An I bond is a type of savings bond issued directly by the U.S. government to consumers. In contrast to well-known EE savings bonds with a form of fixed coupon, I bond yields are inflation-linked. They’re an interesting vehicle, with a few caveats. Purchases have to be made directly through the U.S. Treasury’s Treasury Direct website, an online portal created to maintain electronic records of government securities offered to the public, as paper securities have been phased out. (A person could also use the account for buying EE savings bonds, Treasury bills, notes, TIPs, etc.—intended for long-term holdings, as it’s not a standard trading platform.)
Pricing of I bonds consists of a fixed interest rate (currently 0.00%, updated semiannually) plus a variable inflation rate, which is also calculated semiannually and pegged to trailing CPI (announced in May and Nov. each year). Therefore, the total yield credited will change every six months. After living in relative obscurity since their inception in 1998, the recent inflation crediting rate of 7.12% (annualized, through 4/30/22) has caused I bonds to gain some attention in the press.
Pros:
- The inflation rate is variable. Therefore, like TIPs in a sense, credited interest rates rise directly with recent CPI. The higher the inflation, the more favorable the rate. This makes these different than other savings bonds and traditional fixed income, and even TIPs, which actually pay a fixed rate and the principal being the part that changes.
- Market values don’t change as with other bonds and TIPs—just the interest rate—so principal is protected. Savings bonds have this unique quality, as non-marketable government debt.
- Interest earned automatically reinvests as new principal. Technically, these are considered ‘zero-coupon’ debt due to this characteristic.
- Interest from U.S. government obligations is state income tax-free. (It’s taxable on a Federal level, with some exceptions when principal is used for qualified higher education expenses.)
- Taxes on interest can be deferred until redemption or maturity (but can be claimed annually if desired).
- U.S. treasury debt is considered ‘risk-free’ from the standpoint of credit rating agencies and markets generally when assessing risks of default, so it appeals to those seeking absolute safety.
Cons:
- The inflation rate is variable. The credited rate is a combination of a fixed rate and inflation-based variable rate. If period-over-period inflation goes negative—which is not common, but has happened several times since 1998—the rules state that the ‘deflation’ rate will subtract away from the fixed rate. (However, overall crediting interest rates have a floor of zero, so can’t ever go negative.) If CPI deflated now, for instance, the bond would pay zero interest for six months or longer, since the fixed crediting rate is 0.00% (hence, no buffer). This is the risk/return trade-off you get with any inflation-linked securities.
- Purchase cap. Investments are limited to $10,000 per person per year ($20,000 married/joint), plus an extra $5,000 cap if tax refund money is used to buy I bonds directly.
- Liquidity. The bonds are tied up for at least 12 months. If they’re cashed out within the first 5 years, one forfeits the last 3 months of interest. The stated maturity is 30 years.
- This involves some extra work, including setting up an account with Treasury Direct, with the additional tax reporting, etc.
For broader concerns about inflation, in the context of a total portfolio, certain assets provide stronger protection than others, as we’ve seen over the past few years. Again, the fact that this being discussed to such a degree in the mainstream media could mean we’re closer to the end than the beginning.
- Commodities, while volatile individually in their own right, have a very high inflation ‘beta’ of roughly 10x. This means they ‘punch above their weight’, so to speak, in a portfolio, due to the fact that various commodity items are both driven by inflation as well as can be causes of inflation themselves (such as crude oil, grains, and industrial metals).
- Real estate has the reputation as a solid inflation hedge, due to the fact that real asset price appreciation can follow inflation and landlords have the ability to raise rents as needed to keep up with broader price pressure.
- Equities have been effective while inflation remains contained to moderate, as companies have often been able to raise prices and keep margins intact as inputs costs rise. However, extreme inflation episodes (as in higher single-digits) have been more challenging for equities, since such environments can dampen economic growth overall and reduce the ability to pass on high input costs.
- With the exception of TIPs, traditional bonds have generally not fared well under high inflation, unsurprisingly due to the fact that interest rates have historically risen in these environments. However, shorter-duration bonds, including floating rate bank loans, have fared far better as interest rates are able to ‘float’ upward with market interest rates.