Not Too Thrilled About 1.2% I Bonds

April 21, 2008 by TFB

A reader asked a few weeks ago if I'd write something about the Series I Savings Bonds (or "I Bonds" in short). I was thinking of doing it but I now see Jonathan at My Money Blog already did a very good job on this topic. There is also a long thread on the Bogleheads forum about it.

If you are not familiar with I Bonds, please read:

I'm not going to repeat what Jonathan and Bogleheads already wrote. The gist of it is that if you buy I Bonds at the end of April 2008 and hold the bonds until July 1, 2009, you will earn about 4.5% a year for holding the bonds for 14 months. Think of it as a 14-month CD at 4.5% APY, state income tax free. If you decide to hold longer, you will earn 1.2% plus inflation adjustment.

Is it a good deal? It is a good deal if you shift over existing money in bonds or if you would otherwise buy a CD. The highest yielding 1-year CD is about 4%. Money market funds yield less than 3% which may go up or down.

I will still buy the bonds but I'm not too thrilled about them for several reasons.

First you can't really use I Bonds as an emergency fund because there is absolutely no possibility to redeem them in the first 12 months, not even if you are willing to forfeit interest. For I Bonds bought in April 2008, the earliest you can get your money back is April 1, 2009. You have to be sure you have adequate money elsewhere and you won't need the money before that date.

Second if you are thinking of buying I Bonds but you are not contributing the maximum to your 401(k) and Roth IRA, you are better off increasing your contribution to your 401(k) and Roth IRA. Although I Bonds are tax deferred, they are like a non-deductible IRA. A non-deductible IRA should have a lower priority than 401(k) and Roth IRA. I Bonds are OK if the money is intended for short-term savings, not as a long-term investment for retirement.

Third, the purchase limit makes the difference really small versus a 1-year CD. The maximum amount a person can buy is $5,000 in electronic bonds and $5,000 in paper bonds, for a total of $10k. A married couple can buy $10k for each spouse. Even at $20k, an extra 1% over a 1-year CD is only $200, before federal income tax. After tax it's $150 or less. It's nice to have extra $150 but it's hardly earth shattering.

Finally, if you are thinking of buying I Bonds because you are hesitant to invest in the stock market, that's market timing which usually doesn't work. Just last week, the stock market went up 4.3% in a week. It'll take a whole year for I Bonds to do that. I know I'm comparing apples to oranges and it's unlikely stocks will go up 4% every week, but it's not inconceivable that in a few years you will find you would've been better off adding the money to your investment portfolio rather than chickening out into I Bonds.

Let me share some personal experience. I bought I Bonds in September 2001 at 3.0% plus inflation. These bonds are considered "golden" because many think rates will never be that high again (the current rate is only 1.2% plus inflation). A $100 3.0% I Bond bought in September 2001 is worth $144 today. If $100 was put into a balanced fund like Vanguard STAR Fund at the same time, it'd be worth $164 today, or 14% more. I also bought I Bonds in March 2003 at 1.6% plus inflation. A $100 I Bond bought then is worth $125 today. The same investment in Vanguard STAR Fund would be worth $173 today. That's 38% more. I'm still holding these I Bonds with no regret. I'm just showing you that buying I Bonds should not be a substitution of investing in a diversified stocks/bonds portfolio.

In the end I will still buy some I Bonds before the end of April. I will shift some money currently in tax-exempt funds into I Bonds. In doing so I will pick up an extra $100 or so. But that's it. It's not something worth getting too excited about. My fresh cash will still go to the stock market.

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Comments

3 Comments on Not Too Thrilled About 1.2% I Bonds

  1. Anonymous on April 21, 2008 | permalink
    2.  

    Love your blog!

    Just read that you had an old entry on EE bonds. I had some EE bonds bought in 2003. I really don't see a point to keeping them, not to mention that they will be out of the 5-year penalty by May. I too lose money on them after tax and inflation! Well, at least I earned some cash back because I bought them by credit cards.

  2. Don on April 21, 2008 | permalink
    3.  

    The 12 month to cash wouldn't have to be a severe limitation to using I bonds for emergency fund, particularly if you were expanding from an adequate emergency fund to a "more" adequate amount. You'd just have to stagger so an overly large amount of cash is not tied up.

    However, there is one thing that I think does make bonds inferior. I had a substantial amount of my emergency fund in EE bonds (from back in the day when the terms were better). When I had need of some of that money I it caused a big increase in my taxable interest that year (I had deferred my earnings).

    That's sort of a negative in my mind. Just when you need more money, your taxes go up and you need more money.

    I am resolved to keep only the bonds I have under the best terms and cash them for my daughter's education (taking the related tax credit). I am building the greater portion of my emergency fund in non-deferred ways.

  3. TFB on April 21, 2008 | permalink
    4.  

    Anon – Thanks for the love! For anyone else interested in the previous post about EE bonds, here it is:

    Tax and Inflation Penalize Savers

    I'm glad you brought it up. It can still happen with today's 1.2% I Bonds. Say the inflation is 3.5% and you pay 28% tax. Your after tax return is (1.2% + 3.5%) * (1 – 28%) = 3.384%, which a hair lower than the 3.5% inflation rate. The higher the inflation rate, the more you lose after tax and inflation.

    Don – That's a good point. I also redeemed some EE bonds last year and saw my taxes go up.

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