Government-issued savings bonds offer inflation protection and safety.
Many investors are searching for higher yield in today’s extremely low-interest-rate environment. Some might be considering high-yield bond funds because of their attractive published yields, while others may be eying dividend-paying stocks. When considering these options, investors need to remember that risk and expected return go hand in hand, and they shouldn’t unknowingly take on higher risk in the “safe” portions of their portfolios.
Currently, yields on safe FDIC-insured bank savings accounts are practically non-existent, while those of uninsured mutual fund money market accounts aren’t much better. And the rates on FDIC-insured bank CDs are also near all-time lows. So where should investors turn? Perhaps they should take a fresh look at risk-free government-issued I Bonds.
I Bonds (the “I” stand for “Inflation”) are inflation-protected U.S. Savings Bonds. They’re issued by the Treasury and provide a guaranteed real rate of return as opposed to the nominal or fixed rate of return provided by most traditional bonds and CDs. That guaranteed “real return” means I Bonds provide a rate of return that’s over and above reported inflation. First introduced in September 1998, I Bonds are now available in both paper and electronic form.
The total yield of an I Bond is made up of two components: a fixed or “real return” interest rate that remains the same for the life of the I Bond, and an inflation adjustment that’s announced every six months The interest rate portion is currently 0.3%, and the last inflation adjustment was 3.06%. You add these two components together to arrive at the current composite rate of 3.36%.
Paper I Bonds can be purchased at most commercial banks that act as agents of the Federal Reserve. You can also purchase them directly from the Federal Reserve. Paper I Bonds are available in denominations of $50, $75, $100, $500, $1,000 and $5,000. Electronic I Bonds can be purchased online via TreasuryDirect in any amount of $25 or more, including odd amounts, like $36.59.
I Bonds are designed primarily for small investors. You can buy a maximum of $10,000 of I Bonds a year for each Social Security number—$5,000 in paper bonds and $5,000 via TreasuryDirect.
I Bonds offer many benefits:
–They’re risk-free. They’re backed by the U.S. Treasury.
–They’re tax-deferred. Even though you purchase I Bonds with after-tax money for your taxable account, they offer tax deferral for up to 30 years. You can elect to report the interest annually if you prefer, but most investors choose the default tax deferral option and thus only pay tax on the accumulated interest when they eventually redeem the I Bonds.
–They’re flexible. They can be redeemed anytime between one and 30 years. That offers lots of flexibility. This flexibility allows you to buy I Bonds when you’re in a high tax bracket and redeem them when you’re in a lower tax bracket, such as after you’ve retired or are temporarily out of work. There is one caveat: If you redeem I Bonds prior to five years, you’ll lose the last three months’ interest.
–They’re free from state and local taxation. This can mean higher after-tax returns for those investors who live in high-tax states, and they’re even better yet for folks who live in areas where they pay both state and local taxes.
–They offer inflation protection. That’s especially important for retirees and other investors who need to protect the future spending power of their current assets. With all the current government spending and deficits, inflation could return with a vengeance. I Bonds protect you against the ravages of both present and future inflation.
–They offer a put option. If future I Bonds offer a more attractive fixed rate, it may make economic sense to redeem the older lower-yielding I Bonds, pay the taxes due on the interest earned, and then buy the newer I Bonds with the higher fixed rate. (Remember, however, if you redeem I Bonds within the five years of purchase, you will forfeit the last three months of interest.)
–You can’t lose money. I Bonds will never return less than you invested in them even if the country enters a prolonged period of deflation.
–You never lose the interest you’ve earned. Since the composite rate can never go below 0%, I Bonds never lose the interest they’ve previously earned, even during periods of deflation. A recent bout of reported deflation took the I Bond composite yield to 0% for a six-month period, but as a result of the 0% “floor,” I Bond holders actually outstripped inflation by more than the guaranteed fixed rate during that period. So, if your I bond was worth $1,903.60 before that period of deflation, it would have been worth $1903.60 after the deflation adjustment period ended. However, because of deflation, that $1903.60 would supposedly buy more goods and services.
In my next two columns, I’ll go into more detail on how I Bonds work and we’ll talk about using I Bonds tax-free for qualifying educational expenses. I’ll also provide you with information on how to track the yield and redemption value of your individual I Bonds. Stay tuned!
Mel Lindauer, CFS, WMS is one of the founders of the Bogleheads community and co-author of The Bogleheads’ Guide to Investing, along with Taylor Larimore and Michael LeBoeuf. He is also co-author of The Bogleheads’ Guide to Retirement Planning, along with Taylor Larimore, Richard Ferri, and Laura Dogu.