Series I Bonds: Should Retirement Savers Invest in Them for Inflation Protection?
20:33 Share

Welcome to the Stay Wealthy Podcast with Taylor Schulte. This is not Taylor Schulte, as you may be noticing. It is Jeremy Schneider filling in for Taylor for part of June and July. And today we are talking about I-bonds. Specifically, we're going to go over what are I-bonds and how do they work.

Is this 9.6% rate that you may have been hearing about too good to be true? And should you be buying them? And we'll also be answering two questions from listeners. If you are ready to learn about this unique and virtually risk-free government-issued security that's currently paying over 9% interest, today's episode is for you. For all the links and resources mentioned in today's episode, head over to youstaywealthy.com slash 160. ♪

Alright, so I-bonds. First, let's talk about what is a bond. A bond is when you give money to a company or government with the understanding that they are going to give you your money back at some point in the future, plus a bunch of interest payments. It's a way to have your money working for you to build more money.

The government has a specific type of bond called an I-bond. What is it? Well, it's a bond. You give the government money, the federal treasury in this example, and they agree to pay you a certain rate of interest over a certain term. The I in I-bond stands for inflation because the rate of return they agree to pay you is based on the current rate of inflation. And that's why we're doing this episode. That's why I'm doing this episode right now because I...

I bonds have kind of been on top of mind of a lot of investors lately because inflation is very high. And so I bonds are actually paying very high rates, right?

The rate that the I-bonds pay is actually based on two different numbers. One is the base rate. So every six months, the treasury decides what the base rate is. And then every six months, they also decide the second number, which is the inflation rate. And when you sign up for the base rate, you get that base rate for the duration that you hold the bond, which can be up to 30 years.

I bonds were introduced in 1998. And when they were introduced, the base rate was 3.3%. And so if you bought an I bond in 1998, you would get a guaranteed 3.3% annual interest plus whatever the infomercials

inflation rate was. When you add those two together, you get what's called the composite rate. It's a little bit of a complicated formula. You add them together and then add them multiplied together or something like that because the base rate is an annual rate. The inflation rate is issued every six months. And so it gets a little bit complicated, but generally just adding these two numbers together to get your composite rate. And so if you were lucky enough to buy a bond in 1998 with a 3.3% base rate,

The current semi-annual inflation rate is 4.81%, and that's only for six months, and so you have to double that. If you double that and add the base rate, you actually get a composite rate of 13.18%. So if you bought an I-bond and you still hold it, if you bought it in 1998 and you still hold it, you're getting a 13% annual return right now, which is pretty incredible.

Right now, the base rate isn't 3.3%. In fact, it's never been as high since then. And it's been really close to zero for the last almost decade. And it is zero right now. But today, if you bought a bond today, the composite rate is indeed 9.62%.

That's pretty good. And so let's walk through an example of how buying an I bond would actually work. So you go to treasury direct.gov. And then you follow the instructions. And then you can purchase a bond in any increment from $25 up to $10,000. And then you just hold it. And then when you want your money back, let's say you hold it for let's say you buy $1,000 I bond, and you hold it for five years.

After five years, if you redeem it, you'll get your $1,000 back plus all that interest that compounds every six months based on that composite rate we just talked about. All right. So are these things good? Let's talk about the benefits. Let's talk about the pros. First, they're issued directly by the U.S. Treasury. They're guaranteed by the U.S. government. In investing, especially investing in the U.S., that is a pretty safe bet. If the U.S. Treasury...

doesn't pay their bills, then kind of the whole fabric of our economy isn't going to really be working anymore. And maybe companies don't exist and maybe the stock market doesn't exist. And so as far as risk goes...

buying something directly from the U.S. Treasury is about as guaranteed as it gets. They also offer both the base rate and the inflation rate, which is currently 0% for the base rate and the inflation rate of 9.62% on an annual basis, which is really good. That's like, you know, guaranteed 9.62% is about as great of a risk-adjusted return as you can get. And also another benefit is the gains are not subject to state or local tax. Strangely, they are subject to federal tax. Why?

why is a federal bond or a bond issued by the federal government subject to federal tax, but not stay in local tax? I honestly don't know. Maybe that's a question for our senators. So those are the benefits. All right, what are the negatives? Well, the first big negative is you can only buy up to $10,000 per year. And so if you were hoping to put your half million or million dollar portfolio and get your guaranteed 9.62%, that's not going to work. You're capped at $10,000 per year, but you can buy $10,000

every year. The next con is that it can't be refunded within the first year. And so if you were thinking about just keeping it as a savings account or something like that, and getting your 9% instead of the 0.5% or whatever savings accounts are paying, that's also not going to work because you can't redeem your bond at all within the first year. If you redeem it within the first five years, you do forfeit the previous three months of interest, but that's not that really big of a deal when you're talking about years of interest.

