What Are I Bonds?

Question: What Are I Bonds?

Answer: I Bonds, or Series I Savings Bonds, are like the more familiar Series E Savings Bonds, except for one important advantage. The interest rate is adjusted for inflation every six months. Other advantages:

1. I Bonds can be bought with as little as $25 (if purchased electronically via TreasuryDirect).
2. You will never lose your principle.
3. The interest earned is exempt from state and local income tax, although you will have to pay Federal income taxes (unless you use the bonds to pay for education).

One disadvantage with I Bonds is that you don't receive any interest payments until you redeem the bond. Furthermore, your money is tied up for at least a year. The I Bond is meant to be a long-term investment, so the U.S. Treasury won't allow you to redeem it for at least 12 months. Furthermore, there is a penalty if you redeem your I Bond in less than five years. The penalty is mild, however, as it's only the interest earned in the previous three months.

The main reason people buy I Bonds is as protection against inflation. That's because the interest rate on the I Bond automatically adjusts for price increases. How does it work? First, you are guaranteed a fixed rate of return that doesn't change. Second, the rate will increase twice a year (May and November) if there is inflation, but won't decrease if there's deflation. In May, the rate will reflect the change in the Consumer Price Index for all Urban Consumers (CPI-U) from September of the prior year to March. In November, the rate will reflect the change in the CPI-U from March to September.

The easiest way to purchase I Bonds is online, from the U.S. Government, via Treasury Direct. It is all electronic, so you don't have to worry about losing the bonds. However, if you prefer, you can also buy paper I Bonds from your bank or financial planner. Whatever you do, don't buy an I Bond or any other U.S. Treasury bond on eBay or other third party. These ownership of these bonds are still the original owner, as far as the Federal government is concerned. The owner cannot sell his or her rights to the bond to you. All you are buying is a piece of paper that you cannot redeem.

Gulf Coast Recovery Bonds

There was a special type of I Bond issued to help people hurt by Hurricane Katrina. The Gulf Coast recovery bonds were only issued between March 29, 2006 - September 30, 2007. It was put into law by the Gulf Opportunity Zone Act of 2005, and simply allowed the U.S. Treasury to issue I Bonds for this purpose. However, the proceeds of the Gulf Coast Recovery Bonds weren't specifically allocated to help with recovery from the disaster. Instead, the proceeds went into the General Fund.

What's the Difference Between an I Bond and a TIPS?

TIPS, or Treasury Inflation Protected Securities are both issued by the U.S. Treasury Department as investments that protect you against inflation. However, I Bonds are Savings Bonds, and TIPS are Treasury Bonds. This means that TIPS, like other Treasury notes, can be bought and sold on the secondary market.

Another important difference is how they protect you from inflation. Whereas the I Bond adjust the interest payment for changes in the CPI, the TIPS adjusts the principal for the CPI changes. The second difference is that the TIPS principal can decline if there is deflation. However, you still won't lose money. Why? If you hold the TIPS until it matures, you will receive the inflation-adjusted principal, or the original principal.

Here's some other, minor differences:

• Interest on TIPS are paid twice a year.
• TIPS cannot be purchased for less than $100.
• TIPS are adjusted for inflation monthly.

For more on TIPS, see What Are TIPS?. (Source: TIPS vs I Bonds.)

What Are the Different Types of Bonds?

• What Are Treasury Bills, Notes and Bonds?
• What Are Savings Bonds?
• What Are I Bonds?
• What Are Municipal Bonds?
• What Are Corporate Bonds?
• What Are Junk Bonds?