SPIP - With Inflation Plummeting It Is Time To Sell I Bonds

2023-11-29 23:05:20 ET

Summary

• I bonds were one of the most popular investments of the past two years and with good reason.
• As inflation skyrocketed, so did I bond yields, leading these investments to outperform most other asset classes at almost no risk.
• As inflation plummets, so have I bond yields. As these no longer offer compelling yields, it is time to sell.

I bonds were one of the most popular, best-performing bond investments in 2022 and 2023, as skyrocketing inflation led to significantly higher yields. I bonds yielded upwards of 8.0% in 2022, at a time when T-bills yielded around 2.0%, 10Y treasuries 3.0%. I bonds had good yields during most of 2021 and 2023 too, but they really shined in 2022.

As inflation decreases so have I bonds yields. These vary depending on when investors bought their bonds, but most currently yield 4.0% - 5.5%. Lots of other fixed-income securities yield more than I bonds, including T-bills, treasury inflation-protected securities or TIPs, and high-quality CLO debt tranches. At current inflation rates, I Bond yields should continue to drop in the coming months as well.

In my opinion, there are better investment opportunities than I bonds right now.

TIPs seem like the best alternative, with the same protection from inflation as I bonds, but 1.0% - 2.0% higher yields. Buying individual TIPs seems best, as there are certain issues with TIPs funds .

T-bills are another solid choice, although these lack the inflation protection afforded by I bonds, and yields would drop if the Fed were to cut.

The Janus Henderson AAA CLO ETF (JAAA) is another solid choice, with a growing 5.8% dividend yield, and a stable share price with little credit or rate risk.

I Bonds - Overview and Analysis

Quick overview of I bonds before comparing them to some alternatives. The U.S. Treasury has its own simple overview here .

Inflation-Protected Yields

I Bond yields are determined by a fixed rate and a variable rate.

The fixed rate depends on when the bonds were bought. The fixed rate currently stands at 1.3% but has been close to zero since the financial crisis. For many investors, their fixed rate is close to zero.

The variable rate depends on inflation, as measured by CPI. Rates are reset semi-annually. The variable rate currently stands at 4.0% and is the same for all investors.

I bond yields are a combination of the fixed rate and the variable rate. For newer or prospective investors, that equals 5.3%. For many investors, yields are closer to 4.0% - 4.5%, depending on when they bought their I bonds.

Stable Investor Capital

For I bonds, investor capital is fixed. Invest $10,000 in I Bonds, and you'll always have that $10,000, plus interest. Capital does not decrease from deflation, market movements, or higher interest rates.

Effectively Zero Credit Risk

I bonds are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. Federal Government, the strongest, most credit-worthy institution in the world. Credit risk is effectively zero, barring an unprecedented U.S. government default.

Liquidity

I bonds must be held for a minimum period of one year. If sold before five years, investors lose the previous three months of interest. I bond interest accrues to the bond, meaning investors need to sell their bonds to receive their interest.

I bonds lack liquidity, a negative for most investors. Lack of liquidity makes these broadly inappropriate investments for short-term investors, especially those who might need their cashback in a matter of months.

Maximum Purchase

I Bond purchases are limited to $10,000 per person, per year, for electronic bonds. Investors can also buy $5,000 per year for paper bonds, which can only be bought when filing your income tax returns. I Bonds are meant for smaller retail investors, hence these limits.

I Bonds - Yield Comparison

Although I bonds are reasonable investment opportunities, their yields compare unfavorably to those of most bonds and bond sub-asset classes. The lowly T-bill yields 5.31%, a smidge higher than newer I bonds, but moderately higher than older issues held by many investors.

Yields are lower than those of most bond sub-asset classes. Treasuries and European investment-grade bonds are partial exceptions, depending on when investors bought their I bonds.

At the same time, more traditional TIPs currently yield around 2.2% plus inflation, compared to 1.3% plus inflation for newer I bonds. Most older I bonds yield even less. TIPs rates are as follows.

Importantly, inflation continues to decrease, reaching 3.2% YoY this past October , effectively zero MoM. Under these conditions, I bond yields should decrease by around 1.0% - 4.0% in the coming months, at current inflation rates at least.

Considering the above, I believe that I bond yields are not competitive in this market. Although this does somewhat depend on when investors bought their I bonds, I think it is the case for many, perhaps most, investors. With this in mind, let's have a look at some alternatives to I bonds.

I Bond Alternatives

TIPs

TIPs seem like the most similar alternative to I bonds. TIPs have comparable credit risk and are also protected against inflation. Their face value is pegged to CPI and increases when inflation rises. TIPs have somewhat higher yields and are more liquid as well. On the other hand, TIP prices fluctuate depending on market conditions, and prices tend to decrease when interest rates decrease.

I think holding individual TIPs is best, as there are issues with TIP funds . Right now, holding individual TIPs will almost certainly lead to higher returns than holding I bonds, as the fixed rate component in TIPs is higher than in I bonds. Prices might fluctuate along the way, however.

Bear in mind, the most important advantage of TIPs is their long-term protection against inflation. Investors for whom this is not a significant concern might prefer other securities or funds.

T-bills

T-bills have comparable credit and interest rate risk to I bonds, similar volatility and capital stability too. T-bills yield a bit more and are much more liquid. On the other hand, T-bills are not protected against inflation and would see lower yields if the Fed were to cut rates.

On net, T-bills seem better than I bonds, although there are some important differences between them.

JAAA

JAAA focuses on AAA-rated CLO tranches. Credit risk seems marginally higher than I bonds, but interest rate risk is similar. Volatility is a bit higher, but low on absolute levels. As with T-bills, JAAA is not protected against inflation and would see lower yields if the Fed were to cut rates. On the flip side, JAAA yields somewhat more, with a 5.8% dividend yield, and a 7.2% yield to worst. The yield to worst is a more forward-looking metric.

JAAA does differ from I bonds in several important ways, but the fund is still a comparatively low-risk, stable bond fund. It is my top choice in this space and has performed exceedingly well since inception, significantly outperforming most of its peers with much lower volatility.

Conclusion

I bonds were one of the most popular, best-performing bond investments in 2022 and 2023, as skyrocketing inflation led to significantly higher yields. Inflation is much lower now, as are I bond yields. As such, and in my opinion, there are better investment opportunities than I bonds right now. These include TIPs, T-bills, and JAAA.

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