Sensible Perspectives

I Bonds: What they are and how they might fit into your portfolio

Posted by on September 19, 2016

_RMR0307_September_2015I Bonds are a kind of inflation-protected savings account. In this article, I’ll describe their general characteristics and some of their limitations. In a follow up article, I’ll describe when I Bonds can make sense as an investment.

Series I Savings Bonds: Protection against inflation

Series I Savings Bonds are inflation-protected U.S. Savings Bonds. Also called “I Bonds” (the “I” stands for “inflation”), they are issued by the Treasury and provide a “real”, or inflation-adjusted, rate of return. To understand this essential feature of I Bonds, we must distinguish between “real” and “nominal” rates.

Almost all rates you are familiar with are nominal rates. Examples include mortgages, bank accounts and (most) bonds. A nominal rate is simply the stated interest rate without taking inflation into account. For example, if you buy a $1,000 CD that pays 1.4% annually, it would be worth $1,014 one year later. Your nominal rate of return is 1.4%.

A real rate of return, by contrast, is the rate of return after inflation. Continuing the above example, if inflation is 1%, the real return on your CD is 0.4%, or 1.4% – 1% = 0.4%. The relationship between nominal and real interest rates can be expressed as:

Nominal Rate – Inflation = Real Rate[1]

I Bonds are special: they pay a real interest rate, instead of a nominal rate like most other interest-bearing investments. The total interest on I Bonds is therefore a combination of two rates: a fixed (real) rate and inflation. The sum of these two rates is the “composite rate.”[2] In equation form:

Composite Rate = Fixed Rate + Inflation

So if you were to buy I Bonds in September of 2016, your bonds would pay a fixed (real) rate of 0.26%. No matter what inflation is, your I Bonds will earn 0.26% above inflation. We can compare the real rates of this I Bond to those of our 1.4% CD under different inflation assumptions.

I Bond  CD
 Composite Rate   – Inflation   = Real Rate   Nominal Rate – Inflation   = Real Rate
0.26%  0%  0.26%  1.4%  0%  1.4%
 2.26%  2%  0.26%  1.4%  2%  (0.6%)
 5.26%  5%  0.26%  1.4%  5%  (4.6%)

 

When inflation is 0%, the CD’s real rate of 1.4% is higher than the I Bond’s 0.26%. However, when inflation is higher, the I Bond is the better investment. It always yields 0.26% real.  By contrast, at 2% inflation, the CD yields only -0.6%. At 5%, the CD drops to -4.6%.

We see from the above example that I Bonds are an ideal investment to protect against inflation. That’s because no matter what happens to inflation, you will always receive the same real rate of return.

Other important characteristics of I Bonds

In addition to their inflation-protection, I Bonds have a number of other important characteristics. Here are few.

Tax-deferral. Unlike a typical CD or savings account, whose interest is taxed every year as ordinary income, the interest on I Bonds is not taxed until you sell them. This opens the possibility to shift income from a current, high tax year to a future year when rates may be lower.

State and local tax-free. Like all Treasury bonds, I Bonds are not subject to state and local taxes (they are however subject to Federal income tax). If you live in a high-income-tax state, I Bonds may be attractive.

Backed by the “full faith and credit of the United States.”  When you buy a Treasury bond, you are loaning money to the U.S. government. These bonds are considered very safe and carry (essentially) zero default risk. As such, I Bonds may be a good choice if you want some of your portfolio in a “risk-free” asset.

Principal (plus accrued interest) will never go down. The Treasury guarantees that your composite rate , the sum of inflation plus your fixed rate, will never be less than zero. So if inflation is -1.50% and your fixed rate is 0.25%, even though the sum of these two rates is negative, your composite rate would still be 0.00%.

One additional point. Some investors worry that the value of their bonds will drop when interest rates rise. (For why that is, click here for a great Khan Academy explanation). However, since I Bonds do not trade on a secondary market, their prices do not fluctuate with interest rates. In this way, I Bonds behave more like savings accounts than ordinary bonds.

Things to consider

I Bonds are sold with original maturities of 30 years. Although they can be sold any time after the first year, if sold within the first five years after purchase you’ll be subject to a minor penalty of three months’ interest.

There is an annual purchase limit on electronic I Bonds of $10,000 per person. (You can technically purchase up to another $5,000 in paper I Bonds, but only by using an IRS tax refund). This can be a problem if rates rise and you want to sell your bonds and buy new ones at the higher rate. For example, say you have $50,000 in I Bonds all paying 0.26%. If the fixed rate rises to 0.75%, you are limited to $10,000 in purchases per year. It would take you five years to sell out of your current bonds and repurchase new bonds at the higher rate.

What are I Bonds good for?

Now that you know what I Bonds are, you might be wondering how they might fit into your portfolio. Please read my article next month, where I’ll identify a number of situations where I Bonds can make sense.

 

[1] More precisely, Real Rate = (Nominal Rate – Inflation)/(1 + Inflation), but dividing by 1+ inflation makes minimal difference for rates of inflation in the single digits.

[2] The calculation is slightly more complicated because the Treasury estimates the effect of compounding more precisely. Although the specifics are beyond this article, the Treasury’s website has a detailed explanation with an example here.