Series I savings bonds became a surprisingly hot investment last year. In 2022, the S&P 500 index tanked by nearly 20%. But as inflation surged, Series I bonds -- which pay a fixed interest rate plus a variable rate that's tied to inflation -- offered a guaranteed interest rate of 9.62% for bonds issued between May and October 2022. Demand was so strong that TreasuryDirect.gov, the website where you can purchase I bonds, crashed in May 2022.
But as inflation cools, so do I bond interest rates. I bonds issued between November 2022 and April 2023 paid a 6.89% interest rate. And for I bonds issued between May 2023 and October 2023, the interest rate dropped again to 4.3%. But at only 4.3% interest, are I bonds still a buy?
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How do I bonds work?
Series I bonds are a type of savings bond that have two interest components: a fixed rate that applies throughout the life of the bond, plus an inflation rate that readjusts every six months based on the Consumer Price Index (CPI). Interest accrues monthly and compounds every six months.
The fixed rate on I bonds issued from May 1 through Oct. 31 is 0.9%, while the semiannual inflation rate is 1.69%. The formula is as follows, which brings you to 0.043, or 4.3% when you round up:
[0.009 + (2 x 0.0169) + (0.009 x 0.0169)]
As far as investments go, I bonds are considered risk-free since they're backed by the full faith and credit of the U.S. government. Your principal investment is safe unless the U.S. government were to default on its debts, which has never before happened in history.
But that doesn't mean you're guaranteed to earn 4.3% annually on I bonds you purchase today. I bonds do promise a 4.3% interest rate but only for the next six months. That means if you purchased $10,000 worth of I bonds (the maximum you can purchase electronically), you're guaranteed to earn 2.15%, or $215, since the interest rate is calculated every six months.
Suppose the semiannual inflation rate drops to 0.5% for November 2023. You'd still get the 0.9% fixed rate, but using the formula above , the composite interest rate would be just 1.9% -- meaning you'd earn just 0.95% over six months.
Are I bonds still a buy?
Two more things you need to know about I bonds: You can't cash them out for at least 12 months. And if you redeem them before five years, you'll forfeit the last three months' worth of interest.
It's that first rule that's especially onerous. Because of rising interest rates, many high-yield savings accounts pay interest rates that are on par with what I bonds offer.
Buying I bonds certainly made sense back in 2022. But when you can earn the same amount in interest on a savings account without locking away your money for a year, they lose their luster. Or if you have sufficient emergency savings, you could invest your extra funds for the long term. Though the stock market can be volatile in the short term, historically, it's delivered average annual returns of around 10%.
I bonds are a good place to store extra cash when you have a solid emergency fund -- meaning one that's liquid -- if the interest rate is higher than what you can earn in a savings account. But when you can get the same interest rate from your savings account, the savings account is a better bet.
