Series I Savings Bonds, commonly known as I Bonds, are currently advertising an annual interest rate of 9.62%. This seemingly high rate understandably catches the eye of investors. Recent headlines continue the hype stating “Nearly risk-free I bonds to deliver a record 9.62% interest for the next six months” or “This inflation-proof bond is paying 9.62%. Here’s how to buy it.”

While I Bonds make a good headline, they don’t necessarily make a good addition to your portfolio. If you are planning to buy one, ensure that it will fit your specific needs and goals before focusing on the return.

An I Bond is a government savings bond that earns interest based on the rate of inflation.

The interest rate on an I Bond is made up of a semiannual fixed rate (currently 0%) and a semiannual variable inflation rate (currently 4.81%). These are often stated as an annual composite rate (the sum times two; currently 9.62%).

While reporters like to state I Bond yields as an annual number, you won’t experience this annual income. The variable rate is changed every 6 months in May and November. In this way, your actual annual yield could be lower or higher. For example, the annual rate reported on November 1, 2019 was 2.02% (1.01% times 2), then the annual rate reported on May 2020 was 1.06% (0.53% times 2), making the actual 12-month yield 1.54% (1.01%+0.53%).

While buying an I Bond now just to get the promised yield may be enticing, the government has regulations to prevent investors from doing that. You cannot sell an I Bond within 1 year of purchasing it, and if you sell an I Bond within 5 years you forfeit the prior 3 months of interest payments.

Additionally, the after-tax real return of I Bonds is disappointing. A 0% fixed rate means that I Bonds only offer the variable return equal to inflation. This means that the real return over inflation will be 0% at best. Then, unless you use the proceeds for qualified education expenses, you will owe ordinary income tax on the I Bond’s interest, making the after-tax real return negative.

These limitations of I Bonds exist regardless of your specific goals. However, there are some investors who have more complications using I Bonds.

All savings bonds, I Bonds included, are purchased directly from the government, and they cannot be bought or sold by private parties. This is why they are called “non-marketable.” There is no secondary market for their purchase or sale. The only way to access the funds is to cash in your bond.

Furthermore, the interest from an I Bond is automatically reinvested into the principal and not available for distribution. This means that no cash is available to the investor from the I Bond until the security is cashed out.

Typically, we recommend having 5-7 years of your withdrawal needs invested in bonds. The bonds provide stability during market downturns and help protect your portfolio from running out of money from withdrawals during a poor sequence of stock returns.

However, if I Bonds are a part of that Stability allocation, then you run into the problem that I Bonds are illiquid and non-marketable. They are like a piggy bank; you can only spend a portion of the money held inside after breaking the bank.

This creates a catch-22 for investors with withdrawal needs. If you don’t have withdrawal needs, you don’t necessarily need bonds in your portfolio and could likely capture a higher real return by investing in something other than I Bonds. If you do have withdrawal needs, I Bonds sound like a good investment but don’t provide as much stability during downturns because they cannot be easily spent and do not provide regular income.

In this way, the investors who could benefit from I Bonds are very conservative investors with lower risk tolerances and modest withdrawal needs.

The more you have invested in bonds, the lower the safe withdrawal rate of that portfolio is. However, investors with very modest lifestyles compared to their means have the margin to make that change.

While there is an amount of bonds necessary to support your withdrawal rate, bonds in excess of that target need not be as liquid and therefore could be I Bonds. In this example, since I Bonds would be in excess of your required stability allocation, the lack of liquidity is no longer an issue.

Another group of conservative investors who may benefit from I Bonds are those who are afraid to invest and are sitting on a bunch of cash as a result. Cash has a negative real return as it always loses purchasing power to inflation. So, I Bonds could be a way to elevate your real return without taking much risk. A 0% real return is better than losing purchasing power to inflation.

With recent high inflation, I Bonds may seem more appealing now than in the past, but the real return and liquidity limitations are still the same as they’ve always been. If you’re thinking about buying an I Bond, make sure it fits properly into your financial plan, and you aren’t just chasing the high interest rate.

Photo by Dave Hoefler on Unsplash