America’s Best Kept Financial Secret: I Bonds

Photo of Social Security Checks at the U.S. Treasury. By William Thomas Cain/Getty Images

Boston University finance guru should need no introduction to readers of this page, but for those who would like one, here it is.

Zvi Bodie: Paul asked me to explain why I consider U.S. Treasury inflation-protected savings bonds, “I Bonds,” a must investment. I Bonds are savings bonds, not to be confused with TIPS, which are the U.S. Treasury’s marketable inflation-protected bonds that can be purchased in unlimited quantities at an interest rate dictated entirely by market forces of supply and demand. Paul has written about them favorably, often and recently. But I Bonds offer a much better value to the investor than TIPS, although the government limits the amount you can buy to $10,000 per year per person.

Making Sense

To buy TIPS today, you have to accept a negative real interest rate, except for TIPS that mature in 30 years. Of course TIPS do add on a rate of interest equal to the Consumer Price Index: that’s why they’re called “inflation-protected.” But suppose there’s no inflation. In that case, you’d be paying the government to loan it money.

By contrast, a great virtue of I Bonds is that they can never yield less than zero. This means that in the worst case (unless the U.S. government declares bankruptcy and refuses to pay anyone), money invested in I Bonds will at least maintain its purchasing power. If there were to be outright DEflation, with prices actually going down, money invested in I Bonds would rise in value.

Yes, some day, the interest rate would rise again. But another advantage of I Bonds is that investors could then cash out their existing I Bonds (and keep principal plus accrued interest) and buy new ones at the higher rate of interest. In other words, whether interest rates go up or down, the investor is protected. (But note that if you buy new I Bonds you would be subject to the $10,000 limit.) If you have the money, you would have to be nuts not to invest in I Bonds up to the limit.

Most people I talk to, however, even the financially savvy, have never heard of I Bonds, even though the government started issuing them back in 1998. (Here’s the video of Vice President Al Gore making the public announcement at the time.)

A new 30-year fixed rate is announced every six months on May 1 and on Nov. 1 and applies to all bonds purchased during the following half a year. The total rate of interest is the fixed rate plus the annualized rate of inflation that occurred during the preceding six months. The chart below shows what the fixed and total interest rates have been on newly issued I Bonds from May 1999 to May 2012.

Image via Treasury Direct

But to repeat the basic point, I Bonds are a no-brainer because for every dollar you invest in them today, you have the right to take it out fully adjusted for inflation at any time over the next 30 years. So in a worst case scenario where you get no interest at all, you will maintain the purchasing power of your money. If the fixed rate on new issues should rise above your fixed rate, you can cash your old bond in and buy a new one with no loss of accumulated interest. If you have held the old bond for over 5 years, there is no penalty when you cash it in. I know of no safer way to invest for a long time horizon.
For people of modest income, a combination of Social Security and an annual investment of up to $10,000 per year in I Bonds should suffice to finance a comfortable retirement without any significant risk and without any special tax-deferred retirement accounts. For example, a 30-year-old who buys $10,000 per year of I Bonds and retires at age 70 will have accumulated $400,000 of today’s purchasing power. That would be enough to buy a guaranteed lifetime inflation-proof income benefit (“annuity”) of more than $16,000 per year from a high quality insurance company.

This year the IRS has made investing in I Bonds easier than ever. U.S. residents can buy I Bonds with their federal tax refund. But I believe that the government should do much more to inform and educate the public about these bonds. In the meantime, trustworthy sources of information, such as Making Sen$e, should pitch in and do what they can to inform the public.

There won’t be a second post today due to The NewsHour’s online coverage of the vice presidential debate. Meanwhile, let it be known that this entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions.

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