Opinion: This straightforward funding can earn you greater than 6% with no danger
How are you guaranteed to earn 6.7% or more on your money without taking any risks? Even if it sounds too good to be true, this is exactly the opportunity on November 1st. The investment? Series I savings bonds
I-Bonds are 30-year bonds issued by the US Treasury Department that are available to anyone who opens a free TreasuryDirect account. These bonds are the quintessential risk free investment. Having the full confidence and creditworthiness of the US government, they have minimal credit risk. They also offer inflation protection as their returns are linked to inflation.
The return on I-bonds has two components: a fixed interest rate and an inflation rate. The fixed rate is set at the time of purchase and remains fixed for the term of the bond. It is currently 0% so you can effectively ignore it.
The inflation rate component of the rate of return is adjusted twice a year – on the first business days in May and November. The semi-annual inflation rate of the I-bonds currently sold is 1.77%. This determines the interest income for the next six months. If you double it, you get the annual percentage rate (APR) of the bond, which would be 3.54%.
Read: Why You Should Be Skeptical of the Inflation Panic
While 3.54% isn’t bad, the new November rate is almost guaranteed to be much higher. I suspect that then issued I-bonds will have yields of at least 6.7% and possibly even 7.8%. Let me explain.
The inflation rate is based on the consumer price index for all urban consumers, which I simply call the CPI. The November rate is based on the percentage change in the CPI from March to September of this year. We already know March’s CPI number, which was 264,877. The September CPI won’t be released until October 13, but the August figure was 273,567.
Assuming the CPI does not change in September – not very likely given recent trends – the percentage change after six months would be 3.28%. This corresponds to an effective annual interest rate of 6.56%. The annual effective rate you would earn is 6.67% as I-bonds earn interest semi-annually.
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September CPI levels will most likely be higher than August. How much? The average monthly increase in the CPI has been 0.55% since the beginning of the year. Extrapolating this rate of increase, the CPI in September would be 275,072, which corresponds to a semi-annual inflation rate of 3.85%. The corresponding effective annual interest rate for I-bonds would be 7.85%. That’s not overly shoddy, especially considering that this return is risk-free.
Of course, the tariff is only valid for six months. The course would be adjusted again in May 2022. If the Fed’s transition thesis is correct and inflation slows down next year, I-bond rates would fall. On the other hand, if inflation persists or accelerates, bond yields would remain high, far outperforming money market funds and savings accounts.
Another bonus: unlike TIPS or Treasury inflation-protected securities, I-bonds are protected against capital losses. Similar to a savings account, the net present value of an I-bond can only increase. In the unlikely scenario that inflation is negative, the inflation rate of I-bonds can never go below zero.
I-bonds must be held for at least a year after purchase. If you repay an I-bond before it is five years old, you will lose the previous three months of interest. At an interest rate of 6.67%, an early sale would reduce your return for the last 12 months to 5%.
How many I-bonds can you buy? There is an annual limit of $ 10,000 per person. That means a couple with two children could buy up to $ 40,000 in total. If this family had a trust, an additional $ 10,000 could be bought on behalf of the trust for a total of $ 50,000 in I-bonds per year. Remember that buying an I-bond for a child through a custody account is an irrevocable gift.
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I bonds also enjoy favorable tax treatment. Interest is subject to federal income tax but is exempt from state and local taxes. You can also defer reporting interest on your federal tax return until you cash your bonds or the bonds become due. If you hold an I-bond to maturity, it means 30 years of tax-deductible growth. Speaking of taxes, you can use your federal tax refund to buy up to an additional $ 5,000 in paper I bonds per year.
If you are considering I-bonds, I would suggest waiting until November 1st when the interest rate rolls back to a much higher level. Just don’t expect most consultants to recommend them. I-bonds are only available – commission-free – via TreasuryDirect.gov or when submitting your tax return. Hence, your advisor will gain little from investing in these wonderful bonds.
This column first appeared on Humble Dollar. It was republished with permission.
John Lim is a doctor and author of How to Raise Your Child’s Financial IQ, which is available in both free PDF and Kindle editions. Follow John on Twitter @JohnTLim and read his previous articles.