Why Buy I-Bonds?

by Michael on Apr 24, 2013 · 1 comment

Photo of Definition of Inflation

I’ve received a couple of inquiries about why I’m such a fan on Series I Savings Bonds, so I thought I’d spend a bit of time discussing that today.

As a reminder, I-Bonds are low-risk, inflation-indexed savings bonds that are issued (and backed) by the Federal government.

So what’s so great about I-Bonds? In my view, the advantages lie in the inflation protection, the tax benefits, and the relatively lax redemption policy that gives you access to your money if/when needed.

Inflation protection

Because I-Bond rates are indexed to changes in the CPI-U, they provide a degree of inflation protection. Unfortunately, because the fixed rate has been stuck at 0% for the past several years, your real return (before taxes) is 0%.

But even with an expected real return of 0%, I-Bonds serve an important role in our portfolio. They’re a cash-like holding (once you get past the first year; see below) that’s backed by the full faith and credit of the US Treasury. Not only will they hold their nominal value, they’ll also (more or less) protect your purchasing power.

Tax benefits

Another nice feature of savings bonds (including both I-Bonds and EE bonds) is that their earnings are exempt from state and local taxes. Not only that, but you can defer your Federal tax burden until you redeem the bond (or it reaches maturity). Thus, they provide you with an IRA-like tax deferral.

Better still, if you use your savings bond proceeds to pay for college, the interest earnings will be completely tax free. As always, this is subject to some restrictions (see IRS Publication 970 for details), but it’s a great benefit if you qualify.

It’s worth noting here that these tax benefits translate into higher effective interest rates. Let’s say that you normally face a state and local tax burden of 6%. In that case, the current 1.76% variable rate is the equivalent of a fully-taxable 1.87%. And if you can avoid Federal taxes, too, the situation is even better.

Assuming that you’re in the 25% tax bracket (for a 31% total tax burden), then the current 1.76% variable rate has a tax-equivalent yield of 2.55%. Quite a difference. And considerably better than current risk-free rates of return.

Redemption policy

Finally, while you can’t redeem your I-Bonds within the first 12 months, you can redeem them anytime thereafter in exchange for a 90 day interest penalty. Note that, during periods of low inflation, this penalty could be very low. And after five years, the penalty goes away entirely.

It’s also worth noting that the initial 12 month period could be as short as 11 months and a day (if you buy late in the month). This is because, no matter when during the month you buy your I-Bonds, you’re credited for a full month of ownership.

The downsides

And now, for a bit of balance…

Probably the biggest downside of I-Bonds right now is the aforementioned 0% fixed rate component. Back when they were first introduced (1998), I-Bonds had a fixed rate of 3.40% (plus the variable rate). The fixed rate got as high as 3.60%, but ultimately dropped below 3.00% in 2001 and fell steadily from there.

If you were lucky (or insightful) enough to buy I-Bonds back then, you should do whatever you can to hold onto them until maturity. There’s simply no way to find that sort of guaranteed real return nowadays.

The other downside has to do with purchase limits. While purchase limits were initially $30k/individual, they were reduced to $10k/individual in 2008. Thus, while it’s possible to pick up an extra $5k with your tax refund, you really can’t deploy a significant amount of cash all at once.

I suspect that these restrictive limits are there, at least in part, to prevent people from simply cashing out all of their I-Bonds and re-buying if/when there’s a significant improvement in the fixed rate landscape.


1 Scott @ Youthful Investor May 26, 2013 at 9:26 am

That was a great introduction to inflation protected bonds. Now, if I may ask, since they are at 0% or near 0% when do you think that will change?

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