2023-10-04 13:51:33 ET
Summary
- I Bonds have recently emerged from a period of high inflation, which has been rewarding for investors who bought them before inflation began to climb.
- It now seems unlikely that we will see another period of high inflation like the recent peak of 9.62%.
- Despite potentially lower inflation rates in the near future, I Bonds could still be a good investment, as they often outperformed other bonds even when inflation was 2% or lower.
The inflation rate has now made a round trip to numbers which resemble its level in the decade leading up to 2021. The returns during those years may look puny now compared to the past two years until you compare them to the competition. Since 2000 the yield on ordinary Treasury securities fell close to zero while the real yield on TIPS was sometimes below zero. The real rate, defined for I Bonds as the 30-year fixed rate, occasionally reached .2% when the Treasury was in a generous mood with a single year of the past decade spiking briefly to .5%. What made it more astonishing was that yields derived from the inflation rate were regularly around 2% (not to be confused with the above .2%). I Bonds nevertheless beat every other zero-risk investment and could be recommended without any doubts.
For income investors those were the TINA days, the acronym standing for "There Is No Alternative." Disdainful of the minuscule returns on low risk Treasuries, investors pushed their income investments far out on the risk curve and pounced on any yield that appeared to serve their needs no matter how it was put together (often including return of capital). Slow-growing consumer staples, REITs, and utility stocks sold at price multiples as high as the multiples of growth stocks and some of them still do. Recently they have been tugged down somewhat by the gravitational force of rising rates.
Some day we will tell our grandchildren about the TINA Era which marked the gradual bottoming of a 40-year bull market in bonds. It was reciprocally the historical low point in yield which probably reached a long term bottom in March of 2020. On Sept. 13, 2021, I published my first of eight detailed articles on I Bonds, pounding the table for the risk free return about to be available. I pointed out that the Nov. 1, 2021, reset was likely to present at least a 4.8% return. When the last monthly number came in unexpectedly high the actual number turned out to be 5.3%. That was the beginning of a glorious interlude for I Bonds. My articles then tracked the climb of the inflation rate to a semiannual 4.81% (9.62% annualized) from March through December 2022 with the high month being June 2022. Two years have now passed since that first I Bond article and a lifetime of interest rate and inflation gyrations have been packed into 24 months. As of today we're back to where we started the run-up in inflation although interest rates remain high and continue to rise.
Some say the continuing high rates are simply another Federal Reserve folly while others argue that the Fed is responding to "stubbornly high" inflation which lurks under the surface. Critics mock the Fed for its original assessment that inflation would prove to be transitory, but by most standards the two-year pop in inflation would indeed seem to be transitory. Inflation was originally the product of government largesse to make up for income loss caused by the COVID shut down. As government spending subsided inflation has moved back to normal over a brief and predictable sequence. Stepping back to observe from a distance, the current labor conflicts are less about specific issues and more about the attempt of workers to catch up with purchasing power lost in the rising prices of the past two years. This occurs as people who are not professional economists come to understand that inflation is about the rate of change in prices while high prices usually do not return to the previous level.
The questions involving I Bonds today is just how this affects their value in both short and longer terms. Are they still at or near the top of the list for insurance against inflation? How do they compare to their chief competitors? How should we think about the always uncertain prospects for further inflation, or for that matter deflation? How many of the virtues of I Bonds will continue to give them the flexibility which made them such a helpful safe asset for the first two decades of their existence beginning in 1998? The overarching question is whether the Fed's end point for fighting inflation will leave us with a durable shift in the both yield and inflation tendencies, perhaps with inflation closer to its 100-year average (3.3%) and the yield of many Treasury securities well above 4% at most points on the yield curve. If that proves to be the case how would I Bonds be affected? Is it still worthwhile to buy them? But first, because some readers may be new to the I Bond story, some definitions are in order. If you're thoroughly familiar with the workings of I Bonds feel free to skip the following section, although even those knowledgable about I Bonds might benefit by skimming quickly for reminders.
What Are I Bonds And How Do They Work?
