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What are I Bonds and Why I’m Buying

by retirebyforty on May 29, 2013 · 39 comments

in investing

what are I Bonds

First of all, I must confess that I’m not a big fan of bonds in general. I have always been an aggressive stock investor and I didn’t understand why I needed bonds. Historically, the stock market has a higher return on investment (ROI) than bonds over the long term. So I thought, if I’m not concerned about volatility, then why not just invest 100% in the stock market?

100% invested in the stock market

I think going all in on the stock market is fine if all these apply to you:

  • You are young – You have 20+ years of time to add to your stock market investment, and you can afford to ignore the short term volatility. You will have time to recover from big market crashes.
  • You have a high saving rate – When those bear markets come along, you have plenty of extra savings to take advantage of the bargains. You will be able to dollar cost average your stock positions and reap the benefit later.
  • Your portfolio is small – If your portfolio is small, it’s really not a huge deal to go through a big correction. If you have $50,000 in your portfolio, a 50% drop is just $25,000. That may sound like a lot of money to young folks, but believe me, it’s not. You can recover from that pretty quickly if you have extra income to invest. On the other hand, if you have a $2 million portfolio, it would be much more difficult to recover from a 50% drop.
  • You have high risk tolerance and don’t mind the volatility – The stock market can be very volatile and many people can’t deal with sudden drops in the value of their portfolio.

In my 20’s, I fit the bill perfectly, but that’s no longer the case. I don’t make a lot of money anymore so I won’t be able to add much money during a down market. At this point, I’m not willing to lose 50% of my investment portfolio. what are I Bonds and why I'm buying

Everyone need some bonds

Over the last few years, I have been reading more financial books and all of them recommend holding some bonds. The Millionaire Teacher by Andrew Hallam in particular showed me how holding bonds can be helpful during a down market. Bond prices usually rise during a bear market and you can sell some bonds to buy stocks at bargain prices. After I rolled over my 401(k), only 10% of my portfolio was in bonds and I have been working to correct that. Currently, I have 20% in bonds and 20% in cash. My target is to increase my bond holdings to around 30% in the next few years. Hallam recommends the same % of bonds as your age, but I’m going to take my age minus 10 because I still want to be a bit more aggressive.

What Bonds to buy?

The interest rate is very low now and it will go up at some point. When the interest rate rises, bond yields will rise and bond prices will drop. From what I read, this is not a good time to buy bonds. One way to avoid price fluctuation is to buy bonds directly from the issuers and hold them until maturity. That way, you won’t be affected by the price fluctuation.

Series I Saving Bonds (I Bonds)

I Bonds are issued by the US Treasury and are backed by the US government. This is one of the safest ways to invest your money. A US resident with a social security number can buy up to $10,000 worth of I Bonds each calendar year. You can also use your tax refund to buy additional I Bonds, up to $5,000.

Interest rate – I Bonds are indexed to inflation so the money you invest today will maintain its purchase power. Interest on a I Bond rate is a combination of two rates.

  1. A fixed rate at the time of purchase which remains the same though the life of the I Bond. I Bonds pay interest for 30 years so there is no advantage to hold them longer than that. The fixed rate has been zero since November 2010.
  2. A variable inflation rate which is calculated twice a year.

The good thing about I Bonds is the variable rate will never be negative. Even if we enter a long period of deflation, the rate can drop to 0% at the most. In contrast, the other inflation-protected bonds from the US government (TIPS) already have negative interest rate.

Tax advantages Tax Deferral – I Bond interest accrues in your account over the time you hold it. You only pay tax when you redeem your bond.

Tax Exemption – You don’t have to pay State and local income tax on the interest earned. One good way to take advantage of the tax deferral is to build a bond ladder. You can buy $10,000 of I Bonds per year and redeem them after you retire. You’ll most likely be in a lower tax bracket then and pay less tax. This $10,000 can be a nice supplement to your social security income. I Bonds interest is also tax exempted if you use it to pay for education.  Your MAGI (modified adjusted gross income) needs to below a certain threshold though.

