A 20SF reader recently asked about my thoughts on current inflation concerns and how to hedge against it. While most signs point towards many current inflationary pressures being temporary in nature due to pandemic-related supply chain (e.g. lumber, semiconductor, etc.) and employment disruptions, it did get me thinking more about possible short and mid-term answers, particularly with savings and checking accounts returning close to 0% in interest over the last number of years.
One immediate inflation hedge that is currently hot at the moment, without the risk of securities or digital Beanie Babies (crypto and NFTs), comes in the form of good ole U.S. Treasury Series I Savings Bonds. Back in May, I had heard that the rate of return on new Series I Savings Bonds had jumped up to 3.54% (annually), which is a comparative windfall versus the average national 0.39% rate of return for 5-year CDs, 0.06% for savings accounts, and 0.04% for checking accounts. That rate now has jumped to 9.62%!
The big difference between I bonds and deposit accounts is that I bonds factor current inflation rates every six months into their total rate of return and deposit accounts do not. With inflation rates jumping, at least temporarily, I bonds have a relatively attractive comparative return. So, I decided to take a much closer look at this old school investment vehicle (including purchasing one), in order to share my I bond review here.
What Are Series I Bonds? How Do They Work?
Series I Savings Bonds launched in 1998 and are issued under an arm of the U.S. Treasury Department. They are issued with an expiry of 30 years and feature a composite (total) rate of return that is a combination of:
- Fixed rate return: this rate never changes over the life of the bond. If you buy a bond when the fixed rate is 2%, you will get 2% annually, for the 30-year life of the bond. If you buy a bond when the fixed rate is 0%, you will get 0% annually for the life of the bond.
- Variable semi-annual inflation rate return: this rate is tied to the Consumer Price Index for all Urban Consumers, or CPI-U, which is a measure of consumer inflation that is re-evaluated every six months. All previously purchased, unexpired bonds get this rate of return on top of the fixed rate of return.
In summary: I bond total return = fixed rate (same for 30 years) + variable rate (changes every 6 months).
I bond interest rates are released every 6 months for the following 6 months, on the first business day in May and first business day in November. Interest accrues monthly and compounds semiannually.
What is the Current I Bond Rate of Return?
The current I bond return is 9.62% (for May, 2022 to November, 2022), with a fixed rate of 0% on new issues, and a variable rate of 9.62% (4.81% semiannually) on new and existing issues. Current I bond rates can be seen here.
What are Historical I Bond Rates of Return?
How have I bonds performed over the years? Here is a complete chart of historical I bond rates of return.
Where & How to Buy I Bonds
There are 3 ways to buy I bonds:
- Digitally: you can buy $10,000 per calendar year, per account holder, in digital I bonds through the U.S. Department of Treasury at treasurydirect.gov. Individuals with a Social Security number can have 1 account each.
- Paper: You can buy up to $5,000 per Social Security number in literal paper bonds through the IRS as a form of tax refund payment using IRS Form 8888 (joint filers can purchase for each of the 2 filers) when you submit your tax return. If that sounds antiquated, that’s because it is, but the IRS offers the following: “The SmartExchange program offered through TreasuryDirect allows TreasuryDirect account holders to convert their bonds to electronic securities”, so you shouldn’t have to worry about losing your paper bonds via fire, flood, theft, tornado, termite, dog, or hurricane forever.
- Trust: living trusts can purchase up to $10,000 per year in I bonds.
Hypothetically, an individual could buy up to $15,000 per year in I bonds, or a couple could buy up to $30,000 per year. Living trusts could add $10,000 per trust.
Once you create an account at treasurydirect.gov, you link a bank account and can purchase the I bonds directly through a bank transfer. To purchase an I bond, when in your account, start by selecting the “BuyDirect” tab. Under “Savings Bonds” select “Series I”. Then, select the amount you would like to purchase.
How Long Do you Have to Hold I Bonds? Is there a Penalty for Early Withdrawal?
While I bonds have a 30 year expiry from the date of purchase, they do not need to be held for the full 30 years. They must be held for a minimum of one year. If an issue is held for less than 5 years, the holder forfeits the most recent 3 months of interest returns as a penalty. That’s not that big of a price to pay, particularly in comparison to deposit accounts (which are offering close to zero interest these days, as noted earlier).
Are I Bonds Risky?
Compared to other investment options, Series I Savings Bonds are about as safe as it gets, with the full backing of the U.S. government behind them, similar to FDIC or SIPC coverage for deposit accounts, with no cap on account value.
I bond interest rates cannot go below zero, and the redemption value of your I bonds won’t decline. If CPI-U measured inflation is negative (deflation), the variable rate is subtracted from the fixed rate, but will not go below 0%. Funds will not be subtracted from your I bond value. In addition to the interest earned on I bonds, the initial investment is returned in full at the time of withdrawal or expiry. If it isn’t (e.g. total U.S. government collapse), then we’ve all got much bigger problems than worrying about our I bonds.
Do you Have to Pay Taxes on I Bonds?
I bonds are subject to federal taxes, but exempt from state and local taxes. As for those federal taxes, you can choose either to:
- report the interest every year
- put off (defer) reporting the interest until you file a federal income tax return for the year in which the first of these events occurs:
- you cash the bond and receive what the bond is worth, including the interest, or
- you give up ownership of the bond and the bond is reissued, or
- the bonds stops earning interest because it has reached final maturity
You may also be able to avoid paying all or some of the federal tax on the interest if you use the interest earned from the bond to pay for college expenses.
Are I Bonds a Good Investment?
I’m not your investment advisor, so you need to make the decision on what is a good investment for you. I personally have purchased I bonds, because I currently see them as a low risk, moderate rate of return option and an inflation hedge for medium-term funds (1+ year). While you need to hold on to I bonds for at least a year, interest penalties are pretty small thereafter, if you absolutely need the cash. And if I bond fixed rates go up notably from the current 0%, it might even be worth redeeming 0% issues to lock in higher fixed rates at some point. I bonds probably shouldn’t be more than a small percentage of an individual’s overall portfolio (without much choice on that, as you can only purchase up to $15,000 per year, max, aside from living trusts). Unless you think you’ll need the immediate liquidity of accessing funds within 1 year, I bonds are, right now, a better investment than any deposit account on the market. Long-term, the bulk of most investment portfolios should still be allocated towards low cost index funds.