Another con is that the rates fluctuate. So this is a big one because people hear this current inflation rate of 9.62% and you maybe do that math in your head where you say, oh man, over the course of seven years, it might double. Over the course of 40 years, it might be up 20x or whatever. But these things fluctuate. And in another six months, the rate is going to change. It's based on whatever the current rate of inflation is. And in fact, that inflationary rate can even go negative.

The composite rate, they guarantee will never go negative. So you'll never lose value. But for example, if you did buy that bond in 1998 and had a 3.3% base rate, there have been some six month periods where the inflation rate was negative more than 3.3%. So it actually takes your interest down to zero for that period. Another con is it's not as liquid as cash. You know, you have to redeem the bond and do some transferring in and out of this government website, which is kind of a hassle.

Also, the long-term growth of them is not as good as stocks. So you're still talking about bonds. This is a safer, less volatile asset. You're not going to get as great of a long-term growth as an index fund in the stock market, for example. And the last kind is, is there kind of a hassle to buy? I actually just went through the signup process to buy the iBonds.

You know, you have to create several usernames. You have to type in your password using a digital keyboard on the screen. You can't like type it in or paste it in. And the password is case insensitive. And I actually have a master's degree in computer science. And all this stuff like really makes me cringe. And unfortunately, it's not that atypical from government websites that I've used in the past. But, you know, you just have to decide, do you want that hassle in your life?

So let's look at the actual returns. If you bought an I-bond in 1998, and you were one of those lucky ones to get that 3.3% base rate, plus the inflation rate that updates every six months, and you bought an I-bond in 1998, and you were one of those lucky ones to get that 3.3% base rate, plus the inflation rate that updates every six months, and you bought an I-bond in 1998, and you were one of those lucky ones to get that 3.3% base rate, plus the inflation rate that updates every six months, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought an I-bond in 1998, and you bought

If you put $10,000 into an I-bond in 1998, today it would be worth $39,352. That's pretty good. That's a 6% compound annual growth rate. 6% guaranteed, no downside risk, guaranteed by the government. That's a pretty solid little investment.

But that 3.3% base rate didn't last. If you were buying the average I bond along the way, if you're investing along the way and you're just getting the average rate of return, $10,000 would only turn into about $22,000. So you would have doubled over the course of 23 years, but still not a great return. As a point of comparison, if you were to invest $10,000 in an S&P 500 index fund in

in September of 1998 when these I-bonds were released. Today, you would have $56,000. So in 1998, it wasn't an especially great time to invest in the stock market because you were looking at the dot-com crash and the financial crisis in the next 12 years. But even so, you would end up with $56,000, which is more than double, almost triple the average I-bond. So it's not a fantastically performing asset.

But it does have those benefits, like I said, of the guarantees. So what are my takeaways and I bonds? First of all, I'd say it's not liquid enough to use for an emergency fund. It's tempting to use for an emergency fund. But if you have an emergency in that first year, then you're kind of out of luck because you can't get that money out.

And so, you know, you could ladder, you know, you could ladder into an I-bonds. You could, you know, if you wanted to have like a $30,000 emergency fund, you could keep 30 in cash and put 10 in the I-bond and then slowly move it in every year until you have $30,000 in I-bonds that is all accessible. But, you know...