Limitations You have to hold I Bonds for at least one year. If you redeem before 5 years, then you give up the last 3 months of interest. After 5 years, you can redeem the bonds without penalty. Geez, that’s a lot of info. I tried to go over the most interesting points. You can read more about I Bonds and purchase them at Treasury Direct. what are I Bonds and why I'm buying

Why I’m buying

I’m going to assume most young folks don’t have a lot of bonds for the same reasons I didn’t. It’s a good idea to have a portion of your portfolio in a safe and stable investment though. The next time we have a bear market, I will be able to use these reserve funds to pick up some bargains. Let’s summarize why I’m buying I Bonds.

  • It’s a safe investment that is backed by the US government.
  • I Bonds are inflation protected because their interest rate is adjusted to inflation every 6 months.
  • I need to increase the bond allocation in my portfolio.
  • The interest rate is better than saving accounts and CDs.
  • Tax deferral and exemptions.
  • I have too much cash and want to shift some portions to I Bonds.

I purchased $5,000 of I Bonds each for myself and Mrs. RB40 in March. I’ll probably buy another $5,000 for us soon. I have been retired for almost a year and I found that we haven’t needed our $50,000 cash stash. I’ll shift these over to I Bonds over time. Maybe I’ll buy some I Bonds for Baby RB40, too. What about you? Do you have I Bonds in your investment portfolio? Why not open an account at Treasury Direct and buy some? You only need $25 to get started.

{ 38 comments… read them below or add one }

Maverick May 29, 2013 at 1:27 am

Good suggestion Joe. I’ve opened an I-bond accnt at the Treasury last year for the same reasons you described. It’s a pain to set it up, but once you do, it’s done.

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jane savers @ solving the money puzzle May 29, 2013 at 3:31 am

The old standard Canada Savings Bond is offering 1.4% for 2 years. I am in my late 40s and I need to be very safe but I can still get a slightly higher rate for a GIC at my bank. The GIC deposit is guaranteed up to $100,000 and I am in no danger of going over that amount.

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retirebyforty May 29, 2013 at 2:59 pm

Our best online saving accounts only pay about 1%. I Bonds are paying 1.18% right now, but if we have more inflation, it would increase.
Some day the fixed rate will be non zero…

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Mike@WeOnlyDoThisOnce May 29, 2013 at 5:50 am

While young people do have the time to safeguard against short term volatility, many younger people are also saddled with so much debt that they live almost paycheck to paycheck.

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retirebyforty May 29, 2013 at 3:00 pm

Yeah, that’s tough. Luckily, we didn’t have much debt when we were young.

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Wes May 29, 2013 at 6:17 am

These bond inflation rates are understated. Their intention is to track inflation, but they don’t include food and energy, and since those are increasing far more than the yield on I Bonds, you will significantly underperform and experience a draw down much quicker in your early retirement.

For energy price increases I buy XOM, COP, and BP
For food inflation I buy GIS, K, PEP, KO
For my rising phone bill VZ, T, WIN, VOD
For housing KBH, HD, LOW

Many of these yield more after taxes than the I Bonds.

In a ZIRP environment, these companies have tax lawyers, lending facilities, and access to <1% borrowing. As an individual, I don't have access to the discount window or prime rate financing. They can buyback their own debt far faster and on a much larger scale than you personally can.

I understand that their is more risk of capital with equities, but with a 20 year time frame, I see I Bonds as a far greater risk to going back to work.

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retirebyforty May 29, 2013 at 3:02 pm

I like stocks too and that’s why I’m targeting 70% of my portfolio for stocks.
I just think having some bonds is better in the long term. When the market crashes, I can cash out some bonds and add more stocks.
Do you have any bonds in your portfolio?

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Rich Uncle EL May 29, 2013 at 6:46 am

I have always like I Bonds, because of the inflation protection. We all are getting crappy rates in many investment accounts, but at least with I bonds you protect the purchasing power of the money.

