Series I Savings Bonds, which many Americans informally refer to as "I bonds," offer investors yields that are based on inflation rates. These caught the attention of investors in 2022 as yields soared to due to high inflation rates, as a guaranteed 9.62% annualized yield sounded rather appealing to many, especially considering the turbulent state of the stock market.
I bond yields have cooled off a little bit, falling from 9.62% to 6.89% for the six-month period starting in November 2022. However, this is still a historically high yield and could be a smart inflation hedge if you have idle cash on the sidelines.
Image source: Getty Images.
What are I bonds and how do they work?
As mentioned, I bonds are a special type of savings bond. They are issued by the U.S. government and are designed to protect investors' savings from the effects of inflation. Every six months, the U.S. Treasury Department reveals new I bond interest rates, which take effect for newly purchased bonds in May and November of each year.
Regardless of when you buy I bonds, the initial interest rate will be locked in for six full months, then will change to the prevailing rate for the next six months and will reset every six months thereafter.
Technically, there are two components to the yields paid by I bonds -- a fixed rate and an inflation adjustment. For people who buy new I bonds through the end of April, the fixed component will be 0.40% for the life of the bond, while the inflation adjustment will be 6.49%. It's also worth noting that even if there is deflation, the combined interest rate of an I bond can never be less than zero.
Here's the basic rundown of how this works. Let's say you buy a new I bond on Feb. 1. You would receive a guaranteed 6.89% annualized return on your investment through the end of July. At that point, your I bond's yield would become the 0.4% fixed-rate component, plus whatever the next inflation adjustment is. It would stay that way for six months, and the process would continue.
The interest paid by I bonds is exempt from state and local taxes, and while it is considered taxable income in the eyes of the IRS, you can get out of paying tax on your I bond returns if you use the interest for qualified higher education expenses.
Drawbacks to consider
No investment is without its drawbacks, and I bonds are certainly not an exception. Here's what you should know before you buy them.
- You have to keep your I bonds for at least one year.
- If you sell within the first five years, you forfeit the last three months' worth of interest.
- If inflation declines or even disappears (entirely possible), your I bonds could pay almost nothing.
- I bond investments are capped at $10,000 per person, per year.
Are I bonds right for you?
I bonds can be an excellent way to protect your money from inflation, but be sure to consider the drawbacks before you buy. They are not a permanently high-yielding investment in the same way that other bond investments or dividend stocks can be, but they can provide excellent risk-free returns in inflationary periods.
