I like I Bonds. Should You?
I bonds are issued by the United States government. I bonds can be a great place to stash some of your cash. Let’s discuss the topic of I bonds. Why do I like putting money in I bonds? And how can I bonds fit into building your wealth.
First of all, some background information.
I relate all of my investing decisions back to my investment objectives. In fact, I have documented my investment objectives. Doing so is a key investing principle. Solid investing habits are critical to building your wealth.
How do you know what to invest your money in if you are not clear on your objectives? And do not know what you are trying to accomplish with your money.
The fact is, you do not know without having investing objectives. It’s like anything worth accomplishing in life. Set some solid objectives and a plan to achieve them. Then set off on executing the plan.
INVESTING OBJECTIVES CAN CHANGE
My investing objectives have changed over time. In my 20’s I wasn’t really clear on my investing objectives. That led me to chase the hot performing investment of the moment. And that is not a productive behavior for building wealth. You usually get into the investment late at a high price and then suffer losses.
In my early 30’s, my objectives became more clear. That being growth of my principle. So I invested in growth stocks through mutual funds. I balanced this growth objective with a small allocation to bonds for stability.
But in my late 30’s, as I turned up my focus on early retirement, I set my investing objectives mainly around the pursuit of income. Why income? Because I wanted to get paid cash from my investments in retirement.
Furthermore, I wanted the passive income from our investments to cover all our expenses. And I wanted that passive income to grow over time to keep up with inflation. In this way, our future buying power would not be reduced.
There are other retirement readiness rules of thumb. Like the rule where you need 80% of your working income to retire. Or the 4% rule where you are allowed to withdraw that amount annually from your investments to meet your retirement income needs.
MY CURRENT INVESTING OBJECTIVES
Here are the investing objectives I have used to invest our money over the past 15 plus years.
Objective 1 – Income. Every investment or savings vehicle I purchase must pay income. If it doesn’t pay regular, recurring income I won’t buy it. I like to say, it’s hard to go broke if you are getting paid. Of course building wealth is not that easy, but you get the idea.
Objective 2 – Growth of Income. I prefer that the income from each investment I make will grow passively over time. This is not an absolute requirement. It is a preference. Because a passive stream of income that grows over time keeps up with inflation. This is why I really like dividend growth stocks. They pay current income and that income rises every year. I sit back and collect my dividends and do virtually nothing other than put my money into the stock.
Objective 3 – Growth of Original Investment. Finally, I want my original capital invested to grow over time. This is sometimes called capital appreciation. Growth stocks and other growth investments fit this objective. But again, I prefer dividend growth stocks. Dividend growth stocks achieve all three of my objectives. Over the long term, the price per share of a dividend growth stock will usually rise along with the company’s dividend increases.
Over the entire breadth of our investments, I put equal weight on these objectives. Each individual investment may meet one objective better than another, but over our entire portfolio it balances out.
WHY NOT 100% DIVIDEND STOCKS?
So if dividend growth stocks meet all three of my investing objectives, why not pull all of my money in them? The reason is risk. Dividend growth stocks and the stock market in general can be very volatile.
For example, during the 2007 to 2009 bear market, my dividend stock portfolios value dropped by more than 50%. And I just don’t need that kind of excitement in my life.
Who wants to see their entire wealth cut in half or even more? It can happen. Don’t be fooled into thinking it is different now. It can and probably will happen again.
So underlying my investment objectives is the following philosophy. I would rather give up some potential upside investment gains in order to protect my downside.
I BONDS FOR FIXED INCOME
That is where fixed income investments come into play. They do not have the potential for explosive gains. In contrast, they can limit one’s potential losses. It is the classic risk reward trade off. Less risk, less potential financial reward.
How much in fixed income investments should you have in your portfolio? One quick and dirty rule of thumb is to take your age and subtract it from 100. Put that percent in stocks and the rest in fixed income.
So if you are 35, you should put (100-35) or 65% of your investment portfolio in stocks. The remaining 35% should go into fixed income investments and cash. You can modify the result of this calculation to suit your personal risk tolerance. Are you 35, but risk averse? Then put 60% in stocks and 40% in fixed income investments.
As a side note, academic research shows that a 60/40 asset allocation provides the most risk adjusted potential return on investment. But that’s a topic for another day.