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My Financial Independence Journey May 29, 2013 at 8:22 am

This seems like mostly a capital preservation strategy. The interest rate on I bonds is terrible. I know you don’t have as much money now, but you’re still young and engaged in entrepreneurship via your writing and real estate activities. I would be pressing forward with additional dividend paying stocks or real estate purchases.

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retirebyforty May 29, 2013 at 3:04 pm

Do you have any bonds in your portfolio?
I Bonds will be a very small part of my portfolio. I will definitely buy more stocks if I have extra income.

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My Financial Independence Journey May 30, 2013 at 8:19 am

No bonds here. While I believe in having a diversified portfolio, I have a firm policy of not buying investments that aren’t going to pull their weight, and at this point in time bonds are investment laggards.

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Kurt @ Money Counselor May 29, 2013 at 8:32 am

I think you’re smart to diversify away from always risky equities as you age and given your situation. Your priority since ‘retiring’ has shifted to preservation of capital; I’d make the same judgment in your shoes.

You mentioned that TIPs have a negative interest rate. How does that work in the real world? If I bought an Inflation-Protected bond from the Treasury, would the principal at maturity be less than what I paid for it? Thanks.

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retirebyforty May 29, 2013 at 3:09 pm

I’m not an expert on TIPS, but I think it’s like this.
Say you want to buy $10,000 of TIPS. You’ll have to bid and pay something like $10,300.
I’ll research a bit more and maybe write a how to article.

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Tina May 29, 2013 at 8:46 am

I purchased I bonds during my middle school years (1993-1994) when the rates were pretty good. I let them sit and cashed out 13 years later to cover some law school expenses. I’m going to recommend them to my fiance since he’s fairly risk averse and has way too much cash earning nothing in the bank.

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Steve May 31, 2013 at 7:55 am

Series I savings bonds weren’t created until 1998.

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Sustainable Living May 29, 2013 at 9:21 am

Sounds like a good strategy joe. I am curious – why are you buying bonds for the little guy? Is that a place to park cash for you, or is that something you’re turning over to him in the future? If it’s something you turn over to him in the future, would a dividend producing stock (like BERK:B) be a better fit?

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retirebyforty May 29, 2013 at 3:11 pm

I’m just wondering if it’s a good idea. He can use it to pay for his education and won’t have to pay tax on it. It might affect his financial aid eligibility though so this might be a good idea. I need to research a bit more. Dividend stocks are probably a better fit since he won’t have to pay tax for a while.

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snarkfinance May 29, 2013 at 11:08 am

I think I bonds are a little too on the conservative side, but then again I am not retired as you are. Still, I think there are superior ways to both preserve capital and receive a gain in excess of inflation. Great post though, definitely food for thought.

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TheGooch November 2, 2013 at 11:32 pm

They are great for an Emergency Fund. Start it in savings and slowly(over 5 years ) move 70% of it into I-Series Bonds. That meets the requirements of being non-volatile and accessible.

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krantcents May 29, 2013 at 11:37 am

I have some inflation adjusted bonds, but they are a very small portion of my portfolio. The fixed portion of my retirement is Social Security and a pension so I balance that with equities that will outpace inflation.

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Pretired Nick May 29, 2013 at 12:32 pm

I’ve always had 20-25% in bonds over the years. Unfortunately I’ve felt like a chump for doing so since they lagged so badly. This is pretty reassuring that it’s not a huge mistake to hold some bonds!

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retirebyforty May 29, 2013 at 3:12 pm

I have always been under-weighted in bonds and bear markets have been very painful in the past. Hopefully, more bonds will help stabilize our portfolio. 20-25% is pretty low too. :)

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moneycone May 29, 2013 at 12:47 pm

With IBonds the risk regular bond owners face (of rates increasing) is greatly reduced. Good move!

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Mike May 29, 2013 at 3:25 pm

I have actually been looking at buying a few of those in the next year or two. I know it is a bit late, but sometimes it’s better to get started than to not get started at all!

