How would like an easy way to make over 9 percent interest on your money with virtually no risk?
You might think that an investment like this is an opportunity only available to hedge fund managers and other financially savvy individuals. But in reality, all you have to do is buy something your grandparents probably bought you when you were young – a U.S. savings bond.
Yes … the most boring investment in the world has recently become the coolest kid on the block. But unfortunately, it’s because the bond is tied to that ugly thing called inflation that’s causing us all to spend a lot more for things we need like food and gas.
In this post, we’ll explain what an I bond is and its relationship to inflation. We’ll also explore the pros and cons of investing in one and determine if an I bond would be right for your portfolio.
What is an I Bond?
An I bond is a U.S. savings bond that is indexed to the rate of inflation. The overall interest rate is calculated based on two parts:
- A fixed-rate component – This is an agreed amount of interest that’s paid every year no matter what the interest rate is. Since 2008, this rate has been at or around 0%, so frankly it’s not very enticing.
- A variable-rate component – This part that’s tied to the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items (including food and energy). It gets readjusted every six months on the first business day of May and on the first business day of November
Because inflation rates are currently at their highest levels in 40 years, it’s this variable portion that’s caused the overall interest rate to skyrocket to an incredible 9.62% until the end of October!
To be clear, anyone who buys an I bond between now and October will receive that 9.62% interest rate for the next six months. Afterward, the bond will reset to the new interest rate and earn that value for the next six months.
For example, let’s assume interest rates start to go down but are still relatively high at around 6%. This means that over the next 12 months you’d earn a combined 7.81%, or $781 on a $10,000 investment.
Why Should You Consider Buying an I-Bond?
Over the past few decades, you’ve probably heard zilch about I bonds. And why would you when other investments like stocks and crypto have been experiencing such incredible growth?
However, given our current high inflation environment and the possibility of the economy slipping into a recession, there are a few good reasons why you might want to invest in an I-bond.
Incredibly High Interest
Not since the 1980s has it been possible to invest in a bank CD, government bond, or treasury and get a 9 percent return. Even today, the most reputable online banks are still only offering rates less than 2 percent.
As Safe as It Gets
It’s easy for someone to argue that there are other investments out there that pay well beyond 9 percent. And that’s true … but it can come with incredible risk.
For example, a stock market index fund typically earns an average of around 10 percent per year when measured over a long-time horizon. But if we just look at the current year-to-date performance, the S&P 500 is down about 10 percent.
Some dividend-paying stocks and REITs may come close to issuing distributions that are close to 9 percent. However, there’s never a guarantee that the underlying security won’t lose value. On top of that, dividends can always get slashed if the company that issues the asset starts to run into financial trouble.
At the beginning of the year, some crypto exchanges were paying 8-10 percent on a relatively “safe” form of crypto called stablecoins. But the market was shaken by new government regulation and the 70 percent drop of the stablecoin Terra. So perhaps these assets aren’t as stable as people thought …
By contrast, I bonds are issued by the U.S. That means they’re backed by the full faith and credit of the U.S. government. So far, the U.S. has never failed to repay its debt which is why it’s coveted as one of the most desirable and trusted investments in the whole world.
What are the Drawbacks of Buying an I-Bond?
While it’s hard not to turn down an investment that pays over 9 percent interest and carries virtually no risk, there are some potential drawbacks for investors to be aware of.
One Year Freeze
When you buy an I bond, you have to wait at least 12 months before you can redeem it. That means it wouldn’t make a good place to stash your emergency savings. Even though this money may be earning significantly less money in interest with an online bank, it will be important to have liquidity so that you can access this money when needed.
3-Month Interest Penalty
If you redeem your I bond within five years of holding it, then there is a penalty. You will have to forfeit the last 3 months’ worth of interest.
Investors who are looking to park a large amount of money won’t find it with an I bond. The U.S. Treasury only allows the purchase of up to $10,000 per year.
Rates Won’t Stay High Forever
While the interest rate on these bonds is incredible, remember it’s not for a good reason. High inflation is bad for the overall economy, and steps are being taken by the Federal Reserve to curb it by raising the Federal Funds Rate.
Each time the Fed has met this year, they’ve decided to raise interest rates. This has a ripple effect on the markets that makes borrowing more expensive, slows down the economy, and hopefully drives costs down. The expectation is that by the end of next year (2023), inflation will likely be a more modest 3-4 percent.
While that would be great for the economy, it would mean that the interest on the I bond would be drastically cut and wouldn’t be as lucrative anymore.
How Do You Buy an I-Bond?
If you’d like to buy an I-bond, then go to TreasuryDirect. This is the U.S. Treasury’s online program. Savings bonds are no longer sold in banks like they were a few decades ago.
All bonds are only available for purchase electronically. If you want to buy paper I bonds, then this has to be done when you file your IRS tax return (and are expecting a refund).
Electronically purchased bonds can be gifted to others such as minors. However, the receipt must have an adult custodian with a linked minor account.
Before you lock up your money in the purchase of an I bond for the next 12 months, you should make sure your budget can support it. This is where a good budgeting app like Buxfer can be helpful. Buxfer’s Forecast feature can be used to estimate how much you’ll be spending over the next year. Click here to find out more about Buxfer’s Forecast feature.
Image source: Wikipedia