I Bonds Beat Inflation By 0.9% Guaranteed. Should You Invest?

This article was updated on May 1, 2023 to reflect the latest I bond rates.

Why Are You Hearing So Much About I Bonds Right Now?

Series I Savings Bonds (aka I bonds) have been out of the investing conversation for the last two decades. During that time, they have promised to just keep up with inflation, which remained low and under control, with no real upside potential.

In Nov 2021 they began to make headlines again when the interest rate spiked to a guaranteed annualized 7.12%. By May 2022, they shot up again to 9.62%, at a time when the stock markets and intermediate treasury bonds were both down 20% from recent highs. Then they cooled off to 6.89% in Nov 2022.

As of May 2023, the rate for new purchases sits at 4.30%. Less than half the rate of 1 year ago. But the fixed rate, the portion that is guaranteed to beat inflation, is up from 0% to 0.9% at the same time.

The I bonds you bought a year ago will fall to 3.38% after their next 6-month inflation adjustment, and at that point May – Nov 2023 I bonds will have a more attractive rate!

So what are I-Bonds, how do you buy them, and do they fit into your long-term investment portfolio?

What Are I Bonds Anyway?

Series I Savings Bonds are a type of savings vehicle provided by the US Treasury that’s designed to keep pace with inflation. They have a fixed rate that is determined the day you buy the bond plus a variable rate that changes on May 1 and Nov 1 every year. The variable rate is determined by the Consumer Price Index for all Urban Consumers (CPI-U). Interest compounds semi-annually, which means that your interest earned after each 6-month period also earns interest over the next period.

Until now, the fixed rate hadn’t exceeded 0.5% since Nov 2008. It was 0% between May 2020 and Oct 2022. The best news with the May 2023 rate change is that it came with a 0.9% fixed rate. This means an I bond purchased between May 2023 and Oct 2023 will beat inflation by 0.9% for as long as it is held.

Compared to stocks, which have an average return of about 7% after inflation, a 0.9% real return is not very large. But stocks come with risk and volatility over shorter periods of time. This might give I bonds a place in a portfolio that has shorter-term income needs.

The CPI-U is down from its 2022 highs, and accounts for 3.38% of the current 4.3% rate. In the 23 years from 1998-2020, the average CPI-U was barely over 2% on an annualized basis.¹

For those who are following closely, the other 0.02% in the current 4.3% rate comes from the way the fixed and variable rates are mathematically combined. The formula can be found here.

You also may know that the October CPI-U came in at 5.0%, not 3.38%. I won’t go into the details of how the I bond rate is calculated, but if you simply take the average of the last two rates—6.48% and 3.38%—you get 4.93%. With compounding, this equals a 5% return and matches the CPI-U.

Once you buy an I bond, you must hold it for a minimum of 1 year. After that, you are free to sell it. However, if you don’t wait at least 5 years to sell you will lose the last 3 months of interest. After a 5 year holding period, there is no penalty and you can sell at any time.

I bond interest is free of state and local taxes. The IRS collects federal income tax on earnings, though. No tax is due if the money is used for qualifying education expenses, which makes I bonds a candidate for college savings plans or your own continuing education.²

How Do You Buy I Bonds?

Series I Savings Bonds can only be purchased (electronically) through the archaic TreasuryDirect.gov website. They cannot be traded on the open market, and therefore their price does not fluctuate the way that publicly traded government bonds do. In a time of fast-rising interest rates, I see this as a feature, not a disadvantage.

You can only purchase $10,000 in I bonds electronically each year per social security number in your household. This includes your minor children, whose bonds remain in your custody as long as they are under your guardianship.

It’s possible to buy an additional $5,000 in paper I bonds by mail through your tax return (talk about Stone Age!). But this requires that you have overpaid your federal taxes by at least that amount, effectively giving the government an interest-free loan. Not the best strategy.

There is one more advanced trick for increasing the number of I bonds you can buy annually. If you have other entities such as a trust or a business, then you can buy another $10,000 of I bonds per year under each of those taxable entities.³

For my situation, this means each of my 3 family members can buy $10k of I bonds and each of my two LLCs, one for rental properties and one for Pathway to FI, can also buy $10k for a total of $50k/year!

Are I Bonds A Good Investment?

In a high inflation time, I bonds are a good way to safely store your money without losing value (until federal taxes are taken into account). As I mentioned, they will not grow much in real (inflation-adjusted) terms since newly purchased I bonds are paying a 0.9% fixed rate on top of the CPI-U rate.

But if you bought I bonds to get the 9.62% rate a year ago—as I did—your fixed rate is 0%. After the first 6 months, they adjusted to 6.48%. And as soon as the 6 months at 6.48% is over, those bonds will pay 3.38% (not 4.3%) for the next 6 month period. At that point, newer I bonds will be paying a higher rate.

The low real (inflation-adjusted) returns are a problem when you’re considering them as a part of a retirement portfolio. You want your investments to significantly outpace inflation so that you can reach financial independence sooner!