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thepotatohead May 29, 2013 at 5:08 pm

I’ve been playing the stock market for awhile and had mainly just invested in individual stocks. Not sure if I’m ready to buy bonds yet just because stocks seem to give better yields for the most part, but one day when I want less risk definitely!

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retirebyforty May 30, 2013 at 3:22 pm

You should borrow Millionaire Teacher from the library. He explains it much better than I did. It’s not just having less risk. Your ROI is better in the long term if you have both stock and bonds.

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thepotatohead May 30, 2013 at 6:44 pm

Thanks Rb40, I really do need to read more books on this stuff, I’ll make sure check out Millionaire Teacher

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[email protected] May 29, 2013 at 7:50 pm

I used to have a couple of thousand in savings bonds but ended up cashing them in for a vehicle back in the 90’s. The low interest rate they offer these days just does nothing for me and I would just opt for a higher yielding bond or stock fund.

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Darwin's Money May 29, 2013 at 8:29 pm

I guess it’s a good move for ultra-conservative; I always fear the “inflation” index used doesn’t really reflect my true inflation rate and hence, need to invest in riskier assets to get the returns needed to beat inflation.

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Jacob @ iHeartBudgets May 30, 2013 at 8:58 am

I’ve got a very small portion of my 401k in a bond fund, but no Series I bonds at the moment. So, are you trying to time the market with this a bit? Because it seems like you are moving away from stocks in anticipation of a market downturn. I haven’t invested very much, so I don’t know how to look for tell-tale sings of a market downturn, but I know I should be prepared for the ebbs and flows. Any advice on that front?

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retirebyforty May 30, 2013 at 3:24 pm

Yes, I’m timing the market a bit, but at this point in my life I’m looking for more safe investments as well. I’m really nervous about the stock market and I can’t handle another huge drop.
You’ll probably just have to learn by going through a few bear markets. I don’t have any special insights. I just know that I’d rather be a bit safer now.

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The College Investor May 30, 2013 at 7:42 pm

Good advice! It’s a good way to invest our money if we are gutsy enough to take the risk which most young people are and it also helps that with IBonds there’s less risk.

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Anton Ivanov May 30, 2013 at 7:52 pm

I’m young (25), so for the same reasons you listed I don’t hold bonds as part of my core portfolio – it’s all focused on growth instead. With that being said, I’m planning to shift my asset allocation slowly toward bonds as I grow older to preserve capital.

I do use bonds for short-term investments, at times. For example, I’ve held about $50k in a diversified bond ETF for about 6 months that I’m planning to use for a real estate purchase this year. Never bought single bonds directly from the issuer.

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Steve May 31, 2013 at 8:34 am

IIRC, A Random Walk had a chart that showed that a portfolio with some bonds and annual rebalancing had higher returns with lower risk than a pure stock or pure bond portfolio. So there is a reason to have bonds in your portfolio even if you are young, agressive, etc.

Meanwhile, over at The Finance Buff http://thefinancebuff.com/cd-vs-bond-fund-a-case-study.html they have been making a case for individual investors to use CDs (treasury bonds would work as well) for their bond allocation. Treasury bonds could work for this purpose as well. One nice factor of I-bonds is that as long as inflation is near the Fed’s targets of 2.5-3.5%, the effective interest rate on an I-bond is higher than the rate on other safe investments.

In any case, I have to admit I don’t have much bonds in my portfolio, either, despite knowing the above. What little bonds I do have are due to a subset of my household’s accounts being invested in target date funds.

And further, I am working on transferring our emergency fund into I-bonds, and given the purchase limits, it will be a while before I can invest in I-bonds for investment’s sake. I do agree with @Wes that inflation is understated by government measures. and don’t forget that despite zero real returns, the nominal return is taxable. Nevertheless it’s better than nothing, and for an emergency fund, it’s nice to know that our ability to handle an emergency will stay more or less constant no matter what happens with inflation.

