Why I Bonds Are the Best Place to Park Cash Right Now
Vineel Bhat | 10/14/22
I Bonds Overview
I bonds are a type of bond issued by the United States government. They allow you to loan money to the US government, which then earns interest at a rate which changes every 6 months based on CPI inflation. This is quite different from traditional treasury bonds, which creates unique opportunities. There are also some other interesting properties:
- $10,000 investment cap per social security number
- Maturity date is 30 years after purchase
- Must be held for at least 1 year
- If not held for at least 5 years, the last 3 months of interest are lost
- Taxes are deferred until the bond is sold or matures
- Federal tax rates are the same as would be for ordinary income
- Exempt from state and local taxes
I bonds have gained popularity recently because of record high inflation, which has pushed their interest rates past 9%. Here, we argue why I bonds are the best place to park cash right now, specifically looking at a return estimate for I bonds, as well as their perks, downsides, and alternative investments.
One Year Return Estimate
Why I bonds? The interest rate, which currently stands at 9.62% and comes with little to no risk.
Assuming you hold for one year, your annual return would be a bit lower. The 9.62% rate is available until the end of October, after which the rate is expected to drop to 6.48%. Plus, you’ll lose the last 3 months of interest with a holding period less than 5 years. Combining these, a purchase of I bonds now will yield 9.62% for the next 6 months, about 6.5% for the 6 months after, then 3 months worth of that 6.5% interest are lost when the bond is sold at the 12 month mark.
When you do the math, that comes out to a 1 year return of 6.38%. This is still phenomenal compared to 1 year treasuries yielding 4.6%, CDs yielding around 3.5%, and savings accounts yielding around 2.5% for most banks.
Like treasuries, I bonds are backed by the full faith of the United States government. The United States has never defaulted on a debt security in the past and is almost guaranteed not to in the next decade, making I bonds essentially risk free.
The Other Perks
I bonds are ridiculously tax-efficient compared to other fixed income assets. All I bond interest income, although taxable at the federal level, is exempt from state and local income taxes. Further, all federal income taxes on I bonds are tax deferred, meaning you don’t have to pay taxes on any accumulated interest until you sell the bond. Since I bonds can me held for a maximum of 30 years, this means that you can technically collect interest for 30 years without paying taxes on it. CDs and non-government issued bonds carry neither of the previously mentioned benefits. And while income from government issued bonds like treasuries are exempt from state and local income taxes, interest income cannot be deferred.
I bonds are not liquid cash: investors cannot redeem their money until the 1 year required holding period has elapsed. If you are looking to park cash for a large purchase in the coming year, a savings account is still the best option.
The inflation hedges may also provide subpar returns for investors with a longer time horizon: CPI inflation is likely to head back down to the federal reserve’s 2-3% range with time, while equities have historically averaged a 6-8% annual return.
I bond investments are capped at $10,000 per social security number, which may restrict the amount of cash some individual investors are looking to park. Additionally, the bonds must be purchased through the TreasuryDirect website rather than a traditional brokerage service, which can be a longer, higher hassle process.
Finally, I bonds are always taxable at the federal level and cannot be placed in a Roth IRA or other tax-advantaged account.
1) Treasury Bonds:
These are regular US government bonds: you lend money in exchange for fixed interest. The interest rate for a 2 year treasury currently sits at approximately 4.7%, while the 10 year treasury yields approximately 4.2%. They are nearly risk free and can be sold anytime on the secondary bond market, although if you are looking to sell after inflation / federal funds rate hike expectations have heightened, the value of the bond would drop and you might lose a portion of your principal.
2) Treasury Inflation Protected Securities (TIPS):
TIPS, like I bonds, pay you based on the United States CPI inflation rate. Specifically, they compensate you an amount matching the inflation rate plus offer additional interest payments which currently stand at approximately 1.7% for a 5 year time period. Most individual investors won’t reach TIPS’s investment cap of $5m like they may with I bonds’ investment cap of $10,000 per social security number. TIPS can also be sold at any time on the secondary bond market compared to I bonds’ 1 year holding requirement, but selling may result in a loss in principal depending on the macro environment.
3) S&P 500 Index Fund:
The stock market measured by the S&P 500 has averaged a return of ~10% over the past century, handily outperforming other asset classes like bonds and commodities. The index is down over 21% year to date, making now the best time to jump in since early 2021. Although the S&P 500 is highly volatile and risky compared to many fixed income assets, and may head lower in the coming months (impossible to tell), an S&P 500 index fund offers diversification over individual stocks and is the simplest path to building long-term wealth for investors with a time horizon over 15 years.
Combining the extraordinary yield and tax advantages, I bonds are currently the best place to park cash that you don’t need for the next 1 year but will need sometime in the next 15 years for a larger purchase. If you plan on spending cash soon, I bonds won’t allow withdrawals before one year has elapsed, and if you’re looking for a long-term investment for the next 15+ years, the stock market provides a better vehicle to grow wealth. But for that sweet spot in between, I bonds are a fantastic deal. Inflation will eventually cool down, and the yield for I bonds will drop to a level significantly lower than where it’s at today. At that point, it may be prudent to look around for the highest yield fixed income security with minimal risk (e.g., from the US government). If, for example, short to mid term treasury bonds offered a higher yield than I bonds, selling the I bond and moving any money you need in a couple years to those treasuries would allow you to make more income.
Time is running out to buy I bonds at the current 9.62% rate which will last for 6 months after purchase. October 28th is the final date when which you can buy an I bond before a lower rate takes effect. However, an I bond may take up to 5 days to clear, so it would be ideal to make any purchases before October 21st.
Cheers, and happy investing!
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Disclaimer: Opinions not advice! I am not a registered financial advisor. All views and recommendations expressed in this article are solely my opinions and should not be considered as financial advice.