Hugh F. Wynn
I Bonds: The Wallflower of Retirement Investments is in Bloom
Typically known as the "wallflower" of investments, the virtually risk-free U.S. Treasury-issued Series I Savings Bonds are making a big splash on the investment scene these days. So, what's happened to make this typically low-key retirement vehicle bloom? A perfect inflationary storm.
NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
In November 2021, the U. S. government began paying a guaranteed 7.12% on Treasury-issued Series I Savings Bonds. Why is that exciting? Try and find another guaranteed asset or investment vehicle paying anything close to that today that is federal tax-deferred (until cashed out) and exempt from state and local taxes.
That 7.12% rate is easily more than double the rate on 30-year U.S. Treasury bonds, and according to the FDIC, the national average interest rate for bank savings accounts right now is only 0.06%. Do you see what I mean?
The Inflation Connection
Inflation-proof Series I Savings Bonds were introduced by the U.S. Treasury in 1998 but seldom create much of a stir due to the relatively low inflation rates we've enjoyed these past two decades. That changed in November when the six-month yield on I Bonds shot up to 7.12%...a yield that beats everything in the fixed-bond market – even junk bonds for the moment – and they come with no credit risk. The long ignored I Bonds started capturing lots of attention.
I Bonds are indeed a safe hedge against inflation. Here’s why: The I Bond’s interest rate combines two separate rates: (1) a rate of return that remains fixed throughout the bond’s 30-year life (currently zero), and (2) a variable six-month inflation rate (currently 7.12%) based on changes in the Consumer Price Index for Urban Consumers (CPI-U). This index tracks the cost of everyday consumer goods and is used by the Treasury Department to calculate inflation rates. The combination of rates is called the composite rate. Because of this I Bond/CPI intersection, when inflation goes up the variable interest rate on I Bonds increases as well.
I Bonds' variable inflation rate adjusts semi-annually - on the first business day of May and on the first business day of November each year. On those two days the bond's inflation rate resets, that is, unless the “official” government rate of inflation remains the same. The semiannual inflation rate announced in May is the change between the CPI-U figures from the preceding September and March, while the inflation rate announced in November is the change between the CPI-U figures from the preceding March and September.
With inflation now “five feet high and rising,” that rate adjusted upward - to 7.12% - in November.
Until the last business day of April 2022 (the end of the current six-month period), an investor can lock in the bond’s 7.12% interest rate for six months. On the first business day of May (May 2 in 2022), the I Bond variable rate will change either up or down again, based on inflation. However, as long as the investor purchased the bond before then, they are guaranteed that 7.12% rate for six months.
Once the bond turns six months old, the interest will compound and then the rate will change to the new rate set on May 2, whatever it may be. Even though the investor can’t cash out his or her bond after six months (due to the one-year no-sell limitation), the investor is guaranteed a first year annual interest rate of at least 3.56%. This assumes the worst case scenario - that the interest rate on May 2 drops to 0%. Still, that's roughly 60 times higher than the yield on an average savings account (0.06%).
It's worth a second look, don’t you think?
In case you’re wondering, the value of an I Bond can never be less than what the purchaser paid for it. I Bonds bought today earn a variable rate of interest tied to inflation; as inflation increases, the value of the bond goes up. Still, the value of an I Bond isn't guaranteed to grow to a certain amount. By the same token, the interest rate can't go below zero. If the inflation rate is negative (deflation), it can offset some of the fixed rate. If the inflation rate is so negative that it would pull the combined rate below zero, it’s not allowed to happen. It stops at zero. Thus, the redemption value of the acquired I Bonds can't decline.
By the way, I Bonds are not taxed at a state or local level…and federal taxes on the interest is not incurred until the bond is cashed out. And when are earnings added to I Bonds, you ask? They increase in value on the first day of each month, and interest is compounded semiannually based on each I Bond's issue date…which is the month and year in which full payment for the bond is received.
Rainy Day Option
I view I Bonds as an alternative to earning virtually zero interest on Rainy Day (emergency) funds deposited in a bank account. However, there is a caveat. I Bonds can’t be cashed out at least one year after purchase, and if a bond owner cashes out after the first year but before five years, he or she loses the most recent three months of interest. For these reasons, and because you need some form of liquidity in your emergency fund, you should perhaps avoid investing all Rainy Day dollars into I Bonds at once.
Consider a laddering approach. Initially, place 50% your emergency funds in an FDIC-insured bank savings account and the other 50% in I Bonds. After one year, the I Bond half of your money is now immediately available, allowing you to buy I Bonds with the other 50%. In short, invest in I Bonds gradually – so that there are some savings bank funds available without suffering an early cash withdrawal penalty.
If you have children but don’t don’t need cash flow before those ever-increasing education costs begin, I Bonds are another way to save for college. If you meet certain IRS qualifications and use the funds for higher-education expenses, the interest earned on I Bonds is tax-free.
Naturally, investor demand for I Bonds is increasing, but it’s hard to predict for how long. A New York Fed study revealed that consumer inflation expectations are for no less than 6% this year and probably 4% or so over the next three years. So why not, to the extent possible, invest in an instrument that provides protection against Izzy The Inflation Monster.
Individuals can open accounts to personally buy these securities; acquire them for a trust, estate, or a business; purchase them to gift to others or for a child through a custodial account.
I Bonds are only available online through the U.S. government’s site TreasuryDirect.gov or in paper form using your federal tax income refund. In short, you can only buy paper I Bonds when filing a federal income tax return (minimum purchase $50). Otherwise, you buy them online via Treasury Direct, minimum purchase $25 (including through payroll direct deposit). There is a $10,000 annual limit per individual on electronic purchases through Treasury Direct. And there is a $5,000 annual paper purchase limit per individual and couples – and this paper purchase can only be made through and with income tax returns.
Because financial wazoos don’t earn commissions on I-Bonds, they have little incentive to recommend them to clients. And, of course, “transitory” inflation numbers have fast become extremely burdensome to consumers.
I Bond Hacks
The $10,000 annual limit more than fits the budget of many investors. But those with fatter wallets who want to optimize holdings must demonstrate some degree of creativity. For example:
Open individual accounts on Treasury Direct for each spouse.
If you own a business, open an account for an S Corp or an LLC.
Set up an account for a revocable living trust.
This combination of accounts would allow a couple to buy $40,000 of I Bonds each year. And, if this same couple has an IRS tax refund of up to $5,000 coming, they could…in our example…jointly buy up to another $5,000 of paper I Bonds for a total of $45,000. How? Using IRS Form 8888, individuals can purchase up to a total of $5,000 of paper I Bonds in any calendar year without affecting the $10,000 limit on purchases from Treasury Direct. Paper bonds are delivered by mail to the address on the return. But be advised - a tax return containing errors will result in cancellation of the paper I Bond purchase.
Where there’s a will to maximize purchases, there’s often a way.