US SERIES I SAVINGS BONDS (I bonds)
So where do I bonds come into play? First of all, here are some examples of fixed income investments.
Cash. Examples include savings accounts and certificates of deposit.
Bonds. Savings bonds (including I bonds), other types of US and International government bonds and bonds issued by corporations and other entities like Universities and not for profit entities.
Although I bonds are considered a form of bond, they behave more like a cash equivalent in my opinion.
This is because the principle amount you invest in I bonds never changes. There is very little risk that the US government will not pay back your principle.
Furthermore, I bonds do not trade on the open market at prices different than the denomination that you purchased. These characteristics feel more like cash to me. Not liquid cash, but a long term cash holding.
CHARACTERISTICS OF I BONDS
Here are some of the primary characteristics of I bonds.
INTEREST RATES FOR I BONDS
Interest rate. I Bonds are indexed to inflation so the money you invest today will maintain its purchase power. Interest on an I Bond is a combination of two rates. A fixed rate and a variable rate.
Fixed rate. This rate is calculated at the time of purchase. It remains the same though the life of the I Bond. I Bonds mature after 30 years from purchase. They will no longer pay interest after 30 years. Most recently, the fixed rate has been rising recently along with inflation. The fixed rate was 0% for many years after the great recession. This made I bonds less attractive during that time.
Variable rate. This rate is calculated twice a year. The variable rate changes based on the consumer price index. This is a well-known gauge for inflation in the US economy.
The good thing about I Bonds is the variable rate will never be negative. Even during the deflationary period after the great recession the variable rate did not drop below 0%. In contrast, the other inflation-protected bonds from the US government (TIPS) can have negative interest rate.
TAX ADVANTAGES OF I BONDS
Tax advantages from 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 deferred savings and investments are a huge part of building wealth. Your money can grow so much faster without the burden of paying tax on your income every year.
Tax advantages from tax exemption. You do not pay state and local income tax on the interest earned from I Bonds. If you live in a high tax state like Illinois, California or New York, this is a great deal. One good way to take advantage of the tax deferral is to build a bond ladder. You can buy the same amount of I Bonds each year and redeem one year’s worth of bonds each year after you retire. You will likely be in a lower tax bracket at this time. Which is good since the interest is taxed at that time.
LIMITATIONS OF I BONDS
You must 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. Purchases are limited to a maximum of $10,000 per year.
OTHER I BOND RESOURCES
That’s just a brief summary of I Bond characteristics. You can read more about I Bonds and purchase them from Treasury Direct. The purchase money can be transferred electronically free of charge from your bank account. And you can check the value of your I bonds online whenever you choose. When you are ready to cash out, just transfer your money electronically back to your bank account.
Another great informational resource for I bonds is the website Tipswatch. TIPS stands for Treasury Inflation Protected Securities.
Tipswatch is a blog written by David Enna. The blog is meant to explore ideas, benefits and cautions about TIPS, which David believes are an under-appreciated and under-used investment. I bonds are one form of TIPS as discussed in this article.
Mr. Enna regularly reports on the rates that I bonds are paying. He offers his opinions on what will happen in the future to I bond rates and when it is a good time to buy them from his perspective.
MY I BONDS
I hold a pretty good chunk of I bonds in my investment portfolio. My first purchases date back to the early 2000s.
At that time, the fixed interest rate component was 2%. That fixed rate coupled with today’s variable rate gives me bonds paying a 4.32% interest rate. That’s pretty good for an investment that is virtually risk free, tax deferred and guaranteed to keep pace with inflation in the future.
I bought some more I bonds earlier this year. The fixed rate attached to them is .5%. They pay a total interest rate of 2.82% right now.
I bonds are not going to make you or me rich. But as I said earlier, at my current stage in life, I prefer to give up some potential investment gains to protect my downside.
SHOULD YOU BUY I BONDS?
Are I bonds right for you? I can’t answer that for you. But consider these questions…
- Do have some extra money to sock away for at least 1 year that you can’t afford to take a loss on?
- Maybe you are saving for a down payment on a home?
- Do you need to reduce your exposure to stocks?
- Do you need to add to the fixed income component of your investments?
- Would you like an investment outside of your retirement accounts that is also tax advantaged?
- Are you risk averse and like conservative investments?
- Do you think US inflation is going to run higher in the future