So while I bonds provide some stability and inflation protection in a portfolio, it wouldn’t be a good idea to replace a significant portion of stocks in your portfolio if you are still 10 years or more away from retirement.

Are I Bonds A Good Replacement For Other Government Bonds?

As I write this May 2023 update, 3-month Treasury bills are paying over 5%. T-bills have the same tax advantages as I bonds, so this makes them more attractive over the next 3-month period. However, we don’t know for sure where rates will go from there.

Even short-term government bonds—one of the lowest yielding, but safest asset classes people invest in—have a median positive real growth rate of 2.2% per year over every 10-year period since 1970.⁴ This included a very high inflation period in the 1970s. Government bonds also have an inverse correlation with stocks during economic recessions (they go up while stocks are going down), which can make them useful in some portfolios.

I bonds are not correlated with stocks, but do not have the same characteristic of going up during a recession unless the recession happens to be accompanied by high inflation. So if you’re worried more about recession than inflation for your portfolio, Treasury bills or bonds may be better for you.

Are I Bonds Better Than TIPS?

Treasury Inflation-Protected Securities (TIPS) are the closest cousin of I bonds based on their tie to inflation, with a major difference being that they are priced and traded daily on the open market. Because of this, TIPS have more volatility than I bonds. They currently have much better 5-year real yields—well over 1%—so you should probably not think about replacing them with I bonds in your long-term investment portfolio.

I bonds are a bad place to invest money you don’t need for 10 years or more.

Can I Bonds Be Used As A Savings Account?

I bonds are called “savings bonds” because their intended use is as a savings vehicle and not necessarily as an investment. High yield savings accounts just began offering interest rates of more than 4% in 2023. But interest on those accounts isn’t tax advantaged. Therefore, a better use for I bonds—even in today’s environment—is in place of a high yield savings account when you live in a high income tax state and can afford to leave the money alone for at least 1 year.

If you started purchasing them a couple years ago, as I did for each family member, and bought some again last year, then you are creating what is called a “bond ladder”. The money you put in more than 1 year ago is now available to take out immediately if an emergency or other need arises.

I’m planning a trip around the world in a few years. I also have some home renovation to do over the next couple of years. These are perfect uses for I bonds.

I Bonds Are A Good Savings Account For Money You Need 1-5 Years From Now!

Even if you pull out your money after 1 year and forfeit the last 3 months of interest, you will probably end up ahead of a high yield savings account. Here’s an example:

Let’s assume your savings account averages 4% interest, compounded monthly, over the next year. If you don’t know where you can get this kind of return, check out the Wealthfront Cash Account, where I get 4.3% as of this update. Fully FDIC insured.

Now let’s assume that inflation stays at 5% between April and October. The variable rate on I bonds would go up from 3.38% to around 6.6% to bring the average compounded 12-month return to 5%. And the fixed rate of 0.9% would add to that, for a new 6-month return around 7.5%.

If you buy I bonds before November, you’ll get a full 6 months of interest at 4.3%/year, which comes to 2.15% for half the year, and the other half of the year will also pay a total of 3.75% (7.5% for 6 months). The 3.75% drops by half when you take the money out and forfeit 3 months of interest. But you are still left with a compounded 4.07% return for the year.

Your savings account interest will be taxed by the state. Your I bond interest won’t. If your state taxes capital gains at 4%, for example, your savings account return will drop by 0.16% to 3.88% but your I bonds return will remain at 4.07%.

This example shows that if inflation is not reduced further, and for those who live in a high income tax state, I bonds may still perform well compared to a high yield savings account. But the case is not as good as it was a year ago when savings accounts were yielding in the 2% range.

Example of interest earned by I bonds versus high yield savings account if the variable rate goes to 6.6% and money is spent after 12 months, assuming 4% state capital gains tax

Summary

Though I wouldn’t advocate putting I bonds in your long-term investment portfolio, they may have a place in your financial life these days.

I bonds have recently offered interest rates that are comparable to high yield savings accounts. This makes them useful as a short-term savings vehicle for money that you can afford to hold for at least 1 year. Particularly if inflation remains high.

If you are at the Trailhead, just starting your financial journey, you may not have much use for I bonds yet. Particularly if you have high interest credit card debt, your resources will be better allocated toward debt payoff over the next 6-18 months.

At the Ascent stage of your financial journey, where you are saving and investing aggressively on your way to financial independence (FI), your use for I bonds might be as a bond ladder for your emergency fund. For instance, put in half this year and the other half next year. You could also consider using it for a “sinking fund”, where you are saving up for a big purchase in cash. For instance, if you are buying a car in cash 5 years from now, you can start loading up I bonds for that purpose.

At the Summit and Descent stages, you are already FI. On top of emergency fund and sinking fund savings, you may have an additional use. You could start storing money here to cover some of your upcoming expenses that you would normally hold in cash.

Do you have too much money stashed in savings accounts, where you’re paying a high state income tax rate?

Could I bonds be a better place for your shorter-term savings or income needs?

This article was originally published on PathwayToFI.com and appears here with permission.