I Bonds Explained
When I was a kid, my very wise grandfather would send me these funny looking pieces of paper for birthdays and Christmases. In the early 80’s I wanted money for the arcades. A handful of quarters made for a great Saturday. So I thought I was the Elon Musk of my time when I got this thing that looked like money and had the vast sum of $100 printed on it! I was drunk on unbridled avarice. Turns out it also had the words “Series EE Savings Bond” on the face. The ecstasy of untold riches quickly gave way to a lesson in frustration and patience as it was explained to me how much I would “appreciate” this gift “20 years from now.” 20 years?!? All I heard at the time was, “Your Saturday plans at Exton Mall are shot, Chris.”
For years—nay, decades—no one has cared a whole lot about savings bonds. Maybe you’re not even aware of their existence. It is possibly a surprise to you that you can purchase lots of investments directly from the United States Government. No one has really wanted to in recent times, what with Bitcoin, Gamestop, and a runaway stock market. Specifically in light of ridiculously low interest rates.
But now, in the first half of 2022, not a day goes by I don’t see a new question or article on the more modern version of the savings bond—the Series I. Why? Why the sudden interest in something historically only purchased by those old folks that hand out butterscotch candies at church on Sunday mornings?
In a word….Inflation.
We are going to learn all about Series I Savings Bonds and how they might make a very good addition right now to your investment portfolio. But first, let’s go back to Investments 101, and get a good foundation.
What is a bond exactly?
Probably the easiest way to understand a bond is to think of it as a loan. But you’re the one doing the loaning. When you buy a bond, you are giving a government, a company, or some other entity your money. But your money isn’t gone forever. You’ll get all of that back in the future. That’s the loan part. Or more precisely, that would represent the principle you loaned them. In the case of government bonds, that part is guaranteed. You won’t lose your principle. Loan Uncle Sam $100, and he promises to give you back that same $100 in the future. Honest.
So what do you get out of this deal? No one loans money for free, right? Just like you have to pay interest on your mortgage loan each month because you borrowed money, the entity that sold you the bond has to pay interest on the money you loaned them. So you get interest. This interest can take lots of different forms, depending on the type of bond, but the simple way is that every 6 months or so you get an interest payment over the life of the loan.
When the end of the loan term comes, or in our case, we say when the bond matures, you get your initial loan amount back: The principle. And you of course kept all that interest you received over the years, too. That’s your profit. Make sense? Buy a bond = loaning money. Loans come with interest. Interest = the profit part. You get all the interest and then you get the original loan part back at the end. This is obviously different from a stock that you buy, where there is no upside, and no interest, and no guarantee.
Now, let us take our newfound investment education and use it to evaluate I Bonds.
Series I Savings Bonds are issued by the United States Government. Series I sounds like a funny name, I know. It’s that super creative government naming process we’ve all experience. U.S. Savings Bonds in their current form started in 1935 with Series A Savings Bonds. Then there were Series B, C, D and so on. Each one having a slightly different characteristic to them. Series E Savings Bonds were issued in 1941 and were used to raise money for the government to fight in WWII. As a bit of trivia, President Roosevelt bought the very first E Bond on May 1, 1941. You might have seen some of those vintage posters of famous people encouraging you to “Buy War Bonds" from this time…this is what they were talking about. (Yes, we seek to both educate and entertain here at Barfield Financial!)
After E Bonds, there were F, G, H, J, K, and then EE and HH Bonds. In typical government logic, the letter I was skipped for about 40 years, not being introduced until 1998. Most of the previous series have gone away and are no longer available. In fact, the only savings bonds left to purchase these days are Series EE and Series I.
Series EE Bonds are still out of favor it seems—at least for now. Why? Well as we know from our brief investment course above, the only way we make money on these things is through interest payments, right? So naturally, we determine whether it’s a good investment by how much interest we will get. Remember, interest = profit. Give me a guaranteed government bond paying me 30% interest a year, and I’m selling pretty much every other investment I own to lock in a 30% annual return.
Unfortunately, Series EE Bonds aren’t paying 30% a year. They are actually quite a bit lower than that. 29.90% lower to be precise. That’s right. EE Bonds right now pay 0.10% annually. In case you don’t do well with percentages, I’ll phrase it another way: A $100 EE Bond pays $.10 a year in interest. You loan $100 out to Uncle Sam, and you get $.10 back a year in interest. Hardly Lamborghini money. However, if you do think that is a good deal, contact me we’ll talk. I’ll be willing double that rate on any money you loan me! Double, I tell ya!
(There is a caveat, though, that no matter how low the interest is, the US Government guarantees to pay you twice the amount you paid for the bond if you hold it 20 years. So in this case, you’d get $.10 a year for 20 years—a whopping $2—and then instead of just getting your $100 back, you’d get $200 back. A smart investment? Hmm, probably not. That’s still only about 3.5% a year if we do the math. And you have to hold it the full 20 to get that….Hold it only 18 years and you only get your original $100 back, and $1.80 in interest).
