You may be familiar with Series E or EE savings bonds, which were the paper bonds you used to be able to buy at your local bank. Often used as gifts for birthdays or graduations, Series EE savings bonds earn a fixed rate of interest and, regardless of the rate, are guaranteed to double in 20 years. For example, you could buy a $25 Series EE savings bond today and, in 20 years, redeem the bond for $50 (a nominal return of approximately 3.53%).
Recently, inflation has started to creep back into the minds of investors and ignited a renewed interest in hedging against inflation. Enter the Series I savings bond. I bonds are different than EE bonds because they earn a variable interest rate that is tied to inflation. Unlike EE bonds, the value of a Series I bond is not guaranteed to grow by any certain amount (they also are not capped on the upside, either). Interest, if any, is added to the bond monthly and is paid when you cash the bond. The interest rate on an I bond combines two separate rates.
Like interest rates in general, I bond rates have declined significantly in recent years. Because inflation rates fell over time, I bond rates dropped as well. However, inflation has heated up significantly in the aftermath of the COVID-19 pandemic, with inflation in the U.S. reaching its highest level in 40 years. Consequently, rates on I bonds also have increased and may deserve a second look for investors seeking to protect a small portion of their assets against inflation.
I bonds earn interest for up to 30 years or until you cash them, whichever comes first. The composite rate for I bonds issued from November 2021 through April 2022 is 7.12%. This combines the fixed rate of 0.00% with the semiannual inflation rate of 3.56% (3.56% x 2 = 7.12%). The fixed rate of an I bond applies for the life of the bond. This means that returns on I bonds purchased now will earn the rate of inflation (which resets semi-annually), nothing more and nothing less. Even if inflation were to shift to deflation, the combined rate can never go lower than 0.00%.
If you live in an area with high state and local taxes, Series I bonds may be particularly attractive as they are exempt from state and local income tax. Additionally, if I bonds are used to pay for college, interest earnings may be excluded from federal income tax.
On the other hand, there are tight limits that apply to the maximum purchase of I bonds, limiting their effectiveness in larger portfolios. Series I savings bonds can only be purchased through Treasury Direct (online) or in paper form using your federal income tax refund. Series I bonds have a maximum purchase amount of $10,000 per individual, per calendar year. In addition, I bonds are not as liquid as Treasury bonds or money market accounts, for example. That is because an I bond cannot be redeemed unless held for at least a year. If you redeem before holding the I bond for at least five years, you will forfeit three months’ interest. After five years, there is no penalty for redeeming.
Compared to Treasury Inflation-Protected Securities (TIPS), Series I savings bonds have several distinguishing characteristics. Unlike TIPS, which are marketable securities that can be sold in the secondary securities markets, Series I bonds cannot be bought and sold in secondary markets.
Additionally, Series I bonds do not experience principal increases/decreases with inflation/deflation. Instead, the earnings rate is a combination of the fixed rate of return, which is set at the time of purchase, and a variable semiannual inflation rate. While the fixed rate for TIPS is set at auction and can be negative, the fixed rate on Series I bonds has a floor of zero.
Furthermore, Series I bonds are generally more tax-efficient than TIPS. Series I bonds allow interest to be deferred until the bond is redeemed, whereas the principal adjustment for inflation on TIPS is subject to federal taxation each year.