Have you looked at the Series I Savings Bonds lately?
I have done a bit of research and like what I am seeing. Series I savings bonds are an underappreciated low-risk financial security. The US Treasury hiked its rate to a record annual return of 9.62% as of May 2, 2022, through October 2022, up from an already a desirable return of 7.12% previously. This sleeper security merits your attention for its benefits outweigh the drawbacks. We compare the series I savings bond to common alternatives, including Series EE bonds, TIPs, savings accounts, and stocks.
Issued and backed by the US government, investors may yawn at the notion of buying treasury securities with low yields, but savings I bonds adjust for inflation, bucking that trend.
The average savings account yields are under 1% and most one-year CDs are still paying 1%, according to DepositAccounts so Series I bonds given their virtually risk-free nature are an excellent way to invest money.
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The Impact of Inflation On Bonds
In recent years, inflation has been relatively tame, reflecting pricing stability, hovering at zero to the Federal Reserve’s 2% target. The fear of inflation materialized as the pandemic-related economic downturn required aggressive measures by the Fed to stimulate our economy.
Since March 2020, we have been experiencing significant supply constraints, adding to inflationary pressures. While Fed Chair Powell recognizes inflation is not transitory, March’s inflation rate rose to 8.5%, the highest in 40 years.
With inflationary pressures, consumers, especially savers, worry about reduced purchasing power from the money they save in bank accounts. When inflation is high, the banks typically pay higher interest rates. However, annual percentage yields (APY) on bank savings accounts are averaging 0.50%-0.60% November 2021 and may have fees and minimums. Those rates are likely to continue until the Fed raises fed fund rates, an action that is not expected until later in 2022.
Long-term bonds with low-interest rates without inflation protection mechanisms are particularly vulnerable to inflation. A better alternative for investors is to look at bonds that adjust for inflation based on CPI.
We think Series I saving bonds is a shining example and devote this article to that financial security. We will highlight their features, benefits, and drawbacks, then compare the I bonds to TIPS which have some similarities later on.
Benefits of Series I Savings Bonds
1. Low Default Risk
Series I savings bonds are promissory notes issued and backed by full faith and credit of the US Treasury. Like all Treasury securities, these securities sport the highest AAA credit ratings. Unlike most treasury securities with secondary markets, savings bonds are non-marketable. You can consider the I bonds as being a virtually risk-free investment given the guarantee it gets from the US government.
2. Inflation-Protected Security As Inflation Rises
As of May 2022, the composite rate is 9.62%, adjusted for inflation through October 2022. The Series I savings bond reflects the highest US inflation rate at 8.5% in March 2022, since the US Treasury created the series I bonds in 1998. Investors have been seeking yield from a low-interest environment for years.
3. Shares Similarities With Series EE Bonds But Far Better Returns
Series I savings bonds share some similarities to the Series EE bonds, though the latter provides only a market-based fixed interest rate of 0.10% and does not adjust for inflation which has boosted the interest rate for the I bonds to near 10%.
Imagine if we see higher fixed rates based on the Fed increasing interest rates, it is possible Series I savings bonds could be at higher annualized returns than stocks.
Series I savings bonds have a 30-year maturity compared to the 20-year maturity of the EE bonds.
4. Inflation Protection: How Is the Interest Rate Determined?
The composite interest rate on the series I savings bond combines two different rates, a fixed rate like the series EE bond and the inflation rate.
The fixed rate currently zero remains the same throughout the life of the Series I savings bond, as determined by the Secretary of the Treasury (Janet Yellen) and influenced by the Federal Reserve’s fed funds rate which is likely to rise significantly this year.
The variable inflation resets semiannually based on changes in the Consumer Price Index for all Urban Consumers (CPI-U) each May and November. The May rate changes between CPI-U figures from September and March, while the November rate keys off of March and September amounts.
5. Ease of Purchase
You can buy these bonds electronically by setting up an account on TreasuryDirect or in paper form, using your federal income refund.
The series I savings bonds are available electronically online through Treasury Direct 24 hours seven days a week. You can buy the bonds in denominations for as little as $25. You pay the bond’s face value to the penny and can buy a bond for $50.23 if you desire. There are no fees to pay unlike savings accounts or mutual funds.
6. Have An Interest Rate Floor And No Risk of the Bond Going To Zero
The value of Series I savings bonds will never be less than what you paid for them, and that is because the interest rate can not go below zero. The US Treasury guarantees that the redemption value of a Series I savings bond for any particular month will not be less than its value for the preceding month.
