• Harry N. Stout

273- A Real 7% or More Fixed Income Solution – Series I Bonds


In this post, I am going to address US Government backed Series I Bonds (I Bonds) and how, at this time and likely for the next few years given inflation trends, they offer a much higher return that you can obtain from other highly rated fixed income options. These bonds have a number of purchase restrictions and requirements. You will find all this information at treasurydirect.gov. Here are the key provisions and restrictions highlighted for you.


Today’s Environment

Recently, I Bonds were a fixed income option that grew out of favor due to lower interest rates and low inflation. As you will learn, these bonds pay interest tied to the rate of inflation in our country. Today, most of us have an expectation that interest rates will be going to go up and that inflation is roaring its ugly head with the Consumer Price Index (CPI) going north of 6 percent. These conditions make the I bond look very attractive. In fact as of Nov. 30, 2021, an I bond is paying a 7.12 percent annual percentage yield. Not bad for a government-protected savings vehicle with no risk of principal.


I Bonds Defined

An I Bond is a security that earns interest based on both a fixed rate and a rate that is set twice a year based on inflation. The bond earns interest until it reaches 30 years, or you cash it in, whichever comes first. From a financial strength standpoint, it is a government-backed savings bond similar to the paper Series EE bonds you used to purchase at the bank for birthday gifts or other special occasions. The I Bond is not only guaranteed, but also pays a really great interest rate when inflation rises. Since these are issued by the federal government, they are exempt from state and some local taxes. You will have to pay federal income tax on your gains with certain limited exemptions.


Key Attributes of I Bonds

Here are some key attributes of I Bonds taken from the Treasury Direct website:

You can purchase a combined $15,000 of electronically issued and paper I Bonds each year for a Social Security number.

  • You pay the face value of the bond. For example, you pay $50 for a $50 bond. (The bond increases in value as it earns interest.) Electronic I Bonds come in any amount to the penny for $25 or more. For example, you could buy a $50.23 bond. Paper bonds are sold in five denominations: $50, $100, $200, $500, $1,000.

  • You can buy these bonds as gifts for others.

  • I Bonds earn interest for 30 years unless you cash them first. You can cash them in after one year. but if you cash them in before five years, you lose the previous three months of interest. (For example, if you cash an I bond after 18 months, vou get the first 15 months of interest). This is a three-month withdrawal penalty.

  • You have a choice when reporting the interest earned on, I Bonds for federal income tax purposes. You can: - Report the interest every year - Put off (defer) reporting the interest until you file a federal income tax return for the year in which the first of these events occurs: - you cash the bond and receive what the bond is worth, including the interest, or - you give up ownership of the bond and the bond is reissued, or - the bonds stops earning interest because it has reached final maturity - Per the Treasury Direct website, most people defer reporting the interest, putting it off until they are filing a federal income tax return for the year in which they receive what the bond is worth including the interest. - When electronic I Bonds in a Treasury Direct account stop earning interest, they are automatically cashed, and the interest earned is reported to the IRS.

The Pros and Cons of I Bonds

Pros:

  • I Bonds pay variable interest based on CPI-U, which is a broad inflation metric. Today, inflation is high, and we expect it to go even higher, so over the next year the 7%+ yield will likely be maintained or even go higher. No matter how high inflation goes, you can rest easy knowing the bond's rate will keep up.

  • The principal is safe and guaranteed by the U.S. Government.

  • You can redeem I Bonds whenever you want after 12 months.

  • Redemption is relatively quick, from immediate cash in a bank to a couple of days if redeemed electronically.

Cons:

  • The fixed interest rate you earn is 0%, so your return will match inflation but will not exceed it.

  • Interest rates on the bonds change every 6 months along with changes in the inflation rate.

  • Bonds can only be redeemed through the government. You can't sell them, so there is no opportunity for capital gains. Returns will come through interest payments.

  • To avoid the 3-month penalty for cashing in the bonds early, you must hold them for 5 years.

  • Interest accrues, and you won't receive any cash until you redeem them. The good news is that interest is compounded.

  • You’re limited to $15,000 per social security number per year.

  • Your money is tied up for at least one year. You can take it out after five years without any penalty and a partial penalty from one to five years.

  • Interest is taxed federally. Please make sure you are aware of what your tax implications will be on your interest gained. However, there are some exclusions around education for children, so please speak with your tax professional.

  • You cannot buy them in a brokerage or savings account. You can only own them direct from the Treasury in paper or through a treasury direct account. So, for asset management purchases, your financial planner will not be able to process this for you, and you will need to keep track of your purchases.

Summary

At this time, I Bonds offer a very attractive at a 7.12% yield through April of 2022, and the risks of non-payment are also very low. If you are holding extra cash that you don't need for at least a year and want to protect it from inflation, I Bonds can be a great option. This is especially true if you believe that inflation will remain elevated over the next few years.

 

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