The U.S. Treasury offers two types of bonds that are indexed to inflation: 1) TIPS (Treasury Inflation-Protected Securities) and 2) Series I Bonds. They are different in many respects. TIPS pay a yield equal to the CPI plus or minus a certain percentage. I-bonds, on the other hand, never pay less than the CPI. The I-bond terms are simpler, and designed to appeal to the small investor. Right now, because of the recent spike in the CPI, I-bonds are paying a yield of 9.62%! That figure will hold until next November 1, when it will be reset again based on the CPI rate between April 1 and September 30.
TIPS provide investors of any size with a liquid, tradeable Treasury bond tied to inflation. The principal value of TIPS rises with inflation, and falls with deflation (should that rare event happen). At maturity the principal value will be the greater of the inflation-adjusted principal or the original principal. The inflation adjustment, which is based in the CPI, is applied to the principal value every six months. The coupon rate, which is fixed at issuance, it multiplied by the new principal amount and paid every six months. The yield-to-maturity (often simply called the “yield”) calculation incorporates the principal value, the coupon rate, and the time to maturity. “Yield” can be negative even if the couple rate is positive if the current price is high enough. Thus, TIPS pay the CPI rate plus or minus a certain percentage.
Unlike TIPS, I-bonds are non-marketable, meaning that they cannot be bought or sold in the secondary market. They must be purchased directly from the Treasury and redeemed by the Treasury. An I-bond must be held for a minimum of 12 months. Any I-bond redeemed in the first five years is subject to a penalty of three-months of accrued interest. I-bonds mature and are automatically paid out after 30 years, but may be redeemed without penalty if held between 5 and 30 years.
Interest is accrued monthly and compounded semi-annually. That is, interest is not paid in cash but is added to the value of the bond. The interest rate is the sum of two components (called the “combined rate”):
- A fixed rate, which remains the same throughout the life of the I bond.
- A variable semiannual inflation rate based on changes in the CPI.
Right now, the fixed rate is zero (and has been since November 1, 2019). Because the latest 6-month increase in the CPI (4.81%) rose at an annualized rate of 9.62%, that is the current yield for I-bonds. If the CPI cools, the yield may decline, but can never become negative. Consequently, the accrued value of an I-bond can never decline. I-bonds always pay the CPI rate e at a minimum.
An Unusual Opportunity
The inflation adjustment for I-bonds is made twice yearly, on May 1 and November 1. The inflation rate for the preceding six months (lagged by a month) is annualized and added to the fixed rate to get the new combined rate.
The graph above compares the nominal I-bond yield with the 6-month Treasury bill yield. Both are reset every six months. The recent jump in the CPI has made the I-bond yield unusually attractive compared to the T-bill yield.
Another important comparison is between the I-bond yield and TIPS yields. As mentioned above, whereas TIPS yields can be above or below the CPI rate, I-bonds always pay at least the CPI rate. The spread over CPI for I-bonds is currently zero, but the spread over CPI for the 5-year TIPS bond is slightly negative and for the 30-year TIPS it is only very slightly positive. Of course, these TIPS bonds have considerable levels of interest rate risk and rising interest rates can and have caused their prices to decline. One important feature of I-bonds is their optionality—the owner of the I-bond decides when to redeem, and can do so without any penalty after five years and with only a small penalty after 12 months. Thus, I-bonds can be thought of as having characteristics that are the better of a 5-year bond and a 30-year bond, whichever ends up being more favorable.
Thus, even if inflation goes to zero in five years, and interest rates skyrocket so that nominal bonds become a more attractive option (a highly unlikely scenario), the owner of the I-bond always has the option to redeem and redeploy into a more attractive investment. On the other hand, if inflation stays relatively high, the I-bond owner can surf on top of the full CPI rate for up to 30 years, guaranteed.
Purchase Methods and Limitations
I-bonds are purchased directly from the Treasury on the TreasuryDirect website. The limit per Social Security number is $10,000 per year, which means that a couple could purchase up to $20,000 annually. One strategy to take full advantage of the current high rate is to buy the maximum now, and then in January turn around and buy the maximum again.
Another twist is that up to $5,000 worth of I-bonds can be purchased in the form of paper bonds with the proceeds of a tax refund. You simply complete IRS Form 8888 when you file your return instructing the Treasury to issue paper I-bonds to you. Purchase amounts must be in $50 multiples.
When you purchase an I-bond, you can elect to either pay taxes as interest accrues or defer the taxes until you redeem the bond. If you elect to pay as you go, you must pay taxes on interest income that you do not actually collect in cash. Also, you must keep careful track each year of the amount of tax that you paid on the I-bond, following the instructions on the 76-page IRS Publication 550. For these reasons, and because of the time value of money, most people defer taxes until redemption.
Because they are Treasury bonds, I-bonds are exempt from state and local taxes. And if your income does not exceed certain limits (currently, modified adjusted gross income under $153,550 for MFJ and $97,350 for single filers), as long as the proceeds are used for qualified higher-education expenses, the interest is exempt from federal taxes as well.
“Best Kept Secret”
A recent Wall Street Journal article quotes the highly regarded and often-published former Boston University finance professor, Zvi Bodie, in calling I-bonds “the best-kept secret in America.” Because they can only be bought directly from the Treasury, they are not a security that financial advisors can purchase and allocate to their clients’ brokerage accounts. Consequently, FAs can’t charge a fee on them, and so have little incentive to mention them to clients.
You can buy I-bonds as gifts for any TreasuryDirect account holders. Paper bonds purchased with tax refunds can be bought for others in their name and mailed or handed to them. The $10,000 per year purchase limit applies to the recipient, not the giver, so you can purchase up to $10,000 for as many people as you like as long as they are willing to open TreasuryDirect accounts.
I want to make purchasing your $10,000 worth of I-bonds as easy as possible. Following these step-by steps online instructions should only take about 20 minutes:
Instructions for Buying I-Bonds for an Individual
- Under “Individuals” select “How to Buy Series I”
- Select “How can I buy I bonds?” twice
- Select “TreasuryDirect”
- Select “Open an Account”
- Select “Apply Now”
- Leave “Individual” and select “Submit”
- Fill in required information
- Check box at bottom and select “Submit”
- Review information and select “Submit”
- Select an image and a caption and select “Submit”
- Fill in required security information and select “Submit”
- After you receive the email with your account number, click on the website link in the email
- Under “Account Login” (Orange section, upper right) select “TreasuryDirect”
- Select “Login”
- Enter your new account number (from the email) and select “Submit”
- Go to email and copy the One Time Passcode (OTP) in the email
- Paste the OTP into the box, check the box to register your PC, select “Submit”
- Use the Visual Keyboard to enter your Password and select “Submit”
- Select “BuyDirect” from the top menu
- Select “Series I” and select “Submit”
- Enter purchase amount and select “Submit”
- Review information and select “Submit”
- Print Confirmation page