Investing can feel like a roll of the dice for the uninitiated. News of trendy meme stocks, cryptocurrencies, and NFTs turning teenagers into millionaires reinforces the misconception that investing is no more than a gamble.
In truth, it is if you treat it like one, but there are safe strategies and assets for those with a long-view and low-risk tolerance who want to protect their savings from inflation—Bonds.
Bonds are financial instruments issued by public and private entities like governments and companies. When you purchase a bond from an entity, you purchase their securitized debt in return for a regular interest payment. In short, you become their creditor.
There are various types of bonds—junk bonds, corporate bonds, municipal bonds—but one of the least risky bonds, if you can say there is any risk, are I Bonds.
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What Are I Bonds?
The U.S. The Department of the Treasury began to sell savings bonds in 1935 to encourage saving during the Great Depression. Then, in 1941, they issued the Series E bonds to help finance the war.
Decades later, in 1998, the U.S. government began issuing Series I Bonds designed to give buyers a return on their purchase while protecting their purchasing power from inflation. The “I” in I Bonds stands for “inflation.”
How do they Work?
I Bonds are non-marketable, meaning that they can’t be bought or sold in secondary markets like stocks and cryptocurrencies, which protects bonds from market volatility.
The value may dramatically increase or decrease when you purchase stock due to speculation, news, market forces, etc. For example, your $100 position in XYZ could be $50 or $150 tomorrow.
If you purchase a $100 I Bond, value comes in the form of two types of interest. First, I Bonds earn a monthly interest rate that is fixed for the bond’s life. Second, there is a variable inflation rate which is adjusted bi-annually.
The interest rate and the inflation adjustment make up the composite rate, which can never fall below 0%, even if inflation goes negative.
For example, the current fixed interest rate is 0%. However, the inflation interest rate will be 9.62% until November 1, 2022. Therefore, a $100 bond would earn 9.62% interest every month until the updated inflation rate.
This 9.62% inflation rate is the highest it’s been since 2000. To give you some perspective, it was 3.54% from May to October 2021.
The composite interest rate calculation becomes more complex when the fixed interest rate is not 0%. Luckily the Treasury Department has a savings bond calculator on its website.
The most important thing to remember is that I Bonds are designed to protect your money from inflation. Interest rates typically go up when inflation is high, and vice versa. However, the fixed-interest rate remains constant throughout the life of the bond.
I Bond Example
Let’s clarify this with an example.
Say you purchase a $100 bond with a 4% interest. Your bond would earn $4 a month for six months, at which point it would compound, meaning that you would now earn 4% interest on $100 plus the accrued interest of $24, or $124.
Of course, the inflation rate changes, at which point the composite rate would be recalculated, and a new composite rate would be produced for the following six months.
I Bond Timeline
There are essential thresholds to familiarize yourself with before you purchase I Bonds.
- 1 year — You cannot cash out an I Bond within 12 months of purchase.
- 1-5 years — Cashing out I Bonds during this period is known as “early redemption.” You will forfeit the previous three months’ interest payments.
- 5+ years — The penalty for cashing out is waived.
- 30+ years — You can hold the I Bond past 30 years, but it will no longer pay interest and will start to lose value against inflation.
Remember, I Bonds are designed to be a long-term hedge against inflation. So if you are trying to make a quick buck, I Bonds are not for you.
What are the Benefits of I Bonds?
The current high-interest rates make I Bonds an excellent alternative to CDs, and their low-riskiness makes them a safe substitute for stocks in a volatile market. Below are further benefits of I Bonds:
- Inflationary Protection — Anyone who has been to the pump lately understands how inflation devalues your money. The interest rate of I Bonds is tied to the consumer price index, ensuring that it is protected from inflation.
- Deflationary Protection — Even if inflation goes negative (deflation), I Bonds have a 0% interest rate floor, meaning they can never decrease in value, unlike stocks and other securities that trade in secondary markets.
- Tax-Deferral — You can choose to pay taxes as you go or defer them until you redeem your purchase, which is essential because your tax rate will likely be lower in retirement than it is in your 30s.
- Tax-Exemptions — the federal government issues I Bonds. They are exempt from local and state taxes. Additionally, you can avoid taxes if you spend I Bond earnings on qualified education expenses.
- Zero-Trading Costs — Unlike other securities that may charge fees to purchase and trade, you can buy I bonds directly without any transaction costs.
- No-Risk — I Bonds are backed by the full faith of the U.S. government. So, unless the U.S. government defaults or some catastrophic event occurs, your savings are safe.
- Flexible Redemption — If you need money from your I Bonds account, you can cash out a portion while the rest continues to grow.
- Liquidity — During the first year, I Bonds are illiquid. However, after that, you can cash out at any time, although you’ll receive a penalty for redemptions made before five years.
- Compounding — Warren Buffest said that his wealth came from “a combination of living in America, some lucky genes, and compound interest.” Your I Bond balance is compounded bi-annually so that after six months, you begin to earn interest on the interest you’ve already earned.
- Access — If you have a social security number, $25, and access to a computer or a mailbox, you can start investing in I Bonds.
How to Buy I Bonds?
Buying I Bonds is free of fees, simple, and can be done electronically through the U.S. Department of Treasury’s Treasury Direct website. Alternatively, you can buy them in paper form through your federal income tax refund.
When you purchase a bond, you pay its face value—for a $25 bond, you pay $25. The face value is the principal on which interest will begin to accrue. When you buy I Bonds electronically, you can purchase them for any amount, in pennies, over $25 (e.g., $25.01, $50.75, etc.). However, paper I Bonds can only be purchased in the following denominations: $50, $100, $200, $500, and $1,000.
Individuals are limited to purchasing up to $10,000 I Bonds electronically or $5,000 in paper I Bonds. These limits are separate, so it is possible to buy up $15,000 in bonds annually.
You can purchase I Bonds as gifts for children and adults so long as they have a Treasury Direct account, or you can request paper bonds with the receiver’s name. You also can purchase I Bonds through a business or for a revocable living trust.
When Can you Cash Out I Bonds?
You can cash out your I Bonds without penalties after holding them for five years. However, you can’t cash out before one year, and if you cash out between years 1 and 5, you will lose any interest accrued over the past three months.
Are I Bonds Worth It?
Right now, inflation is extraordinarily high, and I Bond interest rates far outpace anything you’re likely to find in a CD or cash savings account. For example, the average annual return for the S&P 500 is 10%, and the current I Bond interest rate is 9.62%.
If there is ever a time to buy bonds, it’s when interest rates are rising. However, I Bonds should not be viewed as an all-encompassing investment strategy. Instead, they are a hedge against inflation, a safe place to store your savings, and a complement to money you may have put into the market, real estate, or more risky assets like crypto or NFTs.
Whether or not I Bonds are worth it is a deeply individual question. Still, it certainly wouldn’t hurt to diversify if you have a healthy emergency fund, investments in a tax-advantaged account, and some cash to spare.