I Bond You Bond We All Bond Over I Bonds?

As inflation continues biting, folks from coast to coast are scrambling for tools to fight it—an understandable urge. Banks aren’t paying anywhere near enough interest to preserve savings’ purchasing power, and the erosion hurts. A lot. So it isn’t surprising that the US Treasury’s normally obscure inflation-adjusted savings bonds—better known as I Bonds—are suddenly among finance’s hottest topics. Starting next month, they will pay nearly 10%, with interest and principal guaranteed by Uncle Sam himself. Yet as with any investment, there is no free lunch, and reality may be a touch more complicated than the flashy talking points suggest. We aren’t against I Bonds, and we think they may play a small, beneficial role in a broader fixed income strategy. But it is important to know exactly what you are buying and what the tradeoffs are. So, here is a friendly primer.

What are I Bonds?

They are US savings bonds—like a supersized version of those $50 or $100 savings bonds kids sometimes receive as presents or prizes in school raffles. But unlike those bonds, they carry a floating interest rate that rises and falls with the Consumer Price Index (CPI), resetting every May and November. In general, their interest rate will be a skosh higher than the CPI inflation rate. Right now, they pay 7.12%.^[i] In May, that jumps to 9.6%.^[ii]

How does the math actually work?

As the US Treasury’s TreasuryDirect website explains, I Bonds pay a fixed interest rate plus the semiannual CPI inflation rate. From November 2021 through April 2022, the fixed rate was 0%—which applies for the lifetime of the bond—and the semiannual inflation rate was 3.56%. From there, TreasuryDirect calculates the “composite rate,” which is the rate you actually get. That calculation is: Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]. So, for these last six months, the math was [0.0000 + (2 x 0.0356) + (0.0000 x 0.0356)], which works out to 0.0712 or 7.12%.

Sounds attractive! How much can I buy?

The maximum amount you can purchase (per person) is $10,000 per year if you are paying straight cash. It rises to $15,000 if you elect to use $5,000 of your tax refund to purchase I Bonds.

Errrr I didn’t do that.

Sorry. There isn’t a grace period. If you didn’t stipulate an I Bond purchase when you filed your 2021 taxes, you can’t get a redo.

How do savings bonds differ from normal Treasury bonds?

About the only thing they have in common is that they are interest-bearing loans to the Federal government. Treasury bonds are liquid. Even though you can’t redeem them early at their original value, you can buy and sell them on the secondary market. So if you need your money back, it is easy. They are meant to be tradeable. Savings bonds, as the name implies, are meant to sit static for years—a long-term savings vehicle. You can’t trade them. While you can redeem I Bonds early, there are penalties.

Oof. What are they?

Well, for one, you can’t cash out for the first year. After that, if you cash out within the first five years, you will forego the previous three months’ interest.

What are the mechanics? How do I buy them?

You have to open an account with the US Treasury, at their TreasuryDirect website.

Wait, I can’t buy one in my brokerage account?

Nope. Now, this isn’t necessarily a bad thing, as the securities will still be in an account in your name—your property. But that does add a couple headaches. One, it would mean another 1099 to report taxable interest. Two, you will need to keep your beneficiaries informed of the account’s existence and fill them in on any purchases and redemptions. Basically, there are extra headaches, particularly on the estate planning front, that you don’t deal with at traditional brokerages.

Hmmm. That is a tradeoff. I guess I should see if it is worth it, so back to this lovely interest rate. Getting 9.6% sounds great! How does that work?

Well, you know how bonds make regular coupon payments and you get the cash?

Yah!

I Bonds don’t do that.

Wait what?

They accrue interest over their lifespan, then pay it all out in a lump sum with your principal when you cash in.

Ah. I see. So that 9.6% will get added to the value of my I Bond after a year?

Sort of. The prorated interest accrues monthly, and it compounds every six months when the semiannual inflation rate resets. For now, the monthly rate would work out to a 9.6% annual interest rate, and the compounding is nice. But, again, the rate fluctuates with CPI.

