Are I-Bonds A Good Investment?

In this article, I am going to briefly explain, in simple terms, what an i-bond is, the pros and cons of investing in them, an analysis of their use for various purposes, and how to buy them.

Disclaimer: This article is educational and not advice. Please seek the council of a licensed professional before making any changes to your finances, to ensure they make sense for your unique situation. I am happy to help, or you can visit www.brokercheck.org to find an unbiased list of professionals.


Please note: I-bonds are best purchased directly from the government (TreasuryDirect). If they are purchased via a mutual fund or ETF, you lose the protection component due to market risk.


What is an i-bond?

An i-bond is essentially a loan to the United States Federal Government, who then pays you interest twice a year, which is tied to the rate of inflation.


The purpose of these bonds (other than to raise money for the government) is to provide individuals with a way to protect the value of their money from the eroding effect of inflation.


The concept is that the interest received from the i-bond will offset the reduction in purchasing power caused by inflation.


Therefore, theoretically i-bonds do not make money... They are intended to protect the value of money.


What are the pros and cons?

Pros

  1. Since you are lending money to the federal government of a sovereign nation, who has "unlimited taxing authority", i-bonds are one of the safest securities you can buy.

  2. They have a very low minimum investment of $25. So they're accessible to pretty much everyone.

  3. They are fairly liquid (ease of conversion to cash) after a year. You just log on, redeem the bond, and have the money sent to your bank, which takes about 2-3 business days.

  4. They can be owned for as long as 30 years. So you don't have to worry about reinvestment risk.

Cons

  1. The money is locked up for 12 months. You can't redeem (cash-out) the bond until after a year has passed.

  2. If you redeem the bond within 5 years, you lose the last 3 months of interest. So it actually takes 15 months before you truly make anything.

  3. The interest rate is variable, and not designed to make money. If inflation is high, so is the interest rate, and vice versa. They're only appealing when inflation is really high, and unattractive when inflation is normal (~2%).

  4. You must do everything yourself and buy them directly from the government to get all the benefits. If you buy them through a financial professional, inside of a mutual fund or ETF, you lose the principal protection because of market risk.

  5. You can only buy $10,000 of i-bonds per year, per person.

Potential uses

Emergency fund

I'm not crazy about using i-bonds for your emergency fund savings, because the purpose of an emergency fund is to have readily accessible money for unexpected events, which often happen suddenly and in large amounts (like a major health incident, or car trouble, or the loss of a job).


I'm not saying not to use them. You could certainly have a small portion invested in i-bonds, like 10%, if you really want to, but in my experience it's best not to invest your emergency fund at all and just keep it in a separate bank account. I know this flies in the face of conventional wisdom, but the interest and returns you give up are worth it when you need access to the money immediately.


Retirement savings

I don't recommend using i-bonds for your retirement savings unless you are completely terrified of all other forms of investing, which can be remedied with an understanding of how different investments work. Over time, your average returns will be lower than if you'd invested in another product that provides principal protection, such as a CD or fixed annuity, and significantly lower than if you'd invested in investment-grade bonds or income-focused equity.


Major expense savings (down payment, college, wedding, etc.)

Buying i-bonds with all or part of your major expense savings may make sense if you don't care about making money with it and just want to make sure inflation doesn't erode it's purchasing power between now and when you need it. However, it'd probably make more sense to invest in another principal protected product, such as a CD or fixed annuity.


As a gift

Government bonds can be an easy way to give money to kids or grandkids while you're still alive, especially since the maximum is less than the federal gift tax exemption. However, it'd probably make more sense to place the assets in an irrevocable trust, which would accomplish the same thing and have the potential of growing to a much larger amount. Or if you're planning to leave the money as an inheritance, it'd probably make more sense to use permanent life insurance since the benefit to the heir would be much higher, tax free, and [potentially] pass outside of probate.


How to buy i-bonds

You can buy i-bonds either directly from the government at TreasuryDirect.com, or through a TIPS fund which owns a diversified basket of inflation protected securities.


Which one you should use depends on your overall financial situation and personal objectives and preferences.


Conclusion

I-bonds are an interesting financial instrument that can make sense in specific scenarios, but are typically inferior to comparable alternatives due to the nature of their interest rate, interest claw-back, and lockup period.


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