Comments on I-bonds

08/19/22 | Birchbrook Team | Boughs & Branches

Why all the love for I-bonds?

I-bonds are the subject of much chatter and for good reason. The current annual rate is a whopping 9.62%. Few other high-quality fixed income vehicles come near that rate, certainly not bank savings or certificates of deposit (CDs). How can a government bond offer such an off-the-charts yield? In large part, it is due to current inflation rates. Before we dig in, a couple of facts about I-bonds:

1. You are limited to one annual I-bond purchase with a maximum investment of $10,000 (unless you are due an income tax refund in which case you can purchase up to an additional $5,000 I-bonds).

2. You cannot hold I-bonds in pre-tax (retirement) accounts or brokerage accounts; purchases must be made through TreasuryDirect or when filing for your income tax refund.

3. You must hold an I-bond for one full year and you may hold it for a maximum of 30 years. If you redeem the bond within the first five years of ownership, you will forfeit the interest earned in the three months prior to redemption. Of course, if the interest rates have dropped significantly, the loss could be negligible.

4. Interest accumulates for the duration of the time you own the bond and therefore is not cash flow available to you.

5. I-bonds are subject to federal income taxes, but they are exempt from both state and local income taxes.

6. Because the interest is added to the balance of the bond and not paid out to you, that accumulated interest income is not taxed until the year in which you redeem the bond.

The yield on an I-bond is a composite of a fixed rate and an inflation rate. The current fixed rate is 0%. Therefore, the inflation rate is responsible for the entire 9.62% annual rate being advertised. Importantly, however, the inflation rate is calculated semi-annually in May and November. Although the inflation rate was determined to be 9.62% in May, an investor today would reap only a fraction of this because I-bond interest resets every six months (in May and November). The inflation rate will reset next on November 1st. Given inflation expectations, it is likely the inflation rate will land somewhere between 7-8% by the time of the next reset (3.50-4.00% on a semiannual basis); lower, but still nothing to sneeze at.

This highlights one key fact to keep in mind when considering I-bonds – their yields fluctuate with the inflation rate. During periods of little-to-no inflation, like the 2010’s, I-bonds will pay much less than the eye-popping yields advertised today. Unlike a traditional U.S. Treasury bond that pays the same fixed amount year after year, an I-bond purchased today is unlikely to keep paying you 9.62% time and time again.

Those with larger portfolios may not find I-bonds to be all that exciting given the $10,000 buying limit. However, it may be possible to purchase an additional $10,000 bond each year as certain types of trusts may own I-bonds. A married couple in which each spouse has a trust, for example, could potentially invest $45,000 in I-bonds in any given year. This could lead to substantial interest income. The caveat is, of course, that the interest rates on I-bonds could drop to as low as 0%, if inflation were to drop precipitously. Therefore, moderation in I-bond investment is key.

If you make annual gifts to your children, grandchildren, or other folks, you might consider giving I-bonds instead of cash. With both the deferred income tax and what could be a very long-time horizon for the investment to grow, an I-bond might be a welcome gift and a great way for youngsters to learn about saving and investing.

We’d be happy to take a deeper dive into this topic to see how an I-bond strategy might work for you. During periods of high inflation, it is only natural that I-bonds be a subject of conversation, and, over the long-run, they can offer some level of inflation protection to investors. Please be in touch if you would like to talk further on this or any other topic.