I-bonds offer mouthwatering yields -- but there are some arbitrage opportunities available to investors as well
By John Lim
I-bonds are all the rage -- what's the best way to use them?
With the release of March's Consumer Price Index, we now know that a risk-free investment yielding 9.62% is available as of May 2. I'm speaking, of course, about Series I savings bonds from the U.S. Treasury, which have lately been all the rage. To take advantage, all you need to do is open an account at TreasuryDirect.gov. Last year, it took me all of 10 minutes to open my account.
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I first wrote about I-bonds back in October 2021. Since November of last year, these bonds have yielded just over 7.1%, which is pretty terrific for a risk-free investment. Unlike traditional bonds, which have been absolutely pummeled this year, Series I savings bonds are far safer--because you're guaranteed to keep up with inflation and there's no interest rate risk, meaning they don't lose value as interest rates rise.
If you bought I-bonds in April, you were able to lock in the previous 7.1% interest rate for the next six months. After that, you'd receive the new rate of 9.6% for the six months that follow. Because the interest earned on I-bonds compounds every six months, your total return over the 12 months would be 8.5%.
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Thanks to these mouthwatering yields, there are some intriguing arbitrage opportunities available to investors. The strategies exploit the large difference in interest rate between I-bonds and other investments. The most obvious opportunity: Buy an I-bond with cash you have in bank accounts and money market mutual funds, assuming you don't need to access that cash for at least one year. But here are five other strategies to consider:
1. Harvest tax losses among your bond funds.
Given the horrible drubbing bonds have undergone this year--and the worst may be yet to come--chances are good that you have sizable losses in many of your bond funds. If these bond funds are held in a taxable account, you can take advantage of tax-loss harvesting. 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 lower your 2022 tax bill while simultaneously reaping a guaranteed return of 8.5% over the next 12 months--assuming you bought in April.
2. Cash out of existing CDs and invest the proceeds in I-bonds.
Selling certificates of deposits to buy an I-bond makes great sense, even if it means paying a penalty for cashing out of your CD early. For example, if you have $5,000 in a 12-month CD with an interest rate of 1%, you'll earn just $50 of interest. The same cash 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 any early withdrawal penalty on the CD, you'll come out far ahead. Just keep in mind that I-bonds can't be sold until one year after the date of purchase.
3. Buy I-bonds instead of prepaying your mortgage.
If you have a mortgage, chances are extremely good that your interest rate is 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 purchase I-bonds yielding 8% or 9%, there's no reason to pay down your mortgage early by making extra principal payments--at least not until you've invested the annual maximum in I-bonds, which is $10,000 per individual, $20,000 for a married couple and $30,000 for a married couple with a trust. The interest you earn on that I-bond will far exceed the interest you save by prepaying your mortgage.
The same logic applies to a home equity line of credit (HELOC). I'm generally opposed to using leverage, but it could make sense to borrow cash from your HELOC and then invest the money in an I-bond. According to Bankrate.com, many HELOC rates are still below 4%. Should the interest rate on your HELOC rise above that of your I-bond, simply sell the I-bond and use the proceeds to pay down your home loan.
While this strategy requires some effort--including paying attention to interest rates--the payoff isn't insignificant. If your HELOC has an interest rate of 3% and you earn 8.5% on I-bonds over the next 12 months, you would come out ahead by $1,650 on a $30,000 I-bond investment, and that's just for one year.
4. Run 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 math that applies to mortgages and HELOCs also applies to student loans. Given the juicy yields on 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 should I-bond interest rates fall below that of your student loans.
5. Consider building an I-bond 'war chest' for retirement.
If we're entering a new era of higher inflation--say 4% to 5% per year--it may be worth raising an I-bond war chest. Unless the purchase limit on I-bonds is raised, building a substantial I-bond portfolio will take time. But such a portfolio can have many benefits, particularly for retirees.
Inflation is one of the great risks for retirees, and the longer the retirement, the greater the risk. An annual inflation rate of 5% over 13 years, for example, would cut the dollar's purchasing power almost in half. Stocks provide some degree of inflation protection, but at the cost of sequence-of-return risk. I-bonds protect against both inflation and sequence risk. A sizable I-bond portfolio could provide income during the pivotal years just before and after one retires, when sequence risk is at its highest. Also, a substantial I-bond allocation could allow retirees to hold more stocks in the remainder of their portfolio without losing too much sleep. Furthermore, an I-bond could serve as a ready source of liquidity for spending shocks during retirement.
How to go about building an I-bond war chest? Say you're married and 10 years from retirement. If you set up a trust, you could purchase $30,000 a year in I-bonds over the next 10 years. With some tax planning, you could increase that limit to $35,000 a year, because an additional $5,000 in paper I-bonds can be purchased each year with your tax refund.
That means that, all told, you and your spouse could purchase up to $350,000 in I-bonds over the course of 10 years, confident that those dollars will maintain their inflation-adjusted value. Should you retire with stocks at all-time highs, you could hold on to your I-bonds and sell stocks to generate income. But if stocks are in the dumps, you could begin liquidating your I-bonds, giving your stock portfolio time to recover.
(This column has been updated with the I-bond interest rate.)
This article first appeared on Humble Dollar and has been republished with permission.
John Lim is a physician and author of "How to Raise Your Child's Financial IQ," which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.
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May 20, 2022 10:11 ET (14:11 GMT)
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