Inflation sucks. There’s no eloquent way to put it.
Gas costs more than wine, a Camry costs more than a Corvette did in 2019, and America’s favorite dollar store (at least for me it was), Dollar Tree has upped most of their items to a base price of $1.25, in order to combat inflation.
However, the bigger issue is that the money you save by budgeting — the money that stays in your checking and savings accounts — is still losing value due to inflation.
Let’s do something about that.
Invest in stocks? Possible, but risky.
Invest in crypto? Also possible, but also risky.
If only there was a place where you could stash money with zero risk and have it generate interest at the same rate as the rate of inflation. That way it wouldn’t lose value, and when inflation cools off, you could just yank it out.
Well, luckily such a thing actually exists.
What is a U.S. Treasury Series I Savings Bond?
Before covering what makes I Bonds awesome, let’s quickly recap what bonds are in general.
What are bonds, again?
We’ve written a whole breakdown on bonds covering how they work and why they’re a healthy part of a balanced portfolio, but here’s a TL;DR.
A bond is like an IOU. You loan an entity money, and they promise to pay you back by a certain date (known as the “maturity date”) with a predetermined amount of interest. Bonds also typically pay out interest every six months, generating some sweet passive income.
As far as drawbacks go, bond interest rates are typically low (1% to 5%) and your money gets tied up until the maturity date (or until you sell the bond).
Now, bonds issued by the U.S. Treasury, or T-Bonds for short, are popular because they’re virtually zero risk. However, they also pay some of the lowest interest rates below 2%.
“Wait. That’s lower than inflation, meaning I’d lose money loaning it to the government!”
They hear you; that’s why the Treasury offers a unique inflation-fighter called the I Bonds.
How do I Bonds work?
U.S. Treasury Series I Savings Bonds, or just I Bonds for short (thankfully), are bonds that help Americans protect their cash from inflation.
The basic mechanics behind I Bonds are pretty simple: every six months, in November and May, the Treasury adjusts the interest rate of I Bonds to try to match the rate of inflation.
Americans then buy the low-risk I Bonds to protect their cash from losing value, and after at least 12 months, cash in their bonds when things blow over.
Naturally, with inflation spiking in the U.S. right now, I Bond rates have spiked, too. Here are the recent and upcoming rates:
- May through October 2021: 3.54%
- November through April 2022: 7.12%
- May through October 2022: Between 7% and 9% (projected)
As the cherry on top, your interest accrued from I Bonds is exempt from state and municipal taxes. They’re potentially even free from federal taxes, too, if you spend your interest on tuition or repaying student loans.
However, I Bonds aren’t perfect, and do have a handful of shortcomings to consider.
What are the drawbacks to buying I Bonds?
Unfortunately, you can’t just treat your I Bond investment like a high-yield savings account, withdrawing whenever you want to pay bills or buy a PS5.
Rather, I Bonds come with some limitations, such as:
1. You can only buy up to $15,000 worth of I Bonds annually
The Treasury will only sell up to $10,000 worth of I Bonds per year per social security number. You can buy $5,000 more with your annualized tax return for a max of $15,000.
2. Your money’s tied up for at least one year (or five, without penalty)
I Bonds technically have a maturity date of 20 years, but you can cash out without penalty after just five.
Cash out between years one and five, and you’ll take a small penalty of three months’ interest.
Lastly, you can’t cash out an I Bond within 12 months of purchase. At this point you could sell most bonds to recoup your investment, however…
3. You can’t sell I Bonds on the secondary market
Simply put, there is no secondary market for I Bonds. They’re non-transferrable. The only entity you can cash out an I Bond with is the U.S. Treasury.
And you won’t be getting cash in the meantime because…
4. I Bonds don’t pay fixed income
As mentioned, most bonds actually pay you your accumulated interest every six months, which is why retirees love them.
However, I Bonds operate more like non-dividend stocks. Rather than issue you a check every six months, the Treasury reinvests your gains to let it compound further.
Compounding interest will increase the amount of money you get when you cash out, but it also means no passive income.
5. I Bond interest rates may drop
Technically speaking, I Bond interest rates aren’t just the Treasury trying to match the rate of inflation. I mean, that’s the end goal, but it’s not the formula.
The actual formula for calculating the I Bond interest rate involves both a fixed rate and the rate of inflation:
I Bond composite interest rate =
fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)
So, what does this mean for you?
It means that in theory, the Treasury’s fixed rate should provide a cushion to ensure that your interest rate doesn’t fall too far when inflation falls.
But here’s the issue: the Treasury’s fixed rate is 0.00%, and has been for a while. That means the cushion isn’t there. If inflation falls to 0% in 2022, your I Bond interest rate falls to 0%, too.
With the Fed working hard to cool off inflation, does that mean I Bonds aren’t a great buy in 2022?
Not at all. Quite the opposite actually.
Despite the cons, here’s why I Bonds are so hot right now
Despite the “risk” that inflation may slow down in the latter half of 2022, I Bonds are a smart buy in 2022 for a few reasons.
- If you buy I Bonds before the end of April, you’re locked in for six months of 7.12% APY. That’s simply unheard-of levels of interest on a zero-risk investment.
- Even if inflation overcorrects to 0%, and I Bond interest rates plummet, you’re still averaging 3.56% interest for the first 12 months. Again, darn good for a no-risk buy.
- Finally, nobody’s expecting inflation to go down anytime super soon. The Fed has a 2% target this year, but economists are highly skeptical. “We’re expecting CPI to still be roughly 4% at the end of this year,” says Sarah House, senior economist at Wells Fargo.
(CPI is the consumer price index, a predictive metric for inflation).
I Bonds are a smart buy right now, but “smart” doesn’t always mean “universal.”
Are they the right buy for you? If so, how do you buy them?
Are I Bonds right for you?
Buying I Bonds might be the move if
- You have up to $10,000 sitting in checking or a low-interest savings account,
- You aren’t sure what else to do with it, and
- You definitely won’t need it for the next 12 months.
Really, the no. 1 drawback to buying I Bonds isn’t the risk (because there isn’t any) but liquidity. Uncle Sam will protect your cash from inflation, but he won’t let you touch it for at least a year.
If you’re cool with stashing $1,000, $5,000, even up to $15,000 away in a zero-risk investment to protect it from inflation — and not seeing it for a while — buying I Bonds is a smart choice.
How to buy I Bonds
You can buy I Bonds in two ways:
- By submitting IRS Form 8888 with your 2021 tax returns, letting them know you’d like to spend some or all of your refund on I Bonds (up to $5,000).
- Buying them directly from gov (up to $10,000).
Setting up an account with Treasury Direct takes about 10 minutes. From there, the process is pretty straightforward, and they do a pretty good job of walking you through it.
If you’re looking to protect your cash from inflation, buying I Bonds is a lesser-known but very wise option.
Yes, Money Under 30 can help you invest it in other ways to potentially generate much higher returns (buying up index funds comes to mind), but I Bonds are guaranteed.
In summary, when inflation is high, I Bond rates get awesome in equal, opposite measure. If you have money sitting in a pile, let Uncle Sam protect it.
Featured image: ilikeyellow/Shutterstock.com