Serious investors should skip the I bond in favor of higher yielding Treasury-traded debt.
Thief in the Night (Photo by Mark Wilson)
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Personal Finance Experts Love Those Bonds I. Suze Orman: “The #1 investment each and every one of you should have, no matter what.” Burton Malkiel: “Absolutely superb.” Last month, a stampede of these things brought down the TreasuryDirect website.
Contrary opinion: I bonds are absolutely mediocre. They pay worse than marketable Treasuries, clutter your retirement portfolio, and are guaranteed to impoverish you.
The stampede will no doubt continue, given the unpleasant surprise (8.6%) with the latest inflation report. In fact, bonds are a better deal for long-term savers than any bank account. But they don’t do what their holders want them to do, which is to immunize savings from the falling dollar.
I bonds are savings bonds that pay a fixed interest rate plus a semi-annual adjustment adjusted to the Consumer Price Index. You buy these bonds after linking a bank account to the bumbling Treasury website. Maximum purchase per calendar year is $10,000 per person ($20,000 per couple). Bonuses cannot be cashed out during their first 12 months; from then until the 60-month mark, the redemption comes with the loss of three months of interest.
After five years, an I bond can be redeemed without penalty. The buyer has the option to defer taxes until the bond is redeemed or expires, and that’s usually a smart thing to do. At maturity in 30 years, the bond stops accruing interest. Interest on I bonds, like all US government debt, is exempt from state income tax.
The fixed rate of an I bond purchased today is 0% for the life of the bond. The adjustment for inflation changes every six months and now generates 9.62% annualized. That is, if you deposit $10,000 now, you will be credited $481 in interest for your first half year.
In an age of shitty bank returns, a $481 semi-annual coupon looks pretty good. But the 0% flat rate means that, net of inflation, you’re not earning anything. Also, even though you’re only afloat in terms of purchasing power, you’ll eventually owe income taxes on your putative interest. Factor in that tax, and you’ll see that your real return is negative.
Hypothetical Example: You are in the 24% bracket, your principal balance is $10,000, and inflation is 10%. After one year, you have a balance of $11,000 but owe $240 in taxes, due now or later. The $10,760 you own buys less than the $10,000 you made last year.
He understands what is happening. The government has a deficit. It covers that partly by printing money to give away and partly by borrowing from savers. Savers get poorer with each passing year, as a consequence of the fact that the borrower, the inflator, and the tax collector are all the same entity.
This is a raw deal. You can do considerably better by buying Treasury Inflation-Protected Securities, also known as TIPS. TIPS also generate a negative after-tax real return, but not as negative as the return on I bonds.
TIPS maturing in ten years pay a real return of not much 0.7% and those maturing in 30 years pay a real return of 0.9%. TIPS purchasers must pay immediate taxes on both their actual yield and their annual inflation allowances.
You can buy TIPS directly from the Treasury at one of its regular auctions, buy them secondhand from a broker or, better for smaller sums, buy shares in a low-cost fund like the Schwab US TIPS ETF.
The grim results are depicted in the two graphs below. The first chart assumes that inflation starts out high (8% during the first year, 5% during the second) and then falls to a low level that brings the 30-year average in line with bond market expectations.
TIPS beat bonds I
Forbes
Other assumptions: The buyer is in a moderately high tax bracket, takes advantage of the tax deferral option available on the I bond, and chooses a 30-year maturity when purchasing TIPS.
In this scenario, the tax deferral of the I bond is worth something, but it is not enough to overcome the 0.9% yield advantage that TIPS have.
What happens if inflation increases? The second chart assumes inflation two percentage points higher over the next 30 years than what is built into the bond market price.
TIPS still outweigh bonds I
Forbes
Here, the tax deferral allows I bonds, at the end of a long holding period, to reduce the gap to TIPS. But this does not mean that an I bondholder should pray for high inflation. Higher inflation means more phantom income to be taxed. With higher inflation, the depletion of wealth occurs faster. After 30 years, the dutiful citizen who buys a savings bond will lose a quarter of his savings.
In addition to the tax deferral, the savings bond has another advantage: It comes with a free put option. You do not have to remain invested for the full 30-year term. At any time after five years, you can surrender the bond for principal plus accrued interest.
If real interest rates rise, that option will be worth something. You could cash in the I bond, pay taxes on the interest, and use the proceeds to buy long-term TIPS that pay better than the current 0.9%.
But now look at the main drawback of I bonuses. They are available only in small doses. If a $10,000 bonus would be a large fraction of his net worth, that doesn’t matter. But if it’s a small item in a retirement portfolio, it will create financial clutter.
You are allowed to purchase an additional $5,000 a year in I bonds if you overpay your income tax and take the refund in the form of a paper savings bond. That’s more clutter.
I bonds cannot be held with other assets in your broker. You must maintain a separate TreasuryDirect account, with your own login and password. Is there any chance that you or your heirs will lose sight of this asset in the next 30 years? Think about that possibility. Note that the Treasury has $29 billion in unclaimed, maturing paper savings bonds.
Choose your poison. No matter what the bond is, the US Treasury will make you poorer when it lends you money. Bond I surely outperforms bank CDs for long-term savings, but for affluent investors, tradable TIPS make more sense.
We are talking about newly acquired bonds. If you’re lucky enough to have bought I bonds years ago, when the fixed rate was above 3%, hold onto them until they mature.
If your income is low and you have small children, the I voucher becomes a decent savings vehicle. Interest is tax-free if the income is used for college. But this benefit begins to disappear once the parents exceed $125,000 in adjusted gross income on a joint return.
Charts of after-tax bond values assume an investor is in the 24% range today and will rise to 33% when the 2017 tax law expires in early 2026; those rates would apply to a married couple now reporting $250,000 in taxable income. The bond market assumption of future inflation is taken as the difference in yield between nominal and real bonds, less a 0.1% provision for a risk premium on nominal bonds.
Related story:
For more information on bonds I:
Tipsview is a useful reference site.
US Treasury compares TIPS to I bonds here.
The Danger with Those Savings Bonds: Department of Lost and Found it is a warning
Note: This story has been updated to reflect TIPS returns on June 13.
Source: www.forbes.com