I Bonds
Series I Bonds are different however. They are a bit more complicated. Yes, you put out your initial loan to the government (i.e. your purchase), but you get a much higher interest rate. At least right now it’s much higher. Unlike the EE Bonds, the I Bonds interest is not fixed, it can change every 6 months. It is tied to inflation, which means right now, it’s looking pretty good, and might move even higher. Since inflation seems to be moving higher. Let’s dig into how it works exactly because I see people mess this up all the time.
The interest it pays you is comprised of two different parts. The first part is a fixed rate. Fixed means it doesn’t change. Right now the fixed rate is 0.00%. “Now, wait a second, Chris. This sounds like a terrible deal!!” Hold on, hold on.
The second part is a variable rate, because well, it varies. It is technically called the “Semiannual inflation rate”. That is currently 4.81%. But semiannually means every 6 months. So we have to double that rate to get the annual rate of 9.62% See? 9.62% guaranteed by the government doesn’t look too bad now does it? Not when the S Fund is down almost 19% this year! Read on for some better news!
Add these two parts together and you get what is called the composite rate, or the total interest you’ll earn. You might not care that much about the names, but it helps to get the terminology right to avoid confusion down the road. Remember, fixed rate + twice the semiannual inflation rate= composite rate.
How often does the rate change? Every six months is the standard. Understand that rates can go up or down. While 9% sounds good right now, that might not hold for 20 years. In fact it would be very unrealistic to think that it would hold that long. The fixed rate portion would not change throughout the life of the bond, but the variable portion will.
Is 9.62% pretty good? For a guaranteed investment, yes, it’s pretty good. It’s historically pretty high for I Bonds, because the total rate has that inflation component in it. But remember, the guarantee is only for a short time. It could go down (or up) at the next rate change. So you’re really only guaranteed the rate for a 6 month period.
In fact, get this: If the variable rate falls into the negative, it can actually drag the fixed rate down (assuming there was a fixed rate). For example, let’s say the variable rate is negative 1% and the fixed rate is a positive .5%. You won’t be getting .5%, you’ll be getting 0%. Even though if you do the math, you would come out with a negative .5% in this scenario, the bonds are guaranteed not to go below zero. So 0.0% is the floor, even if the variable rate combined with the fixed rate would take it below zero.
How do I buy them? What are the rules, etc? Let’s hammer these answers out, shall we?
Purchase them from the government at Treasury Direct. You set up an online account and just buy them on the web. They will be in electronic form, so you won’t be getting paper bonds in the mail like I used to as a disappointed kid.
And/or purchase them by setting up payroll deductions each pay period
And/or purchase them by choosing to have your tax refund sent back to you in Series I Bonds. These will be in paper form like the good old days. The only denominations printed right now are $50, $100, $200, $500, and $1,000.
Annual limit is $10,000 per entity through Treasury Direct electronically. (So think husband, wife, kids, trust, etc., each have a $10k annual limit each year). The annual limit for actual paper I Bonds is $5,000. This is in addition to the $10k limit. Remember paper bonds can only be purchased through IRS tax refunds. But, if you are getting $5,000 back in taxes, might I kindly suggest you have a CPA look at your taxes? That’s an awful big loan to give to Uncle Sam each year.
You can purchase them in any amount over $25 electronically. (Up to the $10k annual limit mentioned above).
Bonds continue to earn interest for 30 years. After that, the interest stops accruing. But you can always cash the bond in. It never becomes void or worthless.
You don’t have to hold them for 30 years, you can cash them in as soon as 12 months after purchase. Note that you have to hold them for at least 12 months. So don’t put money in these things you need later this year.
If you cash them in (redeem them is the correct word, so let’s use that) before 5 years, you will lose 3 months of accrued interest. Example, redeem the bond after 4 years, and you’ll only get 3 years and 9 months of interest. You lose 3 months of interest. Hold them longer than 5 years and no early redemption penalty. As far as penalties go, this one is pretty benign. I wouldn’t be too concerned about losing 3 months of interest if you need to cash these in.
Interest is earned monthly and compounded semiannually. The interest doesn’t actually get mailed to you; it simply gets added to the amount you’ll get back when you redeem the bond. Don’t expect checks every six months. You’ll get all your money back at one time—principle and interest—when you redeem the bond in the future.
You pay federal income tax on the interest, but you do not pay any state or local income tax. So if you live in a state that has a high state tax rate, these may be more interesting to you than someone that lives in say, Florida, where there is no state income tax.
You can choose to pay the interest each year, or you can wait until you redeem the bond and pay taxes on all the interest at that time. Score one for flexibility! I would think most people would wait until the end, deferring the taxes. But you don’t have to if you’d rather pay each year.
Interest may be tax free at the federal level if used for higher education expenses. See IRS Form 8815 for the qualifications. One is that your AGI has to be less than $154,800 if married filing jointly, $98,200 if single.