I Bonds are a form of US Treasury Savings Bond which is inflation-adjusted. Like ordinary EE Savings Bonds, I Bonds are backed by the United States Treasury. Savings bonds have been around since 1935. Under a temporary name change to War Bonds, US Savings Bonds helped fund World War II. I Bonds have been around since 1998.
I Bonds produce returns with two components. The first is a fixed rate which provides the "real" return - real meaning inflation adjusted. For new purchases this rate resets semiannually on May 1 and Nov. 1, or the next business day if the first day of the month happens to fall on a holiday. Once you purchase an I Bond the real rate in force at that time continues for 30 years until the bond matures or until the owner chooses to redeem it. The second component of I Bond return is the inflation rate as represented by the Urban Consumer Price Index (CPI-U), the same index that is used for Social Security resets. The inflation rate used for I Bonds is reset semiannually at the same time the fixed rate is reset, on May 1 and Nov. 1, and the accrued value of your I Bond is updated so that the return compounds semiannually. Note that the fixed rate and the variable rate are reset every six months, the variable rate from the CPI report, the fixed rate at the whim of the Treasury which has sometimes been thought to track the five or ten year Treasury note.
You can currently buy up to $10,000 annually of electronic I Bonds in a TreasuryDirect account - that's $10,000 per Social Security Number so that you can buy the same amount for your spouse and each of your children. You also can request that up to $5000 of your Federal income tax refund be received in the form of a paper I Bond which will be mailed to you whenever the IRS gets around to sending refunds.
Like all Treasury Bonds, I Bonds are not taxable by states and municipalities. Another advantage of I Bonds is that you can choose to defer paying Federal taxes until maturity or redemption. This can be helpful if you or your heir (whom you designate with each purchase) expect to have lower taxable income at some point in the future. Under some circumstances I Bonds are tax free when used for educational purposes - read the fine print, though.
One of the most important but seldom noticed qualities of I Bonds is that they're not only an excellent inflation hedge but a hedge against deflation as well. The reason is that the inflation component of the composite return never dips below zero. In the event of a deflationary period the accrued inflation value of the I Bond would simply freeze at its highest level. When inflation returns, as it always has, the total value of the account begins to compound again from the highest level it has reached.
I Bonds are probably the most flexible investment available. This is because their duration is any date you choose from one year to their maturity date of 30 years. You cannot redeem your I Bond during the first year, but after that you choose any moment you wish if for any reason you want to get out. You can thus use them as a place to park cash for the short to intermediate term or leave them in place and continue to have an assured long-term hedge against inflation.
For the first five years the price paid for redeeming a bond is giving up one quarter (three months) of returns. After five years of owning an I Bond the forfeiting of one quarter's returns no longer applies. There are, by the way, no commissions or other costs involved in buying or selling I Bonds. Paper bonds - now available only as part of your tax refund - can be bought at price intervals from $50 to $10,000 while electronic bonds may be bought in penny increments starting at $25. You could, for example, buy an I Bond with a face value $25.23. The Treasury Direct site has a slightly more detailed description. Now for the questions.
Are TIPS Finally A Better Deal Than I Bonds?
For two years I have been using tables and charts to show that I Bonds are a better deal than TIPS. Let me just mention at this point that the acronym TIPS was originally used as singular but has come to serve as either singular or plural. Some parts of that argument have now moved strongly in the other direction. To start with, the real yield on TIPS is now more than double the current real yield on I Bonds at all durations.
5 Year | 10 Year | 20 Year | 30 Year | |
Real Yield | 2.55% | 2.42% | 2.55% | 2.46% |
The 10-year just had an auction reopening with the real yield coming in at 2.094%, and the yield has risen since to 2.42%. The most interesting fact to note is that the auction last July had a real yield of 1.37%, more than 100 basis points lower than the current reopening. Why have real rates changed at that pace? In short, it's the fact that Treasury yields have been going up like crazy at all maturities and continue to do so much to the chagrin of many pundits.
