In this post, we will cover the topic of I Bonds, but first, here is our disclosure.
Disclosure: This post may contain affiliate links, meaning we earn a commission on purchases made through those links at no extra cost to you. As an Amazon Associate, I earn from qualifying purchases.
Disclaimer: The content on this site is for informational and educational purposes only and does not constitute financial, investment, legal, tax, or any other professional advice and should not be used as a substitute for professional advice. For more details, read our full Disclaimer.
I Bonds Here, There, and Everywhere
I cannot recall reading one article about I bonds in over ten years; then came 2022, and with it came the worst rate of inflation we have seen in 40 years. Now, I see articles and blogs about I bonds everywhere I look. They are a hot topic discussed by financial gurus on podcasts, and I even think I started to see them in my sleep.
This piqued my interest and had me asking the questions: What exactly is an I bond, and why are they so popular? Should I be investing in them now? Are they another investment fad, and will they still be relevant in 2023?
With these questions in mind, I began researching I bonds and ultimately purchasing them. This is what Crash Test Money is all about. Read on to find out more about the world of I bonds.
I Bond Key Features
Expand the below headers to learn more about the pros and cons of owning I bonds.
I BOND PROS
I BOND CONS
2022: The rise of the I Bond (and inflation)
After the great recession in 2008, interest rates and inflation were so low, and the bull market in stocks that followed was so long that many people poured money into the stock market. There were two main reasons for this:
- The low-interest rates that followed were propelling the stock market to greater heights
- People had to take greater risks with their money to earn a decent rate of return.
The historical average inflation rate is around 3%, with the Federal Reserve targeting 2%. The average rate of I bonds issued over the last decade falls in the middle.
During that time, savings and money market accounts were earning next to nothing. I bonds fared some better, but the rates were nothing to write home about. A couple of times after the great recession, even I bonds were yielding 0%. Yes. 0%. That all changed with the pandemic.
The once-in-a-generation pandemic that followed 12 years after the great recession caused so much devastation to life and the economy. It now seems inevitable that we would face the highest rates of inflation in 40 years, given the trillions of dollars in stimulus, supply chain issues, and labor shortages caused by the pandemic.
This leads us back to I bonds and why they are so popular now.
Why are I Bonds So Popular Now?
Quite simply, I bonds are tied to inflation, and when inflation runs high, so does the interest you earn on I bonds. Add in the fact that I bonds are backed by the US government, and the result is an investment that is as close to risk-free that you can probably get. On top of that, the US government guarantees your principal value even during deflation.
You could buy I bonds at a record rate of 9.62% at the start of the year. That rate was adjusted lower in November as inflation cooled but still yields a solid composite rate of 6.89%.
The 6.89% interest rate is good for the six months following your purchase date. To get this rate, you must purchase I bonds at TreasuryDirect any time between November 1st, 2022, and April 30th, 2023.
Before the feeling of FOMO (fear of missing out) sets in and you kick yourself for not jumping on the 9.62% rate when you had a chance, just know it can be argued that purchasing I bonds now at the 6.89% rate is better than the 9.62%. Why? I will explain later in this post here.
This makes I bonds an excellent alternative for the money you do not need to access in the next 12 months and that you might have kept in a savings or money market account. This was not and may not always be the case when inflation is low, but I bonds become very attractive when inflation runs high like it is today.
What Are I Bonds and How Do They Work
The United States Government issues bonds to help pay for its massive spending obligations. The United States government issues several types of savings bonds, including the Series I savings bond or “I bond” for short.
I bonds were introduced in the late 1990s and are a type of bond that will protect you from inflation. You will earn interest for 30 years unless you cash them before then. They cannot go below zero, even in a deflationary environment, and the US government guarantees the principal value of the I bond. They are subject to federal income tax but exempt from state and local income tax.
The interest rate on an I bond is comprised of two components: the fixed rate and the inflation rate. The rate you earn is derived from a multi-step equation using these two rates.
- Fixed Rate – This is the rate of interest received on your I bond for the bond’s life.
- Inflation Rate – This rate is set every six months on May 1st and November 1st.
Interest on I bonds is earned monthly, with interest being compounded every six months. This means the interest you made over the previous 6-month period is added to the principal balance every six months. This becomes the new and larger principal balance the new interest rate applies to for the next six months. This is a perfect example of compounding in action. Compounding. What a beautiful thing!
Where Do You Buy I Bonds?
I bonds can only be purchased electronically through the Treasury at TreasuryDirect.gov or in paper form using your IRS tax refund. This means you cannot buy them at your bank, through your investment broker, or your favorite investment app.
Please note that paper I bonds can only be purchased using your IRS tax refund and by completing the IRS Form 8888.
