If you have a significant amount of cash in a bank account, you are getting clobbered by inflation right now. The inflation rate over the last year was 8.5 percent. Yet you’ll be lucky to find a savings account that pays more than 1 percent.
Most alternatives to a savings account aren’t much better. For example, even if you’re willing to lock up your money for five years with a certificate of deposit, you’re unlikely to earn more than 3 percent per year.
But one savings vehicle stands out from the rest. The US Treasury Department offers “Series I” savings bonds that this week started to offer a remarkable 9.6 percent interest rate. When you buy a Series I bond, you get a fixed interest rate that’s set at the time of purchase. On top of that, the I-bond pays interest equal to the inflation rate. That ensures that the saver’s money won’t lose purchasing power—at least on a pre-tax basis.
That 9.6 percent interest rate is so much higher than you can get anywhere else that you might be worried there’s a catch—I certainly was when I first heard about them a few days ago. But after doing a bunch of reading and talking to a personal finance expert, I’m confident that I-bonds are a good option for most Americans looking for a low-risk savings vehicle over a period of one to five years.
I-bonds are “by far the highest risk-free return I'm aware of,” said Zach Teutsch, an advisor at Values Added Financial. “You're getting a guaranteed return. You're getting high returns when inflation is high. And it’s backed by the full faith and credit of the US government.”
I-bonds are not a good way to save for retirement. Over the long run, you’ll get a higher return by investing in stocks via a 401(k) or IRA. But for shorter-term goals—like buying a house, saving for college, or just having a cash cushion for emergencies—I-bonds offer a good return without the risks of the stock market.
A comeback for savings bonds
When people talk about US government bonds, they’re usually talking about Treasury bonds, which are sold mainly to pension and mutual funds, wealthy individuals, and other sophisticated investors. Savings bonds are a separate category of government debt designed for retail investors. They were particularly prominent during World War II, as the government encouraged people to purchase them to finance the war effort.
In recent years, savings bonds became something of a backwater. But that all started to change in mid-2021 when inflation started shooting upwards at the same time interest rates were low. One particular type of savings bond, called the Series I bond, has gotten a ton of attention in recent months.
As inflation started to rise last year, I-bonds became a better and better deal. The interest rate paid by an I-bond is updated every six months. In May 2021, the inflation adjustment—and hence the minimum interest rate—was 3.54 percent. In November 2021, it rose to 7.12 percent. On Monday, it increased to 9.62 percent.
As we’ve seen, this is a far better interest rate than you can get from risk-free products offered in the private sector.
A one-year lockup
So is there a catch? The most important downside is that your money is locked up for the first year after you buy a Series I savings bond. So if you have money set aside for financial emergencies, you probably shouldn’t put it all into I-bonds at once.
But there are lots of situations where this wouldn’t be a problem. Say you’re saving money to put a down payment on a house. You know you won’t have enough in the next year, but you expect to start shopping in two or three years. If you put your savings into an I-bond in the meantime, you’ll get a much better return than a savings account.
After that first year, you can cash out the bond at any time.
If you cash out a Series I savings bond between year one and year five, you forfeit the last three months of interest. Hence, if you invest in an I-bond for exactly a year, you would only receive nine months of interest. Still, at current interest rates that’s likely to be much better than the alternatives. For example, someone who invested in an I-bond in May 2021 and cashed out yesterday would have earned just under 6 percent interest. That's far more than you’d get from a conventional savings account.
I-bonds are taxable at the federal level, and unlike conventional government bonds, they can’t be purchased inside a tax-sheltered 401(k) or IRA account. So if you are in a high tax bracket, your after-tax return will be significantly less than the headline 9.6 percent.
But I-bonds are tax advantaged relative to a lot of conventional savings products. I-bonds are exempt from state and local taxes. And taxes on the interest are deferred until you redeem the bond. That’s not true of savings accounts or certificates of deposit.
No interest rate risk
You may have heard of Treasury Inflation-Protected Securities (TIPS), which offer inflation protections similar to those of Series I savings bonds. But TIPS have a couple of important disadvantages.
One is that the inflation-adjusted yield on a TIPS bond is currently negative, whereas I-bonds always pay an interest rate at least as high as the inflation rate. Second, TIPS are subject to interest rate risk: if interest rates rise, the market price of TIPS will fall in secondary markets. As a result, if you want to sell your TIPS early, you might get less than you originally paid for the bond.
I-bonds don’t work like that. You buy them directly from the Treasury Department and you can’t sell them on secondary markets. This means they maintain their face value. When you’re ready to sell (after the one-year lockup period) you’re guaranteed to get at least your principal back.
“Free money with a UX tax”
The direct sales model of I-bonds also means it’s an extra hassle to get them. You can’t add I-bonds to your portfolio at a financial institution like Fidelity or Vanguard. To buy I-bonds, you need to set up an account at TreasuryDirect.gov. It looks and feels like a website that hasn’t been updated since the 1990s.
“I-bonds are basically free money with a UX tax,” Zach Teutsch told me.
But the UX tax isn’t that high. I bought $10,000 worth of I-bonds yesterday. The process was certainly clunky—at one point I hit the back button, got an error message, and was forced to re-enter several screens worth of data. But the whole process took less than an hour. Over the next year, I expect to earn at least $500—far more than I could get anywhere else. And if inflation stays high for the next year, I’ll earn even more than that.
The reason I only bought $10,000 is because that's the maximum amount someone is allowed to buy per year. Later this week, I’ll help my wife buy another $10,000 worth of bonds.
The Treasury Department limits purchases like this because I-bonds are a terrible deal for the US government. The interest rate the Treasury Department pays to I-bond holders is far above the yield on regular government bonds. If the $10,000 limit wasn’t in place, people would dump billions of dollars worth of Treasuries and buy I-bonds instead.
But while I-bonds are a bad deal for the government, I’m glad they exist. At the end of the day, the US government is responsible for today’s high inflation rates. I-bonds provide one way for ordinary savers to limit the damage inflation does to their finances. So if you have money lying around in a savings account or other low-earning investment, you should seriously consider investing in I-bonds.