A Close Eye on I Bonds

May 26, 2022

With the stock and bond markets in turmoil and inflation topping 8%, it is only natural for investors to seek any investment that offers attractive returns. Enter I Bonds – the latest bright, shiny object to grace the investment scene. Much has been written about I Bonds in recent months especially given the 9.6% interest they currently offer. Not surprisingly, I Bonds are proving to be very popular. In the past six months alone, $11 billion of I Bonds were issued – nearly matching the entire issuance of I Bonds during 2020 and 2021 combined.

What exactly are I Bonds, and how do they work? And what are the pros and cons of investing in them?

What are I Bonds?

I Bonds are a specific type of bond issued by the U.S. Treasury designed to protect against losing value due to inflation. Like all bonds, I Bonds are essentially loans (in this case to the U.S. government) with a promise to repay at some point in the future with interest. With I Bonds, the interest rate is broken down into two components – a fixed rate set by the Treasury upon issuance and an inflation-adjusted rate determined by the rise and fall in inflation. The inflation rate is tweaked every May and November.

Unlike with many bonds, holders of I Bonds do not actually receive interest payments. Instead, the interest accrues and only gets paid out when the bonds are redeemed. All I Bonds are issued with 30-year maturities. They can be redeemed prior to maturity, but by doing so, the bondholder may forego the full amount of interest (more on this later).

Because I Bonds are issued by the U.S. government, the interest (when received) is exempt from state and local income taxes. However, the interest is taxable at the Federal level. Since I Bonds do not actually pay interest until redemption, bondholders can defer recognition of this taxable interest until the bonds are redeemed. In some cases, one might want to recognize the accrued interest each year rather than all at once at redemption.

Pros and Cons of I Bonds

While the chance to earn a 9.6% yield in this environment seems like a no-brainer on the surface, there are several pros and cons to consider when investing in I Bonds.

Pros

    • The current yield on I Bonds is higher than the expected return on stocks and other bonds without many of the risks of those investments.
    • Since I Bonds are issued by the U.S. Treasury, there is no risk of principal loss if the U.S. government remains solvent.
    • The tax on the accrued interest can be deferred until the bonds are redeemed. Also, I Bonds may be completely tax-exempt if used for college tuition (only for lower and middle-income families).
    • I Bond yields could go even higher if inflation increases or if the U.S. Treasury decides to raise the fixed interest rate component on future I Bond issuances (it is currently 0%).

Cons

    • As attractive as I Bonds appear, you cannot put all your money into them. I Bond purchases are limited to $10,000 per person per year (plus an additional $5,000 through one’s tax refund, if applicable).
    • I Bonds can only be purchased directly through the U.S. Treasury (www.treasurydirect.gov). They cannot be purchased or held at Schwab or other custodians. Furthermore, the Treasury site can be cumbersome to use and is not known to be particularly user-friendly in general.
    • I Bonds cannot be purchased in retirement accounts (IRA, 401k, etc.). For investors in higher tax brackets, it is preferable to own taxable bonds (I Bonds, other Treasury bonds, corporate bonds, etc.) in tax-deferred/retirement account over a taxable account for tax reasons. Not being able to do this with I Bonds may lower one’s after-tax return.
    • I Bonds have limited liquidity. They cannot be traded like other bonds. They must be held for at least a year after purchase. And if they are redeemed within the first five years, the bondholder foregoes the last three months of interest. I Bonds are also only issued with 30-year maturities and are thus a long-term investment.

One other very important thing to keep in mind: the current attractiveness of I Bonds is due solely to the fact that inflation is at its highest level in 40 years, and I Bonds are reflecting that fact in their 9.6% yield. The entire 9.6% yield comes from the inflation component. The fixed rate on I Bonds is currently 0%. If one purchases an I Bond today, that 0% fixed rate is locked in for the life of the bond. When inflation eventually comes down, the inflation component of the yield will also come down. And, if we do ultimately return to a low inflation environment, I Bonds will no longer be as attractive as they are now and as compared to other non-inflation adjusted bonds. Furthermore, I Bonds are at their core Treasury bonds. And because the risk of the U.S. government defaulting on its debt obligations is minuscule, the fixed rate one can get on a Treasury bond will always be lower in general because the credit risk is lower.

When you buy a non-inflation-adjusted bond (a regular Treasury bond, corporate bond, municipal bond, etc.), you get compensated for inflation risk through a higher yield. And although those bonds do not seem very attractive now because the sharp spike in interest rates caused bond prices to drop dramatically, over time, as a bond investor, you reap the benefits of higher interest rates. Ultimately, the coupon (interest) payments make up 90% of a bond’s return.

As with any investment that, on the surface, appears too good to be true, it is critical to get “under the hood” to make sure you fully understand the pros and cons. Such is the case with I Bonds. And while I Bonds can certainly be one component of an overall portfolio, they should not and really cannot be the entirety of one’s portfolio.

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