• Nicholas Pihl

Should I Buy I-Bonds?

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. Any final decisions should be based on your own personal situation, not this article.

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. An investor who bought the long term treasury ETF (TLT) late in 2021 would have lost roughly 25% of their money, 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 to these two risks.

The final, unsung 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 bonds are normally incredibly inefficient from a tax standpoint. All of your growth is taxed at high, ordinary income rates, and you owe taxes every time interest is paid out, whether or not you need the money. With I-Bonds, though, you get to defer those taxes 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

One 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. 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.

When They're Worth Considering

Here when I-Bonds might be of interest to you: If you're sitting on a small-to-moderate cash reserve that you'll need sometime in the next 12-60 months, but you're not exactly sure when that will be. Maybe that's just your emergency fund, or maybe you're saving for a big purchase, like the downpayment on a new house.

While a market downturn or a recession can offer attractive opportunities to buy real estate, you want to make sure that the funds you're using for a downpayment aren't taking a dive alongside your local market. This is why stocks don't really fit the bill here. They're highly correlated with the broad economy, in addition to exhibiting high volatility over shorter timeframes.

The Catch-22 of all this 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 offer a decent option, at least in our current environment. They have guaranteed principal, and no duration risk. And right now, 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 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.

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