Should I Buy I-Bonds?
Updated: Oct 13, 2022
First off, this isn't meant as a blanket recommendation for anything. Consult your advisor for whether this is a good fit for you and your individual circumstances.
That said, here's a brief summary of Series I Bonds, including some of the features that might make them worth considering. Of course, all financial decisions should be weighed against the relevant opportunity costs. For instance, any money you invest in I-Bonds is money that isn't available to invest in stocks. Consult your advisor to determine the right balance for you.
What are I-Bonds?
The most notable feature of I-Bonds is that you receive interest based on published inflation rates. That means you get paid more when inflation is high, and less when inflation is low. Given that both stocks and bonds have taken a beating this year due to high and rising inflation (and the rising interest rates that come with it), I-Bonds have offered a rare hedge against inflationary surprises.
But the biggest reason I-Bonds have gotten so much attention lately is that they're paying an almost-unbelievably high interest rate (9.62% annualized). More importantly, you're getting that 9.62% with essentially zero risk. If you bought normal treasury bonds, for instance, you'd see the value of those bonds fluctuate with changes in interest rates.
In fact, an investor who bought the long term treasury ETF (TLT) late in 2021 would have lost roughly 25% of their investment's value, as of this writing. Which isn't exactly the safety of principal you normally associate with treasury bonds. Alternatively, you could invest in corporate debt, which pays a higher interest rate (depending on the financial status of the issuer), but carries a higher risk of default. I-Bonds have minimal exposure, if any, to these two risks.
The final, under-appreciated benefit to owning I-Bonds is that you can wait to pay taxes on the interest until you redeem them. This is a benefit that doesn't get enough attention. It's particularly valuable because corporate bonds and treasury bonds are notoriously inefficient from a tax standpoint. All of your interest is taxed at high, ordinary income rates, and you owe tax each time interest is paid out, whether or not you need the money. With I-Bonds, though, you get to defer that income and control the timing of when those taxes are paid, potentially allowing you to redeem your bonds in a low-tax year and save a lot of money.
Downsides and Limits
The biggest limitation is that you have to hold I-Bonds for 1 year before redeeming them. So if you need liquid cash in the near future, don't dump all your savings into it. However, you can scale into it over time, so that eventually your emergency fund is all in I-Bonds that you've held for a year, and that are therefore easy to access.
Another limitation is that each person can only buy $10,000 of I-Bonds per year. That makes it difficult to use them as a true portfolio hedge. Within the context of an $800,000 portfolio, $10,000 worth of I-Bonds works out to a 1.25% position. Even if you bought the full amount every year for 4 years, you'd only reach a 5% position size. $40,000 isn't nothing, but the other $760,000 of your portfolio will remain as volatile as ever.
In essence, your I-Bonds effectively constitute their own separate portfolio. Theoretically, this shouldn't matter. But it does make it harder to realize the diversification benefits of this investment. To rebalance your portfolio, you have to redeem some of your I-Bonds, which means giving up some of the balance that took years to accrue, as well as paying taxes on the interest. Redemption decisions are difficult to reverse.
Furthermore, while I-Bonds are currently paying a high interest rate, that rate is only guaranteed for the next 6 months. After that, the interest rate will reset to whatever the inflation rate is at that point in time. If inflation declines, I-Bonds will look less attractive than other investment alternatives. For example, over much of the last decade, I-Bonds paid less than 4% annually. Meanwhile, the Nasdaq compounded at roughly 20% up through September 2021. Any decision about whether to buy I-Bonds or just put more money into stocks requires thoughtful planning.
In the current environment, stocks have mostly been driven down by higher-than-expected inflation, along with the higher interest rates caused by the Fed's attempts to control inflation. Lower inflation would likely contribute to higher stock valuations. In other words, returns on I-Bonds would decline, while stocks rallied. On the other hand, if inflation comes in higher, I-Bonds would be the winning move.
When They're Worth Considering
Here when I-Bonds might be of interest to you: If you're sitting on a moderate cash reserve that you'll won't need for 12 months, but will likely access in the next few years. Maybe you're saving for a big purchase, like the downpayment on a new house.
The reason I-Bonds are potentially a good fit for this situation is that you want to grow your capital, but without much risk. While a market downturn or a recession can offer attractive opportunities to buy real estate and other assets, you want to make sure that the funds you're using for these purchases aren't taking a dive alongside your local market. This is why an all-stock portfolio doesn't really fit the bill for real estate goals. Stocks are highly correlated with the economy, and experience high volatility over shorter timeframes.
Normally, the Catch-22 of a real estate cash reserve is that the asset you're saving up to purchase is also rising in value over time. The old adage, "time in the market beats timing the market" is working against you here. Even if real estate appreciates at just 4.5% annually, on a $500,000 house, that's a $22,500 price increase in just one year. After 4 years like that, what used to be a $100,000 downpayment might take $120,000! So the question is, what do you do? Roll the dice? Try and trade in and out? Buy bonds? Buy REITs?
Well, I-Bonds are a decent option too, at least in our current environment. They have lower risk than most bonds, and they're paying 9.62% annualized, which beats the aggregate bond index by a wide margin.
For many investors, though, it remains an open question whether I-Bonds are attractive going forward. Sure, if a designated part of your taxable portfolio needs to be held in cash or bonds, by all means consider I-Bonds as part of that allocation. But remember there's also the possibility that inflation moderates over the next 2 years, leading to a situation where stocks could perform really well, while I-Bonds see their returns decline over time. Even if stocks lag I-Bonds in the short term, over the long term you might be better off in stocks.
Of course, what ultimately matters isn't what asset class will do best over the next 2 years, but whether your asset allocation is well-aligned with your financial goals, and that's a more nuanced question which goes beyond what can be covered in an article.