When deflation occurs, and prices go down in contrast to inflation, a bond could reflect a negative inflation rate.
Since the initial offering of I bonds, there have been two times when there have been negative inflation rates. The first time it occurred was during the Great Recession in May 2009 (-2.78%) and the second time it was in May 2015 (-0.80%). When the negative inflation rate was greater than the bond’s fixed rate, which is what happened in these periods, holders didn’t earn interest income for six months.
Typically, a negative bond yield may mean an investor receives less money at the bond’s maturity than the original purchase price. However, this doesn’t happen for the I bonds due to their structure.
7. Purchase Limitations
One person per their social security number can buy up to $10,000 in face value per year electronically and an additional $5,000 as a paper purchase, net of federal tax refund, for a total of $15,000. You can purchase these bonds as gifts for family or friends.
These bonds make an excellent investment for those who want to invest, don’t have a lot of money, worry about the security’s credit risk, and fear losing money.
8. Penalties Expire After Five Years
You cannot sell your Series I savings bonds within the first twelve months unless you can prove financial hardship or a disaster of the sort like an earthquake. With its 30-year maturity, A bondholder can redeem series I bonds any time after 12 months. However, holders will lose the last three months of interest up to a five-year holding period. After holding the bonds for five years, you no longer have to face this penalty.
Think of these penalties as similar to holding CDs which also restrict your ability to cash out of the securities until maturity and will result in a penalty.
9. Tax Advantages
Holders of the savings bonds, like all treasuries, benefit from state and local tax exemption. However, unlike most treasuries, savings bondholders pay federal income taxes at the time of redemption or maturity. Interest on the savings bonds accumulates over the bond’s life and is Federal income tax-deferred until maturity.
Imagine you are in your 30s at peak earnings, and you buy I bonds now, and each year. You can defer those taxes up to 30 years until your retirement when you may be in a lower tax bracket.
Unless you need the money, consider holding these bonds for the longer-term rather than redeeming the bonds. It can act as a way to park additional emergency funds.
10. Additional Educational Feature
The interest from Series I savings bonds is tax-free if used for qualified higher education expenses as long as you earn less than the allowed income limits. You should consult your accountant to see if you can benefit from this feature. If you qualify, you will avoid any penalties.
Drawbacks of Series I Savings Bonds
1. Limited By Purchase Amounts
For those attracted to the Series I savings bond’s features, the purchase limits of $10,000 are off-putting. You can buy that amount annually, but it will take a few years to accumulate money in your portfolio. Each family member can buy this security or buy it as a gift so long as you use their social security number.
2. Can’t Buy From A Brokerage Firm
You can only buy Series I savings bonds through TreasuryDirect, which requires setting up an account. You can’t buy these securities from your broker.
3. Interest Compounds Semiannually
All else being equal, the more frequent the compounding, the better the yield. Typically, compounding can be daily, monthly, quarterly, semi-annually, or annually. Series I saving bonds compound semiannually, as compared to the TIPS, which compound monthly.
How TIPS Differ From the Series I Savings Bonds
Series I savings bonds and TIPS have similarities in that both securities share low default risk as they are issued by the US Treasury and have inflation protection.
Series I savings bonds are non-marketable, meaning you cannot buy or sell these securities in the secondary market, unlike TIPs.
TIPs Differ In 7 Ways:
1. You can buy TIPs via TreasuryDirect and through most brokerage firms.
2. There are no purchase limits like the Series I savings bonds. TIPs are available in five, ten, and 30-year maturities, and there are no penalties if you sell your bonds before five years.
3. The Treasury sells TIPS at regularly scheduled auctions where large institutions competitively bid and determine the interest rate for the rest of the smaller buyers. After issuance, the principal of a TIPS increases with inflation and decreases with deflation. The Series I savings bond price doesn’t change for the life of the bond.
4. The inflation on the TIPs adjusts monthly and is on the principal, not interest amounts. The inflation rate of I bonds changes semiannually.
5. Although TIPS is also exempt from state and local taxes, you can’t defer federal taxes. Also, TIPS can’t use the higher education benefit that the I bondholders can use.
6. TIPs have the potential for price appreciation, but the I bonds stay at face value.
7. While interest rates on I bonds cannot go to zero, most TIPs yields are negative interest rates currently.
Series I savings bonds are often underappreciated but warrant attention from investors. With rising inflation, these securities are generating desirable returns with little risk, are easy to buy, provide inflation protection, tax benefits, and deferral of federal taxes. They make gifts for children and family members.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.