7.12% risk-free?!? Well, sort of…

There is no free lunch. I’m sure you’ve heard that statement before. As it relates to financial markets, it generally means that you can’t get an expected return above the risk-free rate without taking some level of risk. The higher the potential for return, the more risk must be embedded in the investment. Currently, there is somewhat of an exception, at least for the short-term, courtesy of the United States government.

Savings bonds are generally poor investments for the long-term. There are many types (“series”) of savings bonds and all but one are beyond the scope of this post. The exception, Series I Savings Bonds (“i-bonds”). These bonds are unique in that their variable interest rate is determined by a fixed rate, set by the Treasury at issuance (currently 0% and never below 0%) and a variable rate tied to the CPI (Consumer Price Index). The fixed rate portion is intended to reflect the “real” risk-free rate (i.e. net of inflation), with a 0% floor, while the variable portion is intended to reflect inflation. In this way, i-bonds pay an inflation-protected risk-free rate. Because of the current bout of inflation, the CPI increased by just over 3.5% in the last six months ending in September 2021. The variable portion of the i-bond rate is recalculated every six months based on the annualized change in CPI from the preceding six months. That means that i-bond rate for November 2021 through April 2022 is the 0% fixed rate + 7.12% variable rate = 7.12%. These bonds are backed by the full faith and credit of the U.S. Treasury, meaning they are about as default risk-free as can be and they’re currently paying 7.12%! So what’s the catch? There’s no free lunch right? No catches per se, but there are some things to be aware of…

First of all, that 7.12% is variable and will reset in May of 2022 based on the change in CPI between November 2021 and April 2022. For each six-month period of time, you’ll receive the variable interest rate, which is not known in advance. It’s unlikely to stay anywhere near 7% over the long-term unless inflation persists. Even then, your return will always only equal inflation. In normal times, that’s not much of a goal, but in a world of negative real interest rates, keeping up with inflation alone may appeal to at least some investors. While it’s unlikely to beat equity investments over the long-term, it’s certainly better than a savings account at one of the major banks paying 0.01%. But there are a few more disadvantages here…

Second, you are required to hold i-bonds for a full year from purchase. I know what you’re thinking… there’s always a way around requirements like that (CD’s charge some interest penalty for example, or illiquid investments that can be sold at below-market prices in case of emergency). Unfortunately, there is no work-around in this case. One full year holding period is required and there is no way to liquidate during that time. Beyond the one-year holding requirement, you can liquidate at any time, but, if you liquidate during the first five years, you are charged a three-month interest penalty (e.g. if you hold for 18 months, you only get the interest for the first 15 of those months). Once you’re past five years, the bond becomes fully liquid with no penalty, and you can hold it for up to 30 years when it will mature and stop paying interest.

Third, you can only purchase $10k of i-bonds per entity per year. What does “per entity” means? It generally means per person, but if you have a business or a trust, those entities can purchase $10k per year as well. So there’s no way to park hundreds of thousands of dollars in i-bonds for the short-term while they’re paying this rate and then liquidate them if rates fall over the next few periods.

Fourth, because i-bonds pay interest rather than qualified dividends or capital gains, that interest is taxed as ordinary income taxed at your highest marginal tax rate (meaning your after-tax return is going to be well less than the rate of inflation). On the plus side though, that interest is deferred until the year you cash in the bonds, so you can choose an otherwise low-income year to keep the marginal tax rate down. Also, as an obligation of the federal government, they are state income tax free, which makes them a bit more appealing if you live in a high income tax state.

So, what’s the bottom line? Should you run out and buy $10k of i-bonds as soon as possible? Well, they’re not a great long-term investment, paying a guaranteed after-tax rate that is less than inflation. They’re not a good emergency fund given the one-year holding requirement. But, right now, in a negative real risk-free rate environment, the fact that the fixed rate portion of the bond cannot go below 0% makes them appealing for those who have significant savings in cash, beyond an emergency fund and other liquid assets. If you’re the type of investor who likes to have a surplus of cash, beyond what you’d need over the course of a year in the case of an emergency like a job loss or disability, this can be a good place to park $10k ($20k if married, $40k if married with trusts, $60k if married with trust and two businesses). It can also be a good replacement for part of the (especially short and/or inflation-protected) bond portion of an asset allocation, since it’s going to pay a higher rate of return, at least for now.

If you decide that i-bonds are for you, you can’t purchase them or hold them in a bank or brokerage account and your financial advisor can’t buy them for you. You’ll need to go to www.treasurydirect.gov and buy them directly from the US Treasury. Opening an account is fairly straight forward and you can link a bank account quickly which will allow you to schedule a purchase right away. If your information is mismatched with something in the Treasury databases, you may have to mail in a form with a Signature Guarantee (like a notarization, but obtained from a bank) to prove your identity. This is also likely if you open an account for a Trust or a business. Once the account is opened an a purchase is made, you’ll see interest being credited after the first three months you hold the bond (that’s the three-month penalty you’d incur if you sell in the first five years). You can track the bond values over time as they accrue interest and can purchase more in future years as desired. Just remember, you’ll always earn the fixed rate that was in place when you purchased the bond (currently 0%) + the variable rate for each six-month period going forward.

You can find more details about i-bonds at the Treasury’s FAQ page for i-bonds.

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