I-Pod, I-Phone… now I-Bonds??

Inflation-linked savings bonds (I-bonds) are bonds issued by the US government that are designed to protect your investment during periods of high inflation. I-bonds are currently generating an astounding initial annual yield of 9.6% (as of 5/1/2022). After many years of very low interest rates on bank deposits and bonds, this has a lot of folks really excited. Who wouldn’t want to own a bond guaranteed by the US government that produces 9.6% per year? I-bonds are right for some, but they certainly are not a one size fits all solution, so we break down the pros and cons of I-bonds below.

How Do I-Bonds Work?

Like most bonds, when you own an I-bond, you are paid interest at some interval. With most bonds that interest rate is set when the bond is issued, and doesn’t change. However, with I-bonds the rate is reset every six months, and is based on actual inflation over a recent six month period.

Every six months the Treasury Department announces a new issuance of I-bonds, with the following attributes:

• Fixed rate: This is a rate that will persist throughout the term of the bond. For the most recent issuance, the fixed rate is an annual rate of 0%.
• Inflation rate: This is a rate that will change every six months, as we noted above, based on actual inflation for the most recent reported historical six month period. For the most recent issuance, this rate (as noted) is an annual rate of 9.62%, which is fixed for the first six months the bond is owned.
• Combined rate: The combined annual rate can get a little complicated because it includes a compounding factor, but essentially, it is the fixed rate plus the inflation rate, which is currently 9.62%. So for the first six months, the bond will earn 50% of that annual rate, or 4.81%. After the first six months, a new inflation rate adjustment will be calculated and announced, and the combined rate for the next six months will be approximately the fixed rate (currently 0%) plus the new inflation rate, divided by two. If you buy an I-bond now, that fixed rate will stay the same for as long as you hold that bond.
• Minimum composite rate: It is also important to note that the composite rate on an I-Bond can never go below 0%.

The inflation rate is calculated every May and November (the current being 9.62% annually, or 4.81% for six months). So, the inflation rate and fixed rate are changed beginning on May 1 and November 1 of every year. Right now, an investor can buy an I-bond at any point in time between now and October 31st and receive the 9.62% annualized rate for 6 months after the date of purchase. For example, if you buy a bond in October of this year, you will receive 9.6% annualized, until your next rate change in April of 2023.

Some Benefits

• I-bonds allow investors to jump in and benefit from high inflation that already happened, at least for the first six months of their investment, so there is some benefit of hindsight.
• During periods when after-inflation yields on bonds and money market funds are negative, which has been the case recently, I-bonds offer a better return than can be had with other high quality fixed income securities – sort of a free lunch, which is exceedingly rare in the investment world.
• If the proceeds from these bonds are used to pay qualified education expenses, the interest may be tax-free.

Some Drawbacks

• Probably the biggest drawback with I-bonds is that the purchase amount per year is limited. In total, a person can buy up to $15,000 of I-bonds per year. $10,000 can be purchased online through treasurydirect.gov, and an additional $5,000 can be purchased through the IRS when filing your tax documents via form 8888.
• Another drawback is lack of liquidity. An I-bond cannot be redeemed within one year of purchase. There is also a penalty for redeeming within 5 years of purchase, which is the forfeiture of the last 3 months of interest owed on the bond.
• Finally, for those looking to receive a regular interest payment, this bond is not for you. I-bonds don’t pay out interest, but rather accrue it and pay it out when the bond matures or is redeemed. A plus to this attribute is that there is some flexibility with the taxes due on earned interest — it can either be paid annually or when the bond matures or is redeemed – but for those looking for regular income, this attribute can be a drawback.

I-bonds aren’t for everyone, and their value is limited by the relatively small allowed investment amounts. However, for those who just can’t ignore what is one of the few and far between free lunches in the investment world, they are probably worth a look.