated post was originally published in 2014.]