I-Bonds currently yield more than 7% interest but do have risks to consider
Finding yield without taking exorbitant risk is a challenge in today’s fixed income markets. Given the abnormal period of inflation the country is currently experiencing, I bonds, issued by the U.S. Government, may make sense for funds currently in CD’s, money market funds, or bank deposits. With a current yield of 7.12%, which is way above other fixed income investments, caveats on I bonds must be considered.
How They Work
Available in limited amounts, I bonds may be purchased from the U.S. Government electronically or in paper form when you file your taxes. You may purchase $10,000 in electronic bonds per year-per person, while the limit for paper bonds is $5,000 per tax return. Following purchase, I bonds may not be redeemed in the first year, and a redeemer would incur a 3- month interest penalty for redemption between years 1 and 5. I bonds may be redeemed penalty free from year 5 through 30.
Interest is earned monthly, compounded semiannually, and comprised of both a fixed rate and an inflation rate. The fixed rate is presently 0.00% and is set for the life of the bond, and the inflation component changes every six months based on current inflation rates. Coupons are not paid; instead, interest is added to the principal every six months. Interest begins to accrue from the first of the month during which the bond was purchased.
Example: You Purchase A $10,000 Bond
A $10,000 bond is purchased in December, interest accrues from 12/01/2021 at an annual rate of 7.12%. Each month $59.33 (7.12% / 12 * $10,000) is added to the balance of the bond. As of June 2022, the value of the bond would be $10,356, which is the original $10,000 plus 6 months of $59.33. In June 2022, the interest rate changes. The fixed component is still 0%, but the inflation component is now 3.0% (hypothetical, this will be determined by future inflation). Monthly interest would now be $25.89 (3.00% / 12 * $10,356). The value of the bond in December 2022 would be $10,511. The penalty for early redemption as of December 2022 would be $77.67 (or $25.89 * 3 months).
A Compelling Opportunity with Risks
In the inflation-protected bond market, investors are currently pricing in a five-year inflation rate of 2.73% which, if accurate, would generate a similar return for an I Bond over the next five years. Though a 2.73% I bond rate compares favorably to a five-year CD currently paying 1.35%, if inflation is low in future years, then after six months at 7.12% the interest earned on I bonds would be reset lower. The interest rate cannot drop below 0.0% for any given 6-month period. While attractive now, this might not always be the case, so monitoring is necessary. For instance, it was not long-ago that inflation was under 2%, while high grade corporate bonds could be found for 3.5%+.
The current economic environment, which is historically unusual, has opened a unique opportunity for a limited amount of funds that may be in cash or a bank account earning little interest. Though Lincoln Capital is unable to purchase I bonds on client’s behalf, if you have questions or if we may be of assistance in any manner, please contact us.