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Rob @FinancialSprout May 31, 2013 at 9:58 am

I’m still very young (17), so I want to use more of an aggressive way of investing. I will probably start purchasing bonds by the time I am 20, but right now I don’t have the money to buy bonds and stocks, unfortunately.

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davidmichael June 29, 2013 at 10:32 am

I am coming into this discussion from a different viewpoint, namely, that of a 76 old who has made lots of money and also lost a fair amount due to the ups and downs of the stock market.

When I first retired, we shifted $60,000 into I-Bonds ($30,000 each), in 2001 when they paid 3% fixed rate plus variable inflation rate. To make a long story short, they recently doubled, so they are now worth $120,000. I know that a lot of people will say…”That’s not enough.” Well, here’s the deal. There was no risk, and there was no worry. My only regret is that we didn’t buy I-Bonds for several years before (or after) and place our entire retirement cache into this safe investment. They have become our Security Bucket for our last decade of life. Hopefully, we’ll have enough time for them to double again to $240,000 over the next 12 years.

One of the great finance books I read over the past 20 years is “Your Money or Your Life,” by Joel Dominguez and Vicki Robin. I strongly recommend it as a way to understand the trade-offs regarding different investments and life choices. What I learned the hard way is that the turtle approach usually wins the race and the hare is still running around trying to become that illusionary millionaire bouncing around from one scheme to another. Joel got it right the first time, avoid risk. Even Warren Buffet says about investing, “Rule #1: Don’t lose money. Rule #2: Don’t forget Rule #1.”

For all you young whipper snappers who expect to be a millionaire by 40, I’ll go over some real life experiences of my own so you won’t repeat some of the dumb mistakes I made in our financial life.

1) If you decide to invest in the stock/bond market, use Index Funds like Vanguard, and hold for 30 years plus. Never take your money out until you need it in retirement. I thought I could beat the market by trading covered calls. Eventually I lost all of it. Not once but twice I was so confident in my abilities to beat the market. Forget it. Trading is for suckers.

2) All of my teaching buddies with modest incomes became multimillionaires from buying real estate, one house or duplex at a time. Read “Rich Dad, Poor Dad.” Seems easy in hindsight, but I lived through the greatest real estate boom ever in California through the 1960-2000 period. I preferred to put all of our extra money into travelling. Loved every minute of it. Just wish I purchased a few extra houses in the process.

3) Be careful who you marry. Divorce can wipe you out in an instant. Lost my pension that way plus got saddled with child support (no problem there) and lifetime alimony (bummer).

4) Be careful of annuities and insurance companies. My second and final wife received a wonderful annuity as part of her divorce settlement. That was going to be a retirement cushion for us during retirement as she was promised $5000 a month for life at age 65.
Guess what? The largest insurance company in California went bankrupt. Seems incredible that this could happen, but it did. So instead of the $10,000 a month we expected in retirement, we receive $3000 thanks to Social security and our modest savings.

And…the truth is, we have weathered the ups and downs of life, and we have enjoyed a wonderful retirement by working now and then to refill of cash bucket of $50,000.

So, in summmary, yeah! I-Bonds are a winning investment. All that other stuff goes up and down like yo-yos. Even at 76, we are buying more I-Bonds this year. I love that “No risk, and no worry” approach to investing. Finally, I have become a turtle with all of the wisdom that it brings with advanced age.

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retirebyforty June 30, 2013 at 11:57 pm

Thanks for your tips and perspective. I like I-Bonds and we’ll try to invest $10,000/year as long as we can.
It can be difficult for smart people to invest in index fund. They always think they can do better. :)
Real estate seems to be about timing too. If you’re in the right place at the right time, your properties can go up so much.

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Frank Tang November 15, 2013 at 3:28 pm

I think this article is great! Finally, I feel like there is a good solution to parking the emergency cash as I was always scared of losing out to inflation. Based off a 50K emergency cash fund that is just sitting in a brick and morter bank account at 0.1% and the I Bond is currently yielding 1.38%, there is potential to earn $640 more a year. That sounds like a good plan to me.

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