Every other month there seems to be a hot topic in the finance space. Some months the story is about cryptocurrency. Bitcoin mining is setting the world ablaze and Dogecoin has gone to the moon (and back). Other months it’s all about stocks. Tesla is undergoing stock splits. Amazon is crushing small competitors, and Walmart is taking over healthcare. Sometimes we can’t get enough of real estate as we hear stories of folks using cash to pay above-asking price for average homes or scroll down our newsfeeds of targeted marketing for overpriced real estate courses. The recent weeks are no different. Only the craze isn’t crypto or individual stocks or real estate, it’s bonds. Yep, you heard that right, bonds. More specifically I-bonds. Let me clarify some half-truths and dispel some myths.
What are I-bonds?
Generally speaking, bonds are a type of asset. You loan money to an organization, company, or in this case the federal government and they pay you back the money with interest. They promise to give you back the money with interest by issuing you a promissory note called a bond. There are different types of bonds and each one has a slightly different structure. I-bonds are “inflation-protected bonds", which is one of the many different types of bonds a person can purchase.
How do I-bonds work?
You pay for the bond (through the treasury website). Each person can buy a maximum of $10,000 worth of bonds each year. The interest rate that you make on the bonds is based on two factors: a fixed rate and a variable rate. The fixed rate is pre-set and based on market terms. Currently it’s 0%, which is about the norm. The variable rate is based on inflation and changes every 6 months. Currently, its around 9% per year. (A person would earn half of that amount for 6 months and then the rate would be changed once more if inflation changes during the next 6 months).
Why do people want them?
Because they think they can make a lot of money. Because I bonds or inflation protected bonds are based on the inflation, the rate of return on these I bonds seems extremely attractive. As of early May of 2022, the stock market is down, the price of real estate has skyrocketed, cryptocurrency is volatile, and cash is losing value. Having an investment like I-bonds that provides you with a guaranteed interest rate over 9% (at least for the next 6 months) seems like a good deal and much better than other investment choices at the moment.
What’s the catch?
Although I-bonds protect against inflation and provide a guaranteed interest rate the real rate of return on your money is actually zero, or negative. Let me explain. Because the fixed rate of I-bonds is zero and the variable rate is set to inflation (currently around 9%) you haven’t made any true gains. If inflation has gone up by 9% and the value of your bond has gone up 9% then then your true gain is actually zero because your purchasing power is still the same. Stated differently, If you invested $1,000 in I-bonds, with a guaranteed inflation protected rate of 9%, the value of your money is now $1090. However, if the price of monthly groceries for your home also went up by 9% from $1000 to $1090 then you haven’t really gained anything. The price of goods and services went up at the exact rate your bond went up so your net gain was zero. You don't make money by just seeing an asset go up in value. You make money by increasing your purchasing power to outpace inflation. If all you do is simply break even with inflation each year then you haven’t really gained as much as you might have thought.
Are there any other downsides?
Yes. There are taxes and liquidity issues. Per the rules of governmental I-bonds, you must hold the bond for at least 1 year. This means if an emergency comes up, you cannot liquidate or sell your bond to get your money back. You have to keep the money there for at least 1 year. Secondly, if you take out your money in less than 5 years you forfeit 3 months of interest on your money. This means if you cash out the bonds in less than 5 years you lose some of the profit you made. Lastly, you must pay federal taxes on the interest gains (unless you use the money for college expenses or hold it for at least 30 years). So if your money was keeping up with inflation, but then you have to pay federal taxes on your profit, you’ve actually gained less than inflation, putting your real buying power in the negative.
Should you buy them?
It depends. It’s not like I-bonds are all bad. As we mentioned above, they keep up with inflation. So at a time where stocks are down, real estate is too high, and cash in a savings account is losing value, I-bonds can be beneficial. Although your real return is zero, your return is even more negative in other alternatives. For example if inflation is at 9% and your savings account is only giving you a return of 0.01% then the value of your money is losing value drastically day-by-day. I bonds can be a good way to protect some of your purchasing power or at least prevent you from losing so much of it in cash.
Some people think they could come out ahead by buying I-bonds during stock market dips then selling them and buying stocks when the market recovers. That strategy is flawed because it requires you to be able to predict the future and of course none of us have a crystal ball. Trying to predict the future by timing the market is a recipe for disaster. If you have large sums of money in cash or have transitioned from the wealth building stage of your life to the wealth preserving stage of your life, then I-bonds can be a great idea in today’s times. Just make sure you go into them with your eyes wide open and fully understand the value. If you are someone who is saving up for a large purchase like a home downpayment, a future car, or to buy into a practice or new business then I-bonds can be a great investment.
(Of note, I recorded a podcast episode on this topic at the Physician Philosopher with Dr. Jimmy Turner that you can find here)