The Case for I Bonds

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Professor Zvi Bodie, my long-time friend and Boston University colleague, has long been an avid proponent of I-bonds, introduced by the US Treasury in 1998. Given today’s negative yields on TIPS (Treasury Inflation Protected Securities), Zvi’s argument for I-bonds is particularly compelling.

Professor Zvi Bodie is my long-time friend and Boston University colleague. He’s also one of the world’s top finance economists. Zvi’s textbook, Investments, coauthored with Alex Kane and Alan Marcus, is used in all the major business schools around the globe and has been translated into 10 languages in addition to English. With Nobel Laureate in Economics, Robert C. Merton, Bodie co-authored an introductory textbook Financial Economics, which has been translated into nine languages.

But Zvi’s not just an egghead like me. He’s absolutely devoted to helping people with their personal financial problems as his terrific books, Worry-Free Investing, and Risk Less and Prosper, make clear.

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Zvi has long been an avid proponent of I-bonds. I-bonds were introduced by the US Treasury in 1998. It is a program designed to provide middle and lower income Americans with a safe inflation-protected account to use for retirement, education, and emergencies. Given today’s negative yields on TIPS (Treasury Inflation Protected Securities) — negative 1.81 percent out five years and negative 0.21 percent out 30 years — Zvi’s argument for I-bonds is particularly compelling. Consequently, when we spoke yesterday about them, I asked him to make the case in writing and let me pass it on to you. Here’s what he wrote with some commentary from me.

If you have an emergency fund that is currently sitting in a bank account or low-risk mutual fund, there is an arbitrage opportunity waiting for you. Right now the interest rate adjusted for inflation on that money is negative. But Series I Saving Bonds (aka I-bonds) issued by the US Treasury are offering a real rate of interest of zero fixed for 30 years.

Larry: This means that, over the next five years, you can earn, on an inflation-adjusted basis, 1.81 percent above the market entirely risk free! That the annual difference in the real yield on I-bonds and five-year TIPS.

Okay, you may not be investing in five-year TIPS. But say you are invested in five-year nominal Treasuries. After accounting for the risk of inflation watering down your investment return, you’ve effectively opted to earn negative 1.81 percent for five years! I.e., if you have $10,000 invested in such bonds, you can expect to end up with $9,127 in purchasing power five years from now. In contrast, if you invest $10,000 in I-bonds, you’ll have $10,000 in purchasing power five years from now — for sure.

Zvi continuesAnd that’s not all. The interest earned on your bank account or mutual fund is taxable in the year it is earned at the federal and state levels. The interest earned on an I-bond is tax-deferred until the bond matures or until it is cashed in and the money withdrawn. It is exempt from state and local taxes altogether. Even better: If you sell an Ibond and use the proceeds to pay for qualified higher education expenses at an eligible institution in the same calendar year, the interest is exempt from federal income tax!

Larry: Unfortunately, Uncle Sam taxes nominal interest income, even on TIPS. The fact that your return is negative after inflation? Sorry, your problem. So the tax break can matter particularly if you live in a high-tax state like California, and/or if you can spend the bond proceeds on qualified educational expenses.

Back to ZviRelatively few Americans know that I-bonds exist as an investment option. The same can be said of a shockingly large number of professional financial advisors. Even after they are made aware of the existence of Ibonds and are convinced that they ought to own some, people and their advisors rarely act upon that knowledge. Of the total amount of US government bonds outstanding of $21.6 trillion, the amount in the form of I-bonds is merely $46.3 billion or .2 percent.   

Series I-bonds can be issued in any amount between the minimum and maximum purchase annual thresholds. The minimum purchase is $25 and the maximum annual purchase is $10,000 per Social Security number. I-bonds can be held for as little as one year or as long as 30 years, but if they are sold after fewer than five years, the holder sacrifices the last three months worth of interest.

Larry: Say your household numbers five. This means you can buy $50,000 worth of I-bonds ($10,000 for each person) each and every year!

The series I-bond is a zero-coupon bond, meaning that no interest is paid during the life of the bond. The interest is, instead, added back to the value of the bond and earns interest on interest. I-bonds earn the rate at which they are issued year after year for 30 years. If you cash them out before the 30 years, you receive the principal plus the interest accrued up to the cashout date.  

Larry: Since the current I-bonds are yielding zero percent after inflation, the semi-annual inflation rate is the prevailing semi-annual interest rate.

To buy I-bonds and keep track of them, go to the Treasury website, set up an account, and watch your money grow.