Every once in a while, a sleepy corner of the market garners investor attention at a fevered pace and becomes the investment du jour. As inflation surged, the magnifying glass was placed firmly on the lowly I-Bond. With eye-popping yields, investors snatched up I-Bonds at a record pace. But with inflation moderating and yields dropping, investors have turned their backs on the sleepy corner of the fixed income market.
And that might be a mistake.
Overall, I-Bonds may not be the sexiest investment on the block, but they offer plenty of benefits and appeal for investors. Using them as part of an overall long-term investment strategy makes sense. Investors may not want to throw them away so quickly.
Don’t forget to check our Fixed Income Channel to learn more about generating income in current market conditions.
A Record Amount
$27 billion is a lot of money. That’s also the amount of cash investors sent to the Treasury to buy I-Bonds in October of 2022. In contrast, October of 2021 saw only about $386 million in I-Bond purchases.
The reason for the huge surge in purchases? Surging inflation. As the CPI and inflation hit levels not seen since the 1980s, yields on I-Bonds hit an eye-popping 9.62% annual return. All of a sudden, one of the most ignored and sleepy areas of the fixed income market became the hottest. Investors scrambled to add I-Bonds to their portfolios and advice about the bond-type was everywhere.
Flash forward to today. As the CPI has dropped, so has the yield on I-Bonds. That juicy nearly 10% yield has dropped to 6.89% through April of 2023. And with the CPI still falling, estimates are calling for a lower yield at the next reset.
With that, investors have started to ignore the bond type once again. The headlines are dominated by “why I’m not buying I-Bonds” articles.
Rethinking That Stance
Despite the recent yield declines, I-Bonds still have a lot of appeal as a portion of an investor’s portfolio and offer a lot of flexibility in their use.
For one thing, they offer investors another chance at tax deferral. The ability to defer taxes is a surefire way to increase rates of compounding. By avoiding paying taxes today, more of your money earns interest and so forth. However, Uncle Sam will only let you avoid paying taxes on so much of your investments. In 2023—and excluding catch-up additions for older workers—that amounts to $22,500 for 401ks and $6,500 for IRA accounts.
With I-Bonds, investors have the ability to save an additional $10,000 per taxpayer, per year. If you invest your tax refund, you can sock away an extra $5,000. And the taxes applicable on the interest stemming from those I-Bond purchases can be deferred for 30 years. This provides another chance to have a portion of your portfolio compounding outside the reach of Uncle Sam.
Because of the long tax-deferred compounding time and government guarantees, I-Bonds can be used as a tool for spending in retirement. Last year’s negative returns reminded us that the market doesn’t always go straight up. Sequence of returns risk is real and can negatively affect a portfolio’s ability to fund a retirement.
But, by building a cache of I-Bonds today, investors have a pool for safe spending later on. If the market is down, investors can tap some of their I-Bonds and keep more of their money invested in stocks for the rebound. Or this cache of I-Bonds can be used to form a base of spending each year in retirement. Ultimately, I-Bonds provide flexibility for spending.
And speaking of that spending, tapping I-Bonds early before the age of 30 years is an option as well. That can’t be said for 401k accounts. Meanwhile, IRAs come with additional tax penalties if investors withdraw funds before a certain age. Have an emergency or want to retire early? I-Bonds can provide the funding.
Finally, despite being a supplement to 401ks and IRAs, I-onds have an added benefit as a college savings tool as well. Because they qualify for the government’s Education Savings Bond Program, I-Bonds can be used to pay for college in a tax-free manner.
When a parent sells an I-ond, all funds—both interest and initial principal—must be used toward higher education costs for the owner, a spouse, or a dependent. As long as the total proceeds from the bond sale are less than the amount of eligible college expenses, savers can skip paying taxes on the accrued interest. If the sale is more, investors can avoid taxes up to the college cost amount. Given the new rules on 529 college savings plans and their ability to be rolled over to IRAs, using I-Bonds to pay for college expenses instead could be advantageous. It may make sense to use I-Bonds first and leave money in a 529 plan for future roll-over/retirement savings.
The Bottom Line
While I-Bond fever may be fading and yields dropping, investors should still consider them as part of their portfolio. Their ability to defer taxes for decades and their flexibility of use makes them an ideal piece of an income plan, offering a low volatility solution for a portfolio. With low initial investments and ease of use of purchase, investors may want to consider adding them to a portfolio.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