you're kind of looking at a hassle there for maybe limited upside. Another main takeaway is there's not enough growth for long-term prospects. And so I personally would never buy this and plan to hold it for five or 10 years. Obviously right now this 9% sounds good, but that is probably going to go away in the next six months when inflation starts to come back down. I don't know what the future holds. I don't know if inflation is going to go up or down, but I doubt based on the Fed moving rates up and everything that we're going to keep seeing these really high rates of inflation. I feel like it's more of a

rebound effect from the supply chain issues and the stimulus from COVID. So yeah, not a great long-term prospect in my opinion, but it may be the perfect tool for the job if you're looking for a medium-term savings account. And so a couple of examples I would think of is if you're looking to buy a car in three or four years,

and you're someone who wants to have a savings account or a sinking fund for that specific goal, an I-bond could be the perfect thing. If you don't want $10,000 or $20,000 sitting there getting 0.5% interest and you want to at least keep up with inflation so when you buy that car in three or four years,

you're not losing value, you're not losing value of the car you can get, then yeah, maybe throwing some money in an I-bond for a few years is a great option. Another place I might use I-bonds is for a down payment for a house. If you're looking to save $30,000 or $40,000 or $50,000 over the course of three or four or five years to either buy your first home or to upgrade a home, again, an I-bond might be a great place to get that inflationary rate and prevent houses from getting even more expensive over that period of time and losing money.

buying power compared to inflation.

And the big takeaway for me personally is that the 10K limit really limits the ability to move the needle in your financial life in a meaningful way. While those medium-term goals is nice to kind of get some interest to stave off inflation, this isn't going to be your retirement account. This isn't going to change your financial life. This isn't what's going to make you wealthy. In fact, like we saw over long periods of time, you're going to underperform the stock market by double or triple over just the last 23 years.

And for me personally, I have a high net worth. I just don't like the hassle of having to create another account to keep track of 10 grand. I'd rather just have that in a regular bond fund or a regular index fund inside of my brokerage account with the rest of my money. So I don't have yet one more thing to keep track of.

But there you have it. If you're curious about I-bonds, those 9.62% rates you've heard, that's what they are. That's how they work. If you want to buy one, that's not crazy. You can head over to treasurydirect.gov and buy yourself. It's also linked in the show notes. All right, there it is. That was my rant on I-bonds. Now let's go to questions from listeners. We have two questions today. Our first question comes from Giddy from Lakewood, New Jersey. Hi, this is Giddy Zaman from Lakewood, New Jersey.

I want to know if it's a good idea or a bad idea to keep an emergency fund in a bond index fund. It seems to me like it's liquid. You can access your money. It's pretty safe. You don't have so much of a risk of losing capital. But I don't see anyone talk about it. You know, people will usually say use a high yield savings account, not like a bonds index fund. So I wanted to ask that.

Thanks, Giddy. That's a great question. And look at that, a bond question for the iBond show. Yeah, so that's a really good question. And you're right, when people talk about emergency funds, they almost always talk about just something very, very liquid and safe like cash in a checking or a savings account or a high yield savings account. I don't personally love high yield savings accounts because it's just like,

gimmicky term and the rates are so low these days that it basically results in 0% interest. But if rates go up and it makes more sense to go in a high yield savings account, sure. And so if you're looking at a bond index fund, that might make sense. And so for example, one bond index fund

is VBTLX. That's a Vanguard Total Bond Market Index Fund. That was kind of a broad bond market index fund you could use as your emergency fund. One benefit of keeping your money here is if you look at over the last 20 years or so, the compound annual growth rate of this fund is about 3.6%.

And that certainly sounds a whole lot better than the 0.2% or 0.5% or whatever a high yield savings account is. And so, yeah, if you've got 10 or 20 grand, why not throw it in there? And, you know, the answer to that question is that bond index funds are more volatile than cash. And a great example of that is this year, 2022. And so I'm filming this in May of 2022. And if you look at VBTLX.com,

Year to date, it's actually down 9.4%. So if you had a $20,000 emergency fund, for example, you would have lost about 10% or about $2,000 of that emergency fund. And the reason that bond fund is down is because right now rates are going up.

And interest rates and the value of existing bonds have this inverse relationship, where if new bonds are paying more and more interest, because the rates are going up, old bonds are worth less and less because no one wants your old crappy bonds paying lower interest rates. And so if you're holding a bunch of bonds inside of this bond index fund, then the rates go up, then you could lose a lot of value. And, you know, kind of the rule of emergencies is when things go wrong, they tend to all go wrong at once. And so if you lose

lose your job or have a medical emergency or something like that where you need this emergency fund, maybe it's also going to correspond with this weird point in history where rates are shooting up and your emergency fund loses 10% of the value. And generally, I wouldn't put an emergency fund in a bond index fund for this reason. And I think people...

kind of rightfully have this feeling of FOMO or this missed opportunity when you have a bunch of cash sitting there doing nothing. But let me...

maybe sell you on why it's not really a missed opportunity. And that's because that money isn't doing nothing. It's actually being used for insurance. And so when you buy insurance, for example, from an insurance company, you're paying some money to prevent a bad thing from happening. If you put all your money just into a regular old checking account and get 0% interest, for example, you are using that as not poor insurance because becoming poor is very expensive.

