Understanding Series I Inflation Adjusted Savings Bonds and the Pros and Cons of Investing in Them

Intro:

With inflation hitting levels we haven’t seen since the 1980’s, we have had a number of clients ask us about the idea of investing in Series I Savings Bonds (I Bonds for short). This post offers a high-level view of what I Bonds are, how they are structured, and the pros and cons of investing in them.

What are I Bonds and why were they created:

I Bonds are a type of government savings bond with an interest rate that is regularly adjusted based on current levels of inflation. They are designed to be an investment option that is low-risk, being that they are backed by the full faith and credit of the US government with a guaranteed redemption value at maturity, but also low-risk in an inflationary environment, being that they are rate adjusted, protecting your investment from having its value eroded away by rising prices.

Structure:

I Bonds have a 30-year maturity and a minimum holding period of one year. Investors who choose to sell their bonds after one year are penalized, forfeiting the last three months of interest payments they received. Holding I bonds for a minimum of five years allows you to sell you bond back without facing any penalty. These bonds do not have a secondary market, meaning that investors cannot resell their purchased I Bonds to other investors. They can either be held to maturity or sold back to the government.

Taxes:

I Bonds are tax exempt at the state and local levels but are taxable at the federal level. There is, however, a tax caveat; if the proceeds of the bonds are used to fund higher education, they are exempt at the federal level as well. There are two different methods for taxing I bonds: the cash method or the accrual method. In the cash method of taxation, the investor is taxed one time at the date of the sale of the bond. In the accrual method of taxation, the investor is taxed yearly based on the interest earned. The bond holder is responsible for the taxes of the bond, regardless of whether they themselves purchased the bond or if it was gifted to them.

Interest rate calculation (Composite rate):

The rate that you as the investor receive in interest is based off a “composite rate”. The composite rate is a formula that calculates the appropriate interest rate of the bond by combining a fixed interest rate and a variable inflation rate. The fixed interest rate is determined by the Secretary of the Treasury and is fixed for the life of the bond. This rate is determined every six months and is applied to each new issuance of I Bonds. The fixed rate is typically very low. For instance, the most recent issuance of I Bonds has a 0% fixed rate.

The variable inflation rate is a bit more nuanced. This rate is based off of the rate of inflation measured by the Consumer Price Index (CPI). This variable inflation rate is recalculated every six months and is fed into the composite rate formula, adjusting the interest rate of all outstanding I Bonds. If CPI rises, the I Bonds are “rerated” to pay out a larger interest rate, but if CPI falls, the interest rate is adjusted downward. The interest rate on I Bonds has a floor of 0%, so no matter what happened to the rate of inflation, the interest rate on these bonds would never drop below 0%.

Interest payments:

I Bonds earn interest monthly over their lifetime. The interest payout structure is unique from traditional bonds in that interest isn’t paid out to the bond holder each month. Instead, the interest payment is accrued semiannually and added to the principal amount of the bond. While there is a downside to not collecting that monthly interest payment, you benefit from the growth of the principal value as interest accrues, allowing you to earn interest on an increasing principal value.

How to buy I bonds:

I Bonds can be bought electronically through the treasury direct website or in paper form using cash from a federal tax refund. Investors are only allowed to buy up to $15,000 worth of I Bonds each year. $10,000 can be bought electronically with any source of cash, while the remaining $5,000 can be bought in paper form and must be purchased with proceeds for tax refunds.

The risk of buying these bonds:

Investors looking to purchase I Bonds face two risks, each of which is connected to the other. One risk is the lack of liquidity that these instruments provide. Because I Bonds necessitate a lockup period of at least 1 year, (and five years to avoid forfeiting interest payments), investors are unable to access their cash during that time, meaning that their assets are stuck earning whatever rate is determined by the composite rate. This is not a problem assuming the rate is competitive. An issue arises when that lockup period aligns with a period of declining inflation, which is the second risk. I Bonds become less valuable during deflationary environments. If inflation levels were to drop considerably during the holding period, I Bonds could be adjusted to pay an interest rate near zero. Investors would be unable to move out of their investment and would be stuck earning next to nothing on in interest.

The benefit of buying these bonds:

As of today, I Bonds are earning 7.12%. This is a very high rate of return for an investment that is guaranteed by the US government, which has made them a potentially attractive investment option for cash that would traditionally be sitting idle. It is an effective way to protect assets against the high inflation levels that we are currently facing and could earn an even higher rate of return if inflation continues to climb.

Conclusion:

I Bonds are a very safe investment from a capital preservation perspective but can vary widely on the interest rate they pay out to investors. The yearly limit that you can invest in I bonds and the mandated lock up period of capital don’t make these bonds a good fit for everyone, but they are certainly yielding a high rate of return with the levels of inflation that we are seeing, which could make them an interesting fit in certain scenarios. This link to the Treasury Direct website is a great resource to gather more information about these savings bonds. If you have any additional questions or want to discuss if implementing some of these instruments in your investment strategy is an appropriate decision, please feel free to contact us.

Sources:

https://www.forbes.com/advisor/investing/what-are-i-bonds/

https://www.investopedia.com/terms/s/seriesibond.asp