April 27, 2020
With short-term interest rates back near zero and more volatility in equity markets, many investors are looking for the best place to stash some cash. After just a few years of relative respite, savers are once again challenged to generate any significant yield. We routinely monitor yields on cash savings vehicles to see whatever spread is available.
One option that often gets overlooked is I Bonds. Of course, there are limitations and this idea is not right for everyone. Still, it might be worth considering in this low yielding environment. Here’s a short overview on how I Bonds work. First, there is no credit risk because I Bonds are issued by the U.S. Treasury and it is the U.S. Treasury that prints the dollars to pay you back. Second, the interest earned on I Bonds comes in two forms: a fixed component (currently 0.2%) and an inflation component (currently 2.02%). Combine the two and I Bonds are currently earning a composite rate of 2.22%, not too bad in this environment. The fixed component stays fixed for the life of the bond. The inflation component gets adjusted twice a year, in May and November, based on the non-seasonally adjusted consumer price index for all urban consumers (“CPI-U”). This is a very attractive feature. If inflation gets out of hand due to excessive deficit spending, increased money printing, or any other reason, I Bond investors are protected – provided CPI-U accurately captures the true increase in inflation.
I Bonds have some interesting tax characteristics as well. Like all Treasury bonds, I Bonds are not subject to state and local taxation. They are like zero coupon bonds in that they don’t pay out interest to bondholders. Instead, interest is added to the value of the bond and you earn interest on interest for the life of the bond, up to 30 years. You can elect to pay taxes on a cash or accrual basis. With the cash basis election, you only pay taxes when the bonds are redeemed. And if the proceeds are used to pay for college education, no tax is payable.
What are the downsides? For starters, purchases are limited to $10,000 per year, per social security number. So, the maximum amount a married couple can invest in any given year is $20,000. There are some other limitations as well. There is no secondary market for I Bonds. You must redeem them with the Treasury. You cannot redeem I Bonds for one year after purchase and if you redeem them within 5 years of purchase, you will give up the last three months of interest. Finally, I Bonds are issued electronically via Treasury Direct. In my experience, the website is cumbersome and difficult to navigate.
Even with those caveats, a married couple who invested the maximum for five years running could build up a sum of over $100,000 without paying any tax, incurring any fees, or taking on any credit or inflation risk. That’s not a bad deal in this environment.