I Bonds Are a Good Long-Term Investment Amid Macro Environment
What are I bonds? Are they a good long-term investment considering the current macro environment? Here's what investors can expect.
For investors, 2022 hasn’t been fruitful so far. Barring commodities that have spiked amid the Russia-Ukraine war, most other asset classes including stocks and bonds have given negative returns in the year. Another concern for investors has been to beat inflation, which hit a multi-decade high of 8.5 percent in March. I bonds have emerged as an attractive investment proposition amid soaring inflation.
While I bonds were introduced in September 1998, they were at best an obscure asset class. But you can probably find solace in the fact that most financial advisers also didn't advise buying I bonds. What are I bonds and are they a good long-term investment considering the current macro environment?
Bonds are either fixed or floating
When we talk of bonds, some bonds pay a fixed interest. Also, there are floating rate bonds where the interest is linked to a benchmark. Fixed-rate bonds carry interest rates risk since their prices fall when interest rates rise. The opposite also holds and their prices rise when interest rates fall.
Investors can remove the interest rate risks largely out of the equation by investing in floating-rate bonds. The interest rates on these bonds rise when interest rates go up. However, the flip side is that their yields drop when interest rates fall. Also, while their payouts are linked to prevailing interest rates, it isn't guaranteed they would help you beat inflation.
Especially in the current environment where inflation is running way above Treasury yields, fixed income instruments can't beat inflation. This is where I bonds can help.
How are the interest rates determined on I bonds?
According to the U.S Treasury Department, an I bond is “a savings bond that earns interest based on combining a fixed rate and an inflation rate.” The fixed rate on these bonds is currently zero.
The variable interest on these bonds is twice the trailing six months' urban CPI and is calculated twice a year in March and September. The interest is compounded semiannually and resets in May and November, respectively.
You can earn 9.6 percent for six months on I bonds.
Going by the March inflation reading, investors can lock in a 9.6 percent annualized yield on I bonds. However, the interest would only be valid for six months and would reset again in November based on the September CPI data.
There are some special characteristics of these bonds. First, if you're looking for a liquid investment, I bonds aren't for you since they can't be redeemed within the first year. If you try to redeem them within five years, you would end up losing interest for the preceding three months. Therefore, only long-term investors should consider I bonds.
What makes I bonds a good long-term investment?
Beating inflation is possibly the most important goal for fixed-income investors. Through I bonds, an investor is reasonably sure of beating inflation. Also, these are issued by the U.S. Treasury so there's virtually no credit risk. If you're looking at a long-term debt allocation to the portfolio, I bonds could be a good fit.
Also, there are tax advantages if you intend to use the proceeds for higher education. Overall, retail investors can look at I bonds favorably. But you can only buy $10,000 worth of bonds in a year. You can buy another $5,000 in paper form through your tax refund. Married couples are allowed to buy another $10,000 worth of these bonds every year.