Consider Series I Savings Bonds

Over the past 20 years, a 60/40 portfolio has yielded a nominal rate of return of roughly 8%. In the past 10 years, the rate of return was 11%, and one year it was around 18%. However, times may be changing.

Research conducted by Bank of America and EPFR Global found investors poured almost $900 billion into exchange-traded and long-only funds in 2021, which exceeds the previous 19 years combined! The Federal Reserve has also changed its stance on inflation, claiming it may not be as transitory as initially anticipated. Whether permanent or transitory, the rise of inflation has made government-backed Series I Savings Bonds an attractive alternative to riskier corporate bonds and low-yielding certificates of deposit.

Series I Savings Bonds (7.12%)

An I Bond is an interest-bearing, non-marketable U.S. government savings bond offered directly through the Treasury. Until the end of April, they are offering a whopping 7.12% annualized rate of return for the next six months. A reasonable question is how and why the federal government is offering a risk-free interest rate of 7.12%. The interest rate has more to do with the Consumer Price Index for all Urban Consumers (CPI-U) for all items. The Treasury determines the interest or composite rate based on two factors: inflation (CPI-U) and a fixed rate. Currently, the fixed rate sits at 0%; however, the semiannual inflation rate is 3.56% (7.12% annualized).

The 3.56% semiannual interest on government-backed securities is unheard of in today’s environment. For comparison, six-month FDIC-insured bank CDs’ annual percentage yields are roughly between 0.50% and 0.80%. However, the bonds must be purchased before May 2022, which is when the new composite rate is determined. Fortunately for Series I bonds and unfortunately for almost all other assets, inflation will probably remain high for the duration of 2022.

Annual Contribution Limit ($10,000)

A major limitation to I Bonds makes them less attractive to wealthier individuals. There is a $10,000 limit per person per calendar year. Those who were fortunate enough to buy I Bonds in December are again able to buy another $10,000 in January, locking in $20,000 at the current rate for the next six months. The limit is per person, which puts large families at an advantage, as accounts for minors are available.

Another way to extend the $10,000 limit is by directing up to $5,000 of one’s income tax refund toward purchasing what are called paper I Bonds. It can be more complicated, but it does increase a family’s contribution slightly. The $5,000 limit is per tax return and not per person.

Taxation

An I Bond’s interest payments are subject to federal income taxes but not state and local taxes. They are also subject to federal estate, gift and excise taxes, as well as state estate or inheritance taxes. The Series I Bond owner can choose when they would like to report interest. The options include reporting interest every year or when one of the three triggering events occurs:

1. The owner redeems the I Bond and receives both principal and interest.

2. The individual gives up ownership of the I Bond, and the I Bond is reissued.

3. The I Bond stops earning interest because it has reached final maturity (30 years).

Redemption Rules

The redemption rules are as follows:

» Must hold the I Bond for at least 12 months unless there is a federally declared disaster.

» After 12 months, any bond redeemed before five years loses the last three months of interest.

» After five years, interest and principal are redeemable at face value.

The illiquidity for 12 months, combined with the unknown preceding six months of interest, could make some individuals uneasy about I Bonds — especially those who prefer guaranteed FDIC-insured investments. However, even if the CPI-U turns negative for the May 2022 adjustment, the composite rate for the next six months won’t drop below 0%. Therefore, the redemption after 12 months will still provide a 3.56% annualized rate of return (3.56% for the first six months and 0% for the next six). The loss of the three months of interest after the initial 12 months of illiquidity becomes a moot point if the CPI-U turns negative and I Bonds’ six-month interest rate is 0%. Giving up three months of 0% interest is still zero!

The non-seasonally adjusted CPI-U has led to a much higher composite rate for I Bonds. However, the inflation rate, specifically for energy and used cars and trucks, may stabilize, suggesting the composite rate determined May 1, 2022, will be lower. Even if the composite rate is lower in the second half of 2022, a couple still should consider contributing $10,000 each to I Bonds’ as they will outperform CDs over the next 12 months even if the rate drops to 0%. The $10,000 limit is low; however, it is per person per calendar year. Minor accounts can be set up through the Treasury Direct website for children, allowing parents to contribute on their behalf, leading to a much larger family contribution.

The tax deferral, the pure inflation hedge and the backing by the full faith and credit of the U.S. government make it an excellent investment vehicle for individuals who want to maintain their purchasing power over time. I bonds can be purchased through the Treasury Department website, www.treasurydirect.gov.

Colin Slabach, MS, ABD, is assistant professor of retirement and assistant director of the Retirement Income Center at The American College of Financial Services. He may be contacted at [email protected].