For most people, free lunches, the tooth fairy and no-risk investments all end up in the same category: There's no such thing.
Not anymore. Meet the I-Bond, a savings bond from the Treasury Department that offsets the eroding effects of inflation. So no matter what happens economically, you won't lose a dime on the investment. Such an offer may appeal to the many investors who got burned during the recent market downturn.
But security often comes with a price. In this case, the I-Bond's minimal risk is not likely to turn into large gains. As of Nov. 1, the bond has been paying 4.4%, which beats the current average money market savings account rate of 2.44% but falls slightly short of the 5.4% gain in the
during the same period.
But the bond's advantage is its stability. For the next six months, investors will see a steady 4.4% rate, whereas the S&P 500 could drop several percentage points, and given the recent market volatility, such a decrease is very possible. Indeed, since the S&P 500 declined 19.7% in the last two years, investors may consider the I-Bond not just a steady low-risk investment but rather a better overall bet, at least in the near term.
Here's How It Works
The I-Bond's security resides in its double rate system. The bond earns money by combining two separate rates: a fixed rate and an inflation rate. The fixed rate, set by the Treasury Department each May and November, is locked in when a bond is purchased and continues for the life of the bond, which can last up to 30 years. The fluctuating inflation rate is updated semiannually, in line with changes in the consumer price index. The composite rate -- what the bond earns overall -- equals the inflation rate plus the fixed rate.
Like all federal bonds, the I-bond is backed by the government, so it is guaranteed. Interest accrued on the bonds is exempt from local and state income taxes but is subject to federal taxes once redeemed. You can cash an I-Bond after six months, but will have to forgo three months in earnings if you redeem within five years.
Moreover, most people can participate because the bonds are sold at face value from as little as $50 to as much as $10,000, with a cap of $30,000 in total investment per person each calendar year.
Most local financial institutions sell the I-Bond. Some employer-sponsored saving plans also offer the bond. You can buy the bond yourself or with one other person. In the latter case, the names of the two owners appear on the bond, and either person can cash it without the knowledge or approval of the other. If one owner dies, the other becomes the sole owner.
When It Gets Good
The I-Bond is at its most profitable when inflation is high. With inflation currently logging in at 2.65%, the bond is earning less now than at any point in its three-year history.
"This is going to be good when it gets a bigger kicker on the variable interest side," says Deborah Voso, the president of Voso Financial Advisors in Frederick, Md.
* -- annual rates compounded semiannually.
Source: Treasury Department.
In a deflationary environment, when costs and prices decrease, the variable rate slumps, eroding the earning power of the bond. But the government secured the bond with a floor: If deflation becomes so great that it would reduce the composite rate to below zero, the bond's value won't decrease from its most recent redemption value.
Is the Security Worth It?
Despite such guarantees, the bond hasn't been popular among financial planners, even in the current uncertain economic environment. For example, Robert Alley, a bond portfolio manager at AIM Advisors, an investment consultant and research firm, has passed over inflation-adjusted investments such as the I-Bond for ones that offer more growth. Alley doesn't see much of an inflation risk when the economy accelerates, so the I-Bond's ability to offset inflation doesn't interest him.
Consider also that people in high tax brackets won't benefit much from the bond, especially if inflation rises. Let's say the variable rate on the bond is 5% while the fixed rate is 3% -- a composite rate of 8%. A $1,000 bond at 8% results in a gain of $80. Take away $31 in taxes for those in the 39% bracket, and that's a gain of just $49. Meanwhile, the 5% inflation rate makes the buying power of that $1,049 only $996.55 -- less than the initial investment.
Bottom line: Don't think of the I-Bond as an investment but rather as a savings tool. It is a "can't lose" savings vehicle. Use it for emergency funds or to diversify your portfolio. Just don't get too excited about it.
"The bond is a great diversifier," said Voso. "It doesn't behave like any other asset class."
Tied to the CPI, the I-Bond doesn't behave like any other asset class because the bond isn't tied to equities, indices or commodities. Alone, the I-Bond isn't that attractive, but when added to a portfolio, its value increases.
Essentially, the I-Bond is a good place to park your money until the market comes back. But if it revives within five years of purchasing the I-Bond, investors will have to chance that the three-month earnings penalty for redeeming the bond then would be less than possible gains the money would receive in stocks.
The best use for the I-Bond seems to be for investors planning on buying a house or sending a child to college in five years. The I-Bond is a place to keep such funds safe from market volatility that could cut into investment principal.