Are I bonds a good investment?

When U.S. pandemic-era inflation peaked at over 9% in June 2022, Series I savings bonds began to receive massive attention from investors.^1,2 In fact, the U.S. Department of Treasury announced a six-month record interest rate of 9.62% from May to October 2022 – the highest amount since I bonds were introduced in 1998.²

But now that inflation is cooling down, so are interest rates.

From May to October 2023, each Series I savings bond issued will offer 4.3% interest with a fixed rate of 0.9%.³ This has left many investors wondering whether they are still a good investment.

To find that out, let’s take a look at what an I bond is, how it works, and the unique advantages and disadvantages it has for investors.

A Series I savings bond is a type of U.S. Treasury bond that earns interest from two different rates: a fixed rate and a variable inflation rate. While the fixed rate remains the same throughout the bond lifecycle, the variable rate adjusts every six months based on changes in the consumer price index. Because the interest on I bonds is largely tied to inflation, they are a popular choice for investors during times of rising consumer prices. However, they aren’t the only savings option from the Treasury Department.

Series EE bonds are a close cousin to I bonds. They both:

●      Have a minimum purchase amount of $25

●      Can be sold after one year

●      Earn monthly interest

●      Compound interest semiannually for up to 30 years

Unlike I bonds, which adjust for inflation without guaranteeing returns, EE bonds offer a single fixed rate of 2.5%, promising to double the value of your initial investment after 20 years.⁴ This fixed bond yield is ideal when interest and inflation rates remain low for an extended period of time.

The Treasury Department designed Series I savings bonds to offer the average investor a low-risk security option backed by the U.S. government. However, the safety of a government bond means it offers a relatively low return when compared to riskier, high-yield options like municipal or corporate bonds.

Instead, I bonds are more akin to a certificate of deposit or high-interest savings account when it comes to returns.

While Series EE bonds come with a maximum annual purchase limit of $15,000 per investor, I bond investments are capped at $10,000. Both bonds can earn interest for a maximum period of 30 years, but with EE bonds, the rate remains the same for only the first 20 years, after which it may change. You can also sell I bonds after only one year, but anything sold less than five years after purchase will incur a penalty of at least three months’ interest.

Because I bonds come with two interest rates, it can be difficult to determine the actual amount you’ll receive. Fortunately, the Treasury sets a minimum composite interest rate of 0%, so even in the worst case, you’ll still recuperate your initial investment.

To calculate your composite rate, or total bond yield, you can use the following formula:

Composite Rate = Fixed Rate + (2 * Semiannual Inflation Rate) + (Fixed Rate * Semiannual Inflation Rate)

For instance, using the current rates from the Treasury Department,⁵ the composite rate will be:

●      CR = 0.009 + (2 * 0.0169) + (0.009 * 0.0169)

●      CR = 0.009 + 0.0338 + 0.0001521

●      CR = 0.0429521

In other words, you could expect an I bond yield of about 4.3% over the next year.

Series I bonds are considered zero-coupon bonds. This means that they don’t pay interest during the lifetime of the bond, instead adding it to the total value to earn greater interest. Therefore, you don’t have to pay taxes on interest until you redeem an I bond. While there are no state or local taxes related to the investment, you will have to pay federal taxes.

As a bondholder, you have two options to pay this:

1. Cash method: You pay a lump sum in taxes once you sell the bond.
2. Accrual method: You pay yearly taxes on any interest earned.

The government also considers some I bonds interest tax-free if you exclusively use the interest to pay for a qualified higher education expense.

Due to the relative safety and tax-deferred interest of I bonds, they’re often an attractive investment option for those nearing retirement. Many couples choose to invest $20,000 each year to build a staggered source of income.⁶ After 20 years of this, they’ll have a reliable income that adjusts to changing consumer prices.

At the same time, however, inflation has been ebbing recently, sending the variable interest rate down to 4.3% from May to October 2023. As a result, the returns from I bonds – while solid – are falling slightly.

Now that we have a good understanding of what I bonds are and how they work, let’s take a broader look at the unique advantages and potential pitfalls of these investments.

●      The variable interest rate can offer competitive returns during times of inflation

●      They carry low risk because they’re backed by the U.S. Treasury Department

●      They can help diversify and balance riskier portfolios

●      The interest can be tax-deferred, unlike other bonds or bond funds

●      The inflation-adjusted interest rate ensures your savings won’t lose buying power

●      Variable rates can fall (and are currently falling) with inflation

●      You can’t touch the money for one year

●      Early withdrawals before five years will incur penalties

●      There is a $10,000 annual investment limit per Social Security number

●      You can’t buy I bonds in tax-deferred accounts

●      As part of a portfolio, I bonds are more difficult to rebalance over time, relative to bond mutual funds or ETFs

Ultimately, the decision to invest in I bonds will depend on a number of factors, from your financial goals to your timeline.

If you’re looking for a relatively safe investment to hedge against inflation and earn interest on your savings, they’re an excellent choice. However, it’s important to understand how the rules and tax implications will impact your finances down the line. Be prepared to hold I bonds for at least a year and, ideally, five or more to avoid penalties and get the most for your money.

As an alternative to I bonds, Treasury Inflation Protected Securities may suit some portfolios better. Mutual funds or ETFs that invest in TIPS can provide inflation protection, and they are liquid investments that can be bought and sold in small amounts to facilitate portfolio rebalancing over time. They can be held in tax-deferred accounts as well.

To purchase I bonds, you can visit the TreasuryDirect website or use your federal tax refund to buy up to $5,000 of paper I bonds.

Before you start changing your investment strategy to incorporate I bonds, it’s always best to consult with a professional.

At Edelman Financial Engines, our financial advisors use an integrated approach to wealth management, taking all your investments, tax obligations, insurance policies, retirement and estate plans into consideration. Supported by a team of experts, they’ll advise you on a strategy to help build, grow, protect and preserve your wealth.

Contact a financial advisor today.