Wednesday, February 1, 2023

The Curious Case of I-Bonds: Too Good to Be True?

I can’t think of any other investment, off the top of my head, where the rate of return earned two decades ago continues to directly influence what I receive today…with the exception of Series I-bonds issued by the U.S. Treasury. Of course, early compound interest earned also impacts later investment growth, but I’m talking about investment features per se.

Personal Connection

Earlier this week, as part of an annual net worth (assets minus debts) review, I checked to see the value and current interest rate being paid on my twelve I-bonds purchased between 2001 and 2006: three were paying 12.76%, three, 11.30%, and six, least for a six month period. The current rate paid on I-bonds issued through April 30, 2023 is 6.89% and the current fixed rate component is 0.40%. From May 2020 through October 2022, the fixed rate was 0.0% (zero).


Fixed Rate Advantage

How can I be earning more than the current interest rate paid on newly issued I-bonds? Thanks to the high embedded fixed rates of a bygone era when I-bonds could be purchased in person at financial institutions instead of through a clunky website. Since I-bonds were first issued in September, 1998, the fixed rate has ranged from 0% to 3.6% and is adjusted semi-annually. The earliest I-bond adopters (late 1990s) earned as much as 13.39% from May to October of 2022.

I-Bond History

But I’m getting ahead of myself. First, some savings bond history. U.S. savings bonds (Series EE) began in 1935 and inflation-indexed I-bonds, as noted above, began in 1998. In 2008, bond purchases became available electronically and in 2012 paper U.S. savings bonds were no longer issued by financial institutions. Instead, investors were directed to the Treasury Direct website.

Interest Rate Calculation

I-bonds, like any other government bond, are a loan to a government entity, in this case, the federal government. They are currently a high-yielding, low-risk investment paying almost twice the interest rate on a 30-year Treasury bond and about 30x the average savings account rate (0.23% on January 25). Interest is earned monthly and compounded semi-annually. Thus, every six months, interest is applied to a new principal value (i.e., old value + interest earned).

Semi-Annual Interest Rate Changes

The interest (earnings) rate for I-bonds consists of a fixed rate component that remains the same over the life of the bond plus an inflation factor, which is based on the last six months’ Consumer Price Index (CPI). I-bond interest rates are updated every six months on May 1 and November 1 and interest on I-bonds is payable for up to 30 years from their purchase date.

Purchasing Methods

Unfortunately, there is no advertising to tell people about I-bonds. Up to $10,000 of I-bonds can be purchased electronically down to the penny (e.g., $178.36) through Treasury Direct and up to $5,000 (in different increments) of “old school paper I-bonds” (like I have) via a tax refund. I have seen online chatter recently by some people who significantly over-withhold income tax to buy paper bonds to avoid online hassles. When purchasing I-bonds online, investors must provide their Social Security number or other taxpayer ID and bank routing/account number.

The Real Deal

In summary, we have experienced a historically high inflationary time period these past two years which makes I-bonds a very attractive place for cash assets. The rate of return on I-bonds will eventually decrease when inflation decreases, but it will never fall below zero so investors can’t lose money. I-bonds are not “too good to be true” if you understand how they work and their limitations (e.g., annual purchase limits and inability to cash out within a year of purchase).

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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