A Personal Foray Into the I Bond Craze

There is a new investment fad, a nice diversion from crypto frankly, with headlines promoting near 10% guaranteed returns. The investment product is a Series I Savings Bond, or I bond, which, along with the more common Series EE bonds, are issued directly by the U.S. government. Given that U.S. government savings bonds are arguably the most secure bonds in the world and practically guaranteed, a return of 10% is extremely tempting. However, as is with most investment products, the devil is in the details. Here's what I learned as I took a leap into the I bond craze:

How Does the Interest on I Bonds Work?

An I bond is a security, or bond, that earns interest based on both a fixed rate and a variable rate that is set twice a year based on inflation. The fixed rate is currently 0%, so not much to brag about there, but the variable rate is where things get more interesting. The Treasury Department sets the variable rate on the first business day of May and November, and the rate for an investor’s bond will change every six months from the date it was purchased. For example, let’s say you purchased an I bond in April, then the bond would maintain that month’s effective rate — which was set on the first business day of the previous November — until October 1. At that point, the bond would assume the rate set on May 1 for the next six months. Confusing, I know. 

Here’s what is more straightforward. Bonds issued from November 2021 through April 2022 have a variable/combined rate that was set at 7.12%. We also know (or highly expect) that beginning in May the interest rate on I bonds will begin to offer annual interest payments of about 9.6%, based on the bond’s latest inflation-rate calculation, which is tied to March’s consumer-price index. So, if an investor waits until May 1st to purchase an I bond, the return will be annualized at 9.6% for six months until the new variable rate kicks in for the November through April time period. Beyond that time frame, there is uncertainty as to what the future rate will be.

Timing the System

Given the six-month rate periods, someone who purchased I bonds in April at the 7.12% rate would lock that rate in for around six months. On Oct. 1, the rate set on May 1 — which as I mentioned is likely to be 9.6% — would then take effect for the next six months. That amounts to roughly 12 months of guaranteed yields averaged at about 8.3%! 

Contrast that with someone who waits to purchase an I bond when the estimated 9.6% variable rate kicks in on May 1st. Yes, that buyer would have a higher guaranteed rate until Nov. 1 of 9.6% instead of 7.12% until the variable rate changes on the first business day of November. If inflation continues to climb, that November rate might end up even higher. However, if as some predict, inflation declines by then, that investor runs the risk of locking in a lower rate for the following six months.

How to Purchase I Bonds

Purchasing the security may actually be the most frustrating part of I bonds. They cannot be purchased through a financial advisor or custodian like TD Ameritrade, but instead must be purchased electronically through the government’s website at treasurydirect.gov. While most people contend that the website is frustrating and appears to have been built around the turn of the century, I found it to be rather informative, and there are various videos to help along the way. Also, be prepared to input your banking information and just about every other identifiable piece of personal information that you have. People who are a bit computer savvy should be able to complete the purchasing process in under a half hour. Others have been known to abandon purchasing bonds altogether because of the website. 

Also, be aware that you pretty much have to purchase the bonds through your checking account. The I bonds specifically cannot be purchased in the likes of an IRA, 401k plan, or standard investment account. The U.S. government serves as your custodian and you must use after-tax funds to make the purchase, thus making the investment taxable.

The Gotchas

As might be expected, there are limitations with this investment product. To start, each person is restricted to purchasing only $10,000 worth of bonds per calendar year. There are some workarounds to acquire more, which you can do via a trust or a business entity (or buying some under your kids’ names), but for most of us we are limited to that $10,000 purchase. Another option for people really yearning for I bonds is you can use up to $5,000 of your tax refund each year to purchase the bonds. However, it is important to note that if you purchase the bonds using your tax refund (and you must have a refund versus owing taxes), you will need to complete Form 8888 and will receive the bonds as a paper certificate, which you will need to store safely. I would never want to tread there myself, but I am making a note of it.

Possibly the largest caveat is that you are unable to redeem the bond within the first year, and if you redeem the bond within five years then you must forgo three months of interest. Quickly you might see how the “10% guaranteed return” starts to dissipate given the uncertainty of future inflation rates. The person who invested in April, basically locking in about 8.5% in my example above, is looking at only a 6% return if redeemed after one year. 

Taxes

While I mentioned that I bonds must be purchased in a taxable account, there is a little bit of good news around taxes. First of all, if you live in a state with high income taxes, like I do in California, you do not have to pay state income taxes! Also, unlike typical bonds, you do not have to pay federal taxes on the bond interest until you redeem your bond.

That said, you will likely have to pay federal income taxes on the bond interest at some point. If we assume that inflation will eventually subside to its historical 2% to 3%, then an investor in I bonds may want to sell before the five-year holding period. If we use my example above of an investor selling after one year, and assuming a 33% marginal tax bracket, the I bond return quickly falls from the 10% headline return to a realized 3.8% after-tax return, well below historical stock returns!

One positive note on taxes is that if you use the funds to finance qualified education expenses, then you might be able to fully exclude the interest from your federal income tax. Thus, I bonds may be a bit more appealing if you have children who are headed off to college in the next five years and you don’t have college costs fully covered by a 529 plan.

Conclusion

For a long-term investor, I wholeheartedly believe that the best way to position yourself for investment success is by being an investor in companies versus a lender to the federal government. Therefore, buying stocks in companies, with preferred long term capital gain tax treatment, is likely a better alternative. Still, I can see situations where I bonds might be an appropriate savings and investment tool for someone with shorter term cash needs, especially if they are education related and qualify for favorable tax treatment. The bottom line is each person’s financial planning situation is unique and there is no one-size fits all answer here as many headlines may lead you to believe.

In case you’re wondering, ultimately I did make a direct $10,000 I bond purchase in April, locking in that 7.62% rate for the next 6 months. For full disclosure, these are the only bonds that I own in my portfolio, so I do not expect it to be impactful and I thought it would be a fun exercise. Also, in retrospect I was probably having a personal Fear Of Missing Out moment, getting caught up in the hysteria, which heavily contributed to my purchase decision. Fortunately, I believe that if you are going to have a FOMO investment experience, do it with something that can’t hurt your long-term investment strategy, and here the only real downside with this $10,000 investment is the opportunity cost of investing in the stock market instead.

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