Limits on Your Purchase
One person or business can purchase up to $10,000 per calendar year of I bonds through TreasuryDirect.gov and, if applicable, up to another $5,000 in paper I bonds using your IRS tax refund.
The minimum purchase is $25 when purchasing electronically through TreasuryDirect. You can buy any amount over $25 to the penny, which, in my opinion, is a pretty neat feature. For example, you could purchase $30.01 of I bonds.
If you are using your IRS tax refund to purchase paper I bonds, then you can do so only in denominations of $50, $100, $200, $500, and $1,000.
TreasuryDirect will let you set up automatic investments in I bonds, allowing you to make regularly occurring purchases.
Using TreasuryDirect.gov
Before purchasing electronic I bonds, you must open an account with TreasuryDirect. The sign-up process is pretty straightforward and pain-free to get your account up and running.
I have read and heard some negative feedback about the site. I will admit, once you log into your TreasuryDirect account for the first time, the site will appear a little outdated. It will not have all the bells and whistles of the latest and greatest app or a website owned by a giant brokerage company. My advice is not to get hung up on this.
Remember, TreasuryDirect mainly serves one purpose: to enable you to buy Treasury securities, like I bonds, and to do so safely and securely. Let’s face it; I bonds are a safe and boring investment, so the site does not need to have all the fancy features of your favorite investment app or website.
Why the Fixed Rate Matters
Now, back to how 6.89% can be better than 9.62%. You might think I am horrible at math, and everyone knows 9 is bigger than 6. So how can 6.89% be better than 9.62%?
Remember that I bond rates are a combination of two rates. The fixed rate and the inflation rate. It is that fixed rate that makes all the difference here. The 9.62% I bonds have a fixed rate of 0%, whereas the 6.89% have a fixed rate of 0.4%.
Since the great recession, it is not uncommon for I bonds to be issued with a fixed rate of 0%. In fact, I bonds issued between May 2020 and October 2022 all had a fixed rate of 0%.
If you bought I bonds when they were at 9.62%, you would have received a fixed rate of 0% on those bonds for the next 30 years. Whereas, if you buy I bonds at the 6.89% rate, you will receive a fixed rate of 0.4% interest for the life of the bond.
So, for example, when the I bonds at 9.62% adjust to the lower rate, they will receive 6.49%, not 6.89%. If inflation goes to 0%, the I bonds bought at 9.62% will also go to zero, but the I bonds purchased at 6.89% will still yield 0.4%. Over time that little difference of 0.4% adds up.
Compounding is powerful when it comes to investing. Half a percentage point here or a percent there may seem small, but it makes a big difference over time.
Therefore, in the short term, 9.62% trumps 6.89%, but if you plan on holding I bonds for the long term, buying I bonds at 6.89% will eventually win out.
Proceed With Caution
12-Month Restriction Before Cashing I bonds
One downside to I bonds is you cannot cash them in the first 12 months after purchase. Any money you have marked for short-term goals, those less than one year, or emergencies, should not be placed into I bonds. The better alternative for this money would be a high-yield savings or money market account.
Bottom line, if you will have a big purchase in the next 12 months, like a new car, don’t put that money into I bonds. Don’t put your emergency fund into I bonds. You need to have these funds in a safe, highly liquid place like a savings or money market account.
WARNING: You cannot cash Series I savings bonds in the first 12 months after your purchase, and you will forfeit the last 3 months of interest if you cash them before 5 years.
Rates Can Decrease Quickly
Another downside of I bonds is their rates can swing quickly with each 6-month adjustment. Right now, they are yielding high rates of return, but those rates can plummet fast if inflation cools. You only have to look at the recent change in I bond rates to see how much their rates can change.
Between May 1st, 2022, and October 31st, 2022, I bonds yielded 9.62%. From November 1st, 2022, to April 30th, 2023, they yield 6.89%. That is roughly a 30% decrease in only six months. The interest rate will only continue to drop fast if inflation continues to cool.
Remember, if rates plummet, you can always cash out your I bonds after 12 months and move them to other investments. You will lose 3 months of interest, but you are not locked into I bonds after the first 12 months.
Summary
I bonds can be a great place to put some of your money in a well-balanced, diversified portfolio. Their current rates make them a competitive option to your typical savings or money market accounts for money you will not need in the next 12 months. This all sounds good, but there are downsides to owning I bonds.
I bond rates are adjusted twice a year and can fluctuate significantly every six months. Also, you must hold I bonds for 12 months before you can cash them, and you will be hit with a 3-month interest penalty if cashed before five years.
Bottom line, at today’s rate, I bonds can be an excellent option to diversify your cash or fixed-income holdings. I encourage you to visit TreasuryDirect.gov to find out more about I bonds.