How often does that happen?

TreasuryDirect adjusts the semiannual inflation rate for new bonds purchased in May and November. When the composite rate you actually receive would change depends on when you buy the bond, but it is always every six months. If you buy in January, then your rates reset in January and July of each year. If February, they reset in February and August. You can find the schedule here: https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm

Does the rate go down if inflation slows?

Yep.

So, if I buy in May, I won’t get 9.6% year in, year out.

Correct. The semiannual inflation rate will reset in November and every six months after that. If inflation stays high indefinitely, your composite rate stays high. If it starts slowing, which we think is likely, then your composite rate drops.

Furthermore, remember: You can’t redeem in the first year you own the I Bond. So if inflation falls, the rate will reset lower in November—and new I Bond buyers have no recourse. Of course, it may rise. Point being, though, the rate you see today is unlikely to be the rate you get over the timeframe you own the I Bond.

How low have those rates gone?

Well, the composite rate hit 0% in 2015, when the US experienced some deflation.^[iii]

Didn’t stocks do great that year?

Yes. I Bonds can carry a big opportunity cost.

I have read that I Bonds are a good place to stash my cash so that inflation doesn’t eat it. I am starting to think that isn’t quite right.

It depends what your goals for that pool of money are. If you are looking for a way to preserve your emergency cash reserves’ purchasing power, we doubt I Bonds are a fit. Emergency funds should be liquid. If you need a new roof in nine months, you don’t want to have your money locked where you can’t access it. You probably also don’t want to be penalized for early withdrawal in that situation—having to buy a new roof is pain enough.

Sounds like they aren’t much good for living expenses, either.

We reckon not, since they don’t pay interest to you in cash.

How do you suggest I think about I Bonds?

So the chief way we suggest thinking about them is this: Perhaps you have money earmarked for an expense a little over a year out. I Bonds could be great for that, considering there isn’t material principal risk, and you don’t need liquidity within a year or interest payments to help meet cash flow needs.

Beyond this, we think their role is pretty limited. The size restrictions hurt their utility pretty badly. They could work as a less liquid and potentially higher-yielding fixed income investment than typical Treasury bonds. If holding fixed income makes sense for your goals, then I Bonds might play a small role there. They would work with your broader fixed income allocation, not replace it.

Then, too, remember fixed income’s primary purpose in a long-term portfolio: To lower expected volatility versus a 100% equity allocation, presuming your cash flow needs, time horizon and other variables make it beneficial for your portfolio to swing less. People who blend stocks and fixed income generally have higher cash flow needs, which points to more liquidity and flexibility. A locked-in, long-term fixed income security like an I Bond sort of cuts against this, so we think the tradeoffs merit careful consideration.

Aren’t there other Treasury bonds that try to guard against inflation?

Yes! They are called Treasury Inflation Protected Securities (TIPS). Those don’t have floating interest rates, but the principal value rises with inflation, and the Treasury applies the fixed interest rate to that higher amount. They also pay interest in cash and are generally pretty liquid. We should note, however, that the principal also falls with deflation, which has created headaches for TIPS owners at times. Again, there is no free lunch.

In your opinion, if I am focused on interest rates and inflation, am I barking up the wrong tree?

Prooooobablyyy? We always encourage readers to consider total return: Price movement plus dividends and interest. At the risk of oversimplifying things, we think investing is about defining your goals, time horizon and comfort with volatility, determining the long-term return necessary to meet those goals, then finding the asset allocation (the mix of stocks, bonds and other securities) likeliest to deliver that return without running far afield of your volatility comfort. Whether I Bonds (or TIPS, for that matter) fit with that will depend on your personal needs. But in general, we think focusing on interest payments conflates income and cash flow. Interest is a form of portfolio income. It is one way to generate cash flow, but not the only one. Depending on your situation, generating what we call home-grown dividends with stocks may be a better way, with more long-term return potential than relying on interest.