Why most investors should consider buying I-bonds

Inflation-adjusted securities are guaranteed by the U.S. government to pay investors a fixed rate of interest plus or minus the periodic inflation rate over the life of the bond. If you are planning to use your investment earnings to fund living expenses or pay for a child’s education, the inflation adjustment will ensure you have the purchasing power you need. You can buy I-bonds directly from the U.S. Treasury to avoid brokerage fees and market price volatility.

Most investment portfolios should include an allocation to ‘safe’ assets such as government bonds. To capture this safety from default while avoiding market volatility and maintaining purchasing power, inflation-adjusted bonds could be a good choice for you. Click here to view an expanded video version of the article below.

What are inflation-adjusted securities?

Bonds whose interest payments include a fixed rate plus or minus the latest 6-month inflation rate, as measured by the Consumer Price Index (CPI). Because the amount of the inflation adjustment isn’t known in advance, the amount of each semi-annual payment is variable.

Investors can buy inflation-adjusted bonds directly from the U.S. Treasury so you don’t need to worry about price fluctuations due to changing market conditions. If you need your money back before the maturity date, you can sell the bonds back to the Treasury at the adjusted principal amount, less a 3-month interest penalty if you sell before you’ve owned the bond for 5 years.

How do inflation-adjusted bonds (I-bonds) differ from traditional savings bonds (EE-bonds)?

Both types of savings bonds have a fixed interest rate component and allow investors to buy as little as $25 at a time to a maximum of $10,000 per year. Both bonds allow investors to sell the bonds back to the Treasury before maturity at the adjusted principal amount, regardless of market conditions. EE bonds are guaranteed to double in value over 20 years (investors pay half the face value at purchase.) The terminal value of I-bonds can’t be predicted at time of purchase, though the ending value can’t be lower than the original principal.

The table below compares the interest rate on traditional EE savings bonds to inflation-adjusted I-bonds as of March 10, 2024. The current interest rate of the I-bonds is nearly twice that of the EE bonds because recent inflation has been relatively high. At the next semi-annual reset date, the I-bond interest rate will change to a level that may be higher or lower than the current rate.

What happens if inflation is negative?

Even if inflation is negative, the semi-annual interest on an I-bond can’t go below $0. And when the bond matures, investors receive the higher of the inflation-adjusted principal value or the original principal value. I-bond investors may not know what their earnings will be from period to period, but they can be confident they will earn an amount above inflation over the life of the bond and won’t take a loss on the capital they invested.

Here is a hypothetical example of how the interest payments and adjusted principal might look for a traditional EE savings bond versus an inflation-adjusted bond over several semi-annual periods:

In this example, the traditional bond has a fixed interest rate of 2.70% and the inflation-adjusted bond has a fixed rate of 1.30%. Every six months, each bond’s principal value will change based on the interest earnings. In the first period, the EE bond earned $13.50 bringing the principal value to $1,013.50 (assuming an original principal value of $1,000.) The inflation-adjusted bond earned a much smaller fixed rate, but the inflation adjustment brought the total earnings to nearly double the traditional bond, bringing the adjusted principal amount to $1,022.00.

At the next semi-annual period, the interest earnings are compounded based on the adjusted principal from the previous period. The traditional bond’s principal value increases to $1,027.18 while the hypothetical inflation-adjusted bond increases to $1,041.42. In the next period, inflation is negative causing the I-bond to earn only $1.56 while the traditional bond earns $13.87, bringing the adjusted principal amounts closer together. In the final period in this example, inflation becomes positive again and the I-bond value pulls ahead.

Bottom line: If the average inflation rate over the investment period is higher than 1.40% (the difference in the fixed rates of the bonds), the inflation-adjusted security will earn more than the traditional security. If average inflation over the investment period is lower than 1.40%, the traditional bond will be a better choice.

Given the uncertainty of the periodic payments, why do I recommend buying inflation-adjusted bonds?

Prudent investors should have at least a small portion of their portfolio allocated to ‘safe’ securities such as government bonds, but safe securities tend to pay low returns. To capture the benefits of safety and also ensure I earn enough to buy what I need when the bonds mature, I prefer inflation-adjusted bonds to traditional government bonds. The variability in the semi-annual payments is a small price to pay for the confidence in my future purchasing power. But you may be different! If uncertain semi-annual payments make you nervous, stick with traditional government bonds, Certificates of Deposit, or similar investments for the ‘safe’ portion of your portfolio.

If you decide that inflation-adjusted bonds are right for you: Be sure to buy directly from the Treasury to avoid market price fluctuations. Set up an account at www.TreasuryDirect.gov, connect to your bank account, and you’re ready to make your first purchase.