I-bonds are all the rage – what’s the best way to use them?
With the release of the March Consumer Price Index, we now know that a risk-free investment yielding 9.6% will be available from May 2. I’m talking, of course, about the Series I US Treasury Savings Bonds, which have been all the rage recently. To take advantage of this, all you have to do is open an account at TreasuryDirect.gov. Last year, it took me 10 minutes to open my account.
I first wrote about I-bonds in October 2021. Since November last year, these bonds have returned just over 7.1%, which is pretty great for a risk-free investment. Unlike traditional bonds, which were completely torn down this year, Series I Savings Bonds are much safer because you’re guaranteed to keep up with inflation and there’s no interest rate risk. which means that they do not lose value when interest rates rise.
A unique window of opportunity exists this month. By buying I-bonds in April, you can lock in the current interest rate of 7.1% for the next six months. After that, you will receive the new rate of 9.6% for the following six months. Since interest earned on I-bonds is compounded every six months, your total return over the next 12 months will be 8.5%.
Lily: The silver lining of soaring inflation: I bond yields set to climb above 9%
Thanks to these appetizing returns, interesting arbitrage opportunities are available to investors. The strategies exploit the large difference in interest rates between I-bonds and other investments. The most obvious opportunity: buying an I-bond with money you have in bank accounts and money market mutual funds, assuming you don’t need access to that money for at least a year. But here are five other strategies to consider:
1. Harvest tax losses among your bond funds.
Considering the horrific beatings bonds have taken this year – and the worst may yet be to come – there’s a good chance you’ll face significant losses in many of your bond funds. If these bond funds are held in a taxable account, you can profit from the harvest of tax losses. By selling up to $10,000 of these bond funds and using the proceeds to purchase an I-bond, you can use the capital loss to reduce your 2022 tax bill while simultaneously earning a guaranteed return of 8.5 % over the next 12 months, assuming you buy in April.
2. Cash in existing CDs and invest the proceeds in I-bonds.
Selling certificates of deposit to buy an I-bond makes perfect sense, even if it means paying a penalty for cashing in your CD early. For example, if you have $5,000 on a 12 month CD with a 1% interest rate, you will only earn $50 in interest. The same money invested today in an I-bond with a prospective yield of 8.5% would earn you $425 in interest, or $375 more. Even after paying an early withdrawal penalty on the CD, you will come out far ahead. Remember that I-bonds can only be sold one year after the date of purchase.
3. Buy I-bonds instead of prepaying your mortgage.
If you have a mortgage, chances are your interest rate will be well below 8%. The last time interest rates on 30-year fixed-rate mortgages were above 8% was in 2000. This presents an arbitrage opportunity for homeowners. If you can buy I-bonds yielding 8% or 9%, there is no reason to prepay your mortgage with additional principal payments, at least not until you have invested the annual maximum in I-bonds, which is $10,000 per person. , $20,000 for a married couple and $30,000 for a married couple with a trust. The interest you earn on this I-bond will far exceed the interest you save by paying off your mortgage early.
The same logic applies to a home equity line of credit (HELOC). I’m generally opposed to using leverage, but it might be a good idea to borrow money from your HELOC and then invest the money in an I-bond. According to Bankrate.com, many HELOC rates are still below 4%. If the interest rate on your HELOC exceeds that of your I-bond, simply sell the I-bond and use the proceeds to pay off your home loan.
Although this strategy requires effort, including attention to interest rates, the payoff is not negligible. If your HELOC has a 3% interest rate and you earn 8.5% on I-bonds over the next 12 months, you will earn $1,650 on a $30,000 I-bond investment, and this, for one year only.
4. Do the math on student loans.
The average interest rate on student loans, both federal and private, is 5.8%. The average is 4.12% for federal student loans. The calculations that apply to mortgages and HELOCs also apply to student loans. Given the juicy returns from I-bonds, it may be worth making the minimum payment on your student loans and investing the rest in I-bonds. Again, this strategy could be reversed if I bond interest rates fell below your student loan rates.
5. Consider building an I-bond “war chest” for retirement.
If we are entering a new era of higher inflation, say 4-5% per year, it may be worth raising an I-bond war chest. Unless the purchase limit for I-bonds is raised, building up a substantial portfolio of I-bonds will take time. But such a portfolio can have many advantages, especially for retirees.
Inflation is one of the big risks for retirees, and the longer the retirement, the greater the risk. An annual inflation rate of 5% over 13 years, for example, would almost halve the purchasing power of the dollar. Equities offer some degree of inflation protection, but at the cost of return sequence risk. I-bonds protect against both inflation and sequence risk. A large portfolio of I-bonds could provide income during the pivotal years just before and after retirement, when sequence risk is at its highest. Additionally, a substantial allocation of I-bonds could allow retirees to hold more stocks in the rest of their portfolios without losing too much sleep. Additionally, an I bond could serve as a source of liquidity for spending shocks during retirement.
How do you go about building an I-bond war chest? Let’s say you’re married and 10 years from retirement. If you set up a trust, you could buy $30,000 a year in I-bonds for the next 10 years. With a little tax planning, you could increase that limit to $35,000 per year, because an additional $5,000 in paper I-bonds can be purchased each year with your tax refund.
This means that, all told, you and your spouse could buy up to $350,000 in I-bonds over a 10-year period, confident that those dollars will hold their inflation-adjusted value. If you retire with stocks at record highs, you can keep your I-bonds and sell stocks to generate income. But if the stocks are in the dumps, you can start liquidating your I-bonds, giving your stock portfolio time to recover.
This article first appeared on Humble Dollar and has been republished with permission.
John Lim is a physician and author of “How to Boost Your Child’s Financial IQ,” which is available in a free PDF and Kindle edition. Follow John on Twitter @JohnTLim and discover his previous articles.