Ask the Adviser: What are the pros and cons of Series I savings bonds? - Rodgers & Associates

Ask the Adviser: What are the pros and cons of Series I savings bonds?

Q: I’ve been hearing about Series I savings bonds as a way to hedge against inflation. What are the pros and cons of investing in this savings bond?

A: We’ve been hearing about these types of savings bonds, too, which have been in record demand recently. Because their interest rate is tied to inflation, I bonds are currently paying an annualized rate of 9.62% through October 2022—the highest yield for these invest­ments since they were intro­duced in 1998. (This rate is adjusted semi-annually based on the CPI‑U, an inflation measure used to track price levels in urban areas.)

Issued by the U.S. Treasury, Series I savings bonds can be purchased directly at treasury​direct​.gov. Holders of I bonds receive interest payments twice per year for 30 years, after which point the bond matures and interest payments cease. Since I bonds are designed to be long-term invest­ments, they can’t be redeemed within 12 months of purchase. If they’re redeemed within the first five years, a penalty equal to the previous three months of interest applies.

Pros of Series I savings bonds

  • The guaranteed interest rate, which is backed by the U.S. government, is superior to other fixed-income invest­ments that have a similar risk profile.
  • If inflation remains high, these bonds will continue to pay out at a high rate relative to other fixed-income investments.
  • Like other types of U.S. savings bonds, federal taxes on the accrued interest can be deferred until after the bond is redeemed.
  • They’re easy to purchase through treasury​direct​.gov.

Cons of Series I savings bonds

  • I bonds are illiquid for the first 12 months, and penalties apply if they’re redeemed within five years.
  • If inflation decreases in the future, rates of these bonds would also be adjusted downward.
  • Each person is limited to purchasing a maximum of $10,000 in I bonds per year ($20,000 per couple).
  • Assuming inflation reverts to its historical norm, you’ll likely achieve a higher long-term return by investing in equities.

Now let’s consider an example.

Say Jack and Jill each purchase $10,000 of Series I savings bonds (for a total of $20,000) at the current rate of 9.62%. Let’s assume inflation declines to 6% in the second year and then down to an average of 3% for the remaining years of the bond. If the couple holds the bonds for five years, they could cash them in and receive $25,869 (principal plus interest). This equals an annualized compound rate of return of 4.38%.

Now let’s say Jack and Jill redeem the bonds at the end of the 12-month minimum holding period. If we assume the rate remains at 9.62% during that time, they could redeem the bonds for $21,970. Because they redeemed them within five years, however, they would need to pay back the previous three months of interest. This leaves them with a net gain for the year of about $1,466—a 7.33% return—which is still superior to other fixed-income instru­ments with a similar risk profile.

In short, Series I savings bonds can be a good way to achieve a relatively high return with a minimal amount of risk. You might consider using them for cash needs in the next one to three years (or as long as inflation remains elevated). As inflation returns to its long-term average and the market recovers, they’ll likely become less attractive as investments.