If you're poor, you might overdraft your bank account or you have to take out money from a credit card or a payday loan or, you know, all sorts of horrible things that occur when you end up broke. And if you can keep a buffer of cash there, even though it's giving you zero percent interest, it's acting as insurance against being poor. And so, you know, I like the emergency funding cash. You just kind of bite the bullet. That said, you know,

It's not a huge deal. If you lose 10% of your emergency fund, that would kind of suck and you don't want to. But over long periods of time, if you're sitting there with that in cash for 10 or 20 years, and you're getting your 3.6% instead of just having it be zero, maybe it's worth it. Generally, I say keep your emergency fund in cash, keep your investing dollars working for you, because your emergency fund is never going to make you rich. Even at 3% and your 10 or 20 grand in there, it's not going to make you rich. Your investments, your long-term investments and

stock market index funds are what's going to make you rich. Your emergency fund is there to make you not be poor. But it's a great question. And Giddy, if you want to throw your entire emergency fund into a bond index fund, hey, that's fine with me. Go for it. I think you'll still live a long, happy and successful life because it seems like you're a kind of person who's paying close attention to this stuff. And I'm sure you're going to do great. So thank you for the question. Our next question comes from Emily from Phoenix.

My name's Emily. I live in Phoenix, Arizona. I purchased a house and sold my old house and made a profit of about $100,000. Should I take the $100,000 and pay off my new mortgage or should I take the $100,000 and put it in to investments in index funds?

Pamela, well, it's a little bit tough to answer that question without like a full or complete picture of your financial life, of course. But if we just boil down this question to, should you take a lump sum of cash and more aggressively pay off your mortgage or more aggressively invest, which one is better? Well, this is one of those questions where it's really choosing between two good things. There isn't really a best option. And it kind of comes down to more of your own gut decision. If you put it into the spreadsheet,

and say what is going to be more likely to make you more money, generally, paying off your mortgage as slowly as possible and investing will be more likely to make you more money. The reason is because mortgage rates, at least

recent in history have been relatively low in the three or four or 5% range. And the market over long periods of time returns seven, eight, nine or 10%. And so if you are paying a lower interest rate on the debt and getting a higher return on the investments over long periods of time, you know, it's removing risk and volatility and all that good stuff, you are probably gonna make more money. That said,

risk and volatility are real things. And maybe the market's going to go down for five years and your mortgage company is going to keep charging the interest. If that is true, then you would have been better off paying off the house. Plus, I think there's just

an emotional win to hang down your mortgage. I personally don't have a mortgage. I live in a totally paid for house. A bank is not involved in my life at all. I come home and don't make a payment and it just feels good and I don't have to worry about it. It's like one stress that's not in my life. And so if you are the kind of person who just wants to give a big old middle finger to the spreadsheet and say, I want to live in a mortgage-free home,

go for it. It's a guaranteed win. Even if the rate is 3% or 4%, that's a guaranteed 3% or 4%. There's something to be said for that over the volatility involved investing in the market. If you're the kind of person who says, hey, I've got an emergency fund. The rate is super low. I'm comfortable with the risk.

We're doing grand investments and we just want to be as aggressive as possible and dump this money in the market. I say that's good too. Go for it. And so, sorry, Emily, I'm not giving you a concrete answer. I'd say you're choosing between two good things. The fact that you're answering means you're a person who's thinking about this stuff and probably going to be on the ball. And so I say, listen to your gut, go with what you feel good. If you want to pay off the mortgage, go for it. And if you want to be aggressive and just go play some ponies in the stock market, go

it. Go for that too. All right. That is the end of our question section. And that is the end of the podcast. How sad. That's all I have for you today. For the links and resources mentioned, head to youstaywealthy.com slash 160. Thank you again for putting up with me as I fill in for Taylor. He will be back in mid-July. And as always, I will leave you with my two rules of building wealth. Rule number one is live below your means. And rule number two is invest early and often. See you next week.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.