How would you like to earn a guaranteed 6.7% or more on your money without taking any risk? Although it sounds too good to be true, that’s exactly the opportunity that will be offered on Nov. 1. The investment? Series I savings bonds.
I bonds are 30-year bonds issued by the U.S. Treasury, which are available to anyone who opens a free TreasuryDirect account. These bonds are the quintessential risk-free asset. Backed by the full faith and credit of the U.S. government, they have minimal credit risk. They also offer inflation protection, as their yields are indexed to inflation.
The yield on I bonds is the sum of two components: a fixed rate and an inflation rate. The fixed rate is set at the time of purchase, and remains fixed for the life of the bond. It’s currently 0%, so you can effectively ignore it.
The inflation rate component of the yield adjusts twice a year—the first business days of May and November. The semiannual inflation rate for I bonds being currently sold is 1.77%. This determines the interest earned over the next six months. Double it and you get the bond’s annual percentage rate (APR), which would be 3.54%.
While 3.54% isn’t bad, the new rate in November is all but guaranteed to be much higher. My guess is that I bonds issued then will carry yields of at least 6.7% and possibly as high as 7.8%. Let me explain.
The inflation rate is based on the Consumer Price Index for All Urban Consumers, which I’ll simply call CPI. The November rate will be based upon the percentage change of CPI from March to September of this year. We already know March’s CPI number, which was 264.877. September’s CPI won’t be released until Oct. 13, but the August number was 273.567.
Assuming there’s no change in CPI in September—not very likely given recent trends—the six-month percentage change would be 3.28%. That corresponds to an APR of 6.56%. The effective annual rate you would earn is 6.67%, since I bonds compound semiannually.
More than likely, September’s CPI level will be higher than August’s. How much? The average monthly increase in CPI has been 0.55% year-to-date. Extrapolating that rate of increase, September’s CPI would be 275.072, corresponding to a semiannual inflation rate of 3.85%. The corresponding effective annual rate for I bonds would be 7.85%. That’s not too shabby, particularly considering this return is risk-free.
Of course, the rate would only apply for six months. In May 2022, the rate would be adjusted once again. If the Fed’s transitory thesis is correct, and inflation slows next year, the interest rate on I bonds would fall. On the other hand, if inflation persists or accelerates, I bond yields would remain high and vastly outperform money-market funds and savings accounts.
Another bonus: Unlike TIPS, or Treasury inflation-protected securities, I bonds are protected against capital losses. Akin to a savings account, the principal value of an I bond can only increase. In the unlikely scenario that inflation is negative, the inflation rate on I bonds can never go below zero.
I bonds must be held for a minimum of one year after purchase. If you redeem an I bond before it’s five years old, you’ll lose the last three months of interest. Assuming a 6.67% interest rate, selling early would reduce your return for the final 12 months to 5%.
How many I bonds can you purchase? There’s an annual limit of $10,000 per individual. That means a married couple with two children could buy up to $40,000 in total. If that family had a trust, another $10,000 could be purchased in the name of the trust, for a cumulative $50,000 in I bonds per year. Keep in mind, if you buy an I bond for a child through a custodial account, that constitutes an irrevocable gift.
I bonds also enjoy favorable tax treatment. Interest is subject to federal income taxes, but is free from state and local taxes. You can also defer reporting the interest on your federal tax return until you cash in your bonds or the bonds mature. If you hold an I bond to maturity, that’s 30 years of tax-deferred growth. Speaking of taxes, you can purchase up to an additional $5,000 in paper I bonds per year using your federal tax refund.
If you’re considering I bonds, I would suggest waiting until Nov. 1, when the interest rate will reset to a much higher level. Just don’t expect most advisers to recommend them. I bonds are only available—commission-free—through TreasuryDirect.gov or when you file your tax return. As such, your adviser stands to gain little by having you invest in these wonderful bonds.
This column first appeared on Humble Dollar. It has been republished with permission.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.
This artical is first shown on Market Watch Source link Author on date 2021-10-09 20:31:00
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