I-Bonds: Forgotten Stepchildren Of Guaranteed Inflation Protection
Summary
- I-Bonds provide a unique combination of inflation protection, liquidity, and tax advantages.
- They are the best way to guarantee protection of principal against inflation.
- Worried about deflation? I-Bond "real" returns are enhanced by deflationary periods.
If there is one investment that should be at the core of any long-term savings plan, it is I-Bonds. The U.S. Treasury began issuing I-Bonds in 1998, but they have remained below the radar; as of January 2016, only a total of $117 billion of these bonds were outstanding, less than 1% of the Treasury's total debt. Few advisors seem to recommend them, possibly because they cannot be held at any financial institution and thus do not generate any commissions or fees. Yet I-Bonds provide a unique combination of protection against inflation, almost complete liquidity and significant tax advantages.
The mechanics of I-Bonds are a slightly complex, but worth exploring in more detail. The bond face amount (or principal) is fixed at the time of purchase. This is similar to most newly issued bonds. However, unlike regular bonds that decline in value when interest rates rise, I-Bonds can always be redeemed at full principal value plus accumulated interest (beginning 12 months after they are bought and subject to a modest interest penalty during the first five years.) In this respect, they are akin to bank Certificates of Deposit.
I-Bonds pay interest every six months for 30 years. Interest is not paid out in cash, but is added to the principal value of the bond. Thus, interest compounds semi-annually and all interest income is automatically protected against inflation until the bonds mature or are redeemed.
The interest rate on I-Bonds changes every six months. Each bond pays a rate that combines 1) a fixed rate that does not change for 30 years and 2) a rate equal to inflation (change in the CPI-U index). Here is an example of how the rate is calculated.
The fixed portion of the interest rate is thus a "real" rate over and above inflation. However, because this "real" rate compounds, the effective "real" return is higher.
Another favorable element of the inflation protection afforded by I-Bonds is that deflation will not reverse gains from inflation in prior years. While negative inflation in a period will be subtracted from the fixed rate, the combined rate will not be less than zero. A deflationary period during the 30-year interest-bearing life of an I-Bond will actually enhance the real return over the life of the bond (there have been two such six-month periods since the bonds began to be issued.) Thus, even an I-Bond issued in December 2010 with a 0% fixed rate had a "real" annual return of 0.3% through the end of 2015.
Real Pretax Returns from Selected I-Bonds:
I-Bond Issue Date ($100) | Dec 2015 Value* | Fixed Rate Set When Issued | Increase From Inflation | "Real" Gain | "Real" Annual Return |
Dec-98 | $257.24 | 3.40% | $144.31 | $112.93 | 3.5% |
Dec-01 | $180.32 | 2.00% | $133.86 | $46.46 | 2.2% |
Dec-02 | $165.72 | 1.60% | $130.75 | $34.97 | 1.8% |
Dec-05 | $138.60 | 1.00% | $120.19 | $18.41 | 1.4% |
Dec-06 | $137.16 | 1.40% | $117.21 | $19.95 | 1.8% |
Dec-10 | $109.40 | 0.00% | $107.91 | $1.49 | 0.3% |
What about protecting against inflation when you want to withdraw rather than accumulate savings? I-Bonds are uniquely suited to these situations because of their redemption feature. Unlike their big brethren, TIPS, which protect against inflation only at maturity, I-Bonds provide inflation protection at every point during their 30-year interest-bearing life. No need to construct inefficient TIPS ladders.
Also unlike TIPS, I-Bonds come with significant tax advantages. Inflation ultimately affects after-tax wealth and purchasing power. Taxes on I-Bonds may be deferred until the bonds mature or are redeemed, which means interest can compound at the full inflation rate. I-Bonds are not subject to state and local taxes. In addition, subject to income limitations and other conditions specified in IRS Publication 970, I-Bond interest may be tax-deductible when used to pay for higher education expenses.
Electronic I-Bonds can be easily purchased and owned through the U.S. Treasury's website at www.treasurydirect.gov in any amount greater than $25. The government limits electronic I-Bond purchases to $10,000 per year per social security number. In addition, physical (paper) bonds can be purchased in increments of $50 up to another $5,000 per tax return. Thus, a couple filing a joint tax return could save up to $25,000 annually. To maximize purchases, one would need to ensure a sufficient tax refund. This may require some planning ahead, either by increasing withholding or making estimated tax payments.
The main risk of I-Bonds is probably the capriciousness of government. Tax regulations, investment limits, and the calculation of the CPI have all changed in the past and can change again. But as long as the ability to redeem the bonds remains in place, investors can always walk away whole. And while I-Bonds are relatively new, the Savings Bond program has been in place since 1935. It is a program targeted at small savers and it is not clear that great political, budgetary or other benefits could be had by sticking it to these voters. The greater risk is that the chance to invest in a very favorable investment opportunity simply goes away.
*Calculated using Treasury Direct calculator at http://www.treasurydirect.gov/BC/SBCPrice
This article was written by
Analyst’s Disclosure: I am/we are long I-BONDS AND TIPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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