What Are I Bonds?

If interest rates start climbing you are going to start hearing more and more about I Bonds. What are they and are they worth buying?

What are I Bonds?

I Bonds are a type of U.S. Savings bonds. They are issued by the Treasury and they are designed to help investors protect their income and investments from the ravages of inflation.

They do that by paying interest that is pegged to inflation rather than pay a fixed rate as most bonds do.

How Much Do I Bonds Pay?

The yield on I Bonds is actually comprised of both a fixed rate and a floating rate. The fixed rate never changes but the floating rate is adjusted twice a year. The current rate (through Aril 1st 2014) is 1.38%.

Calculating the Return.

It’s fairly easy to figure out how much you will earn on your I Bonds. First, go to the website. Then, take the fixed rate and add in twice the inflation component of the I Bond.

For example, if the fixed rate is .6% and the current inflation rate is .4% you would add .6% plus .4% and then add another .4% to come up with a composite rate of 1.4%.

If inflation heats up (as measured by Consumer Price Index or CPI) the Treasury will increase the inflation component. If inflation decreases that portion of the composite rate will be cut.

Where Can You Buy I Bonds

You can buy I Bonds directly from the Treasury or from commercial banks. You can buy them in denominations from $50 to $5000 each. But each person can only buy up to $10,000 in I Bonds per year.

The Upside

Because I Bonds are issued by the U.S. Treasury they are secure. You don’t have any risk of losing your capital. Also, you can elect to defer paying Federal tax on the interest until you cash the bonds in. But you never have to pay state or local tax on the interest. And it doesn’t stop there.

While the bonds are issued for 30 years, you can redeem your bonds whenever you want to. That means if your financial situation changes and you either need the money or want to reallocate your investments, you won’t have a problem. The only catch is if you cash in during the first 5 years of owning the bonds you will forfeit the last 3 months interest.

Of course, the major reason why some people buy these bonds is because they are somewhat of an inflation hedge.

The Downside Of I Bonds

If you love I Bonds because you think they shield you from risk, you might want to reexamine how you define risk.

Remember, I Bonds are long-term investments. Sure, when the stock market is falling and typical bonds are cratering, I Bonds might look pretty swanky. But I Bonds aren’t going to make you money over the long-run. They’ll just keep up with inflation and little more.

They might help you side step market losses. But they could actually cost you a fortune over the long-term. That’s because your fear of short-term losses could sideline you from the opportunity to grow your assets over the long-run.

Do you think there is a good reason to buy I Bonds for the long run? Why?