Should you immediately rush to buy TIPS while ignoring I Bonds? The single major number for real yield presents a powerful argument for buying TIPS over I Bonds but some of the seemingly minor qualities of I Bonds suggest stepping back and considering all the factors. One such factor is the flexibility of I Bonds which allow you to get your money at any point you choose after 15 months with the terms improving in two stages. There's zero sacrifice after five years, and in fact a small gain in rate of return achieved if you sell early in the final month.
The fact that TIPS trade on the open market may sound like an advantage but in fact it often is not. To be fair, TIPS are totally safe Treasuries and if held to maturity will return par value for the bond. On the other hand, if you find yourself needing to extract your money when rising rates have caused your bond to sell below the price at which you bought it, you will suffer a loss. The reason for that is that TIPS trade in part like ordinary bonds, and when the price of ordinary Treasuries is declining it pulls down the value of TIPS along with them. This is exactly what has happened so far this year as shown in the chart below:
Note that that the Vanguard TIPS fund ( VIPIX ) and ordinary bonds represented by the Vanguard bond fund ( BND ) had almost exactly the same total return. You could potentially do something about it, selling to take a tax loss and replacing with a different TIPS, but the commissions would likely wipe out the advantage. If you are like me, you want your bond portfolio to provide a steady and stable return to moderate the volatility of your overall portfolio. While TIPS were losing 1.59%, I Bonds would get you a dependable 5.3% if bought before May 1 and 4.3% with one month still out if you bought on May 1 or later. That leaves out the potential change in fixed rate, which will be discussed in the next section.
When it comes to taxes the winner is I Bonds by far. You can, if you wish, defer all taxes until redeeming the bond. With TIPS, however, you must pay taxes annually on both the fixed rate payments and the accrued inflation value. If there's one thing I have always tried to avoid it is taxes that must be paid on phantom income. If you're an income investor you may have an even stronger antipathy.
One more advantage I Bonds enjoy is the fact that they also protect against deflation as the inflation component of their return never drops below while the aggregate inflation number may decline on a monthly basis. Meaningful deflation has been a rarity in US economic history except for the great deflation of the 1930s with the two exceptions being a two-year inflation spike after both WWI and WWII. In both cases a huge inflation spike was followed by similarly sharp bursts of deflation. Those post-war bursts of inflation followed by deflation have a few similarities in causation to today's now fading inflation spike. It probably won't happen, but it's worthing noting.
For I Bonds It May Be Up To The Increase In Fixed Rates
The short answer is no. The Fed may influence inflation by the way it pushes and pulls the economy but its influence is generally indirect. The most likely impact is on the I Bond fixed rate which was raised on May 1 from .4% to .9%. That's the most substantial jump in years and took place as inflation was falling but rates determined by the Fed continued to rise. The public statements by the Fed continue to suggest that rates will remain "higher for longer." This accounts for the rise in the expected fixed return on TIPS from 1.375% on May 1 to 2.33% as I write this line. It's all a matter of the TIPS price having declined sharply as in the chart above.
It's unlikely that the Treasury will lift the I Bond fixed rate by the full .95% rise the market has assigned to the 10-Year TIPS rate but it wouldn't be too surprising if it raised the I Bond rate to as much as 1.5%. The reason the Treasury will likely stick with the lower number is that the I Bond has a potential maturity of 30 years. Subtracting the current 2.46% yield of the 30-Year TIPS from the 4.79% yield of the ordinary non inflation-adjusted Treasury leaves a 30-year inflation expectation less than 2.4%. The Treasury might conclude that such a moderate expected inflation rate suggests that the rate on ordinary Treasuries is likely to subside and make a higher fixed rate on I Bonds inappropriate. It's all a matter of how the Treasury looks at numbers including the one remaining number for inflation (September) before the upcoming Nov. 1 reset. Note that my estimate for the May1, 2023, was low. Does that mean the current estimate of 1.5% might be too high? Or might I might be on the low side again? Who knows. The one thing I'm very sure of is that the current .90% will not decrease.
On Oct. 12 at 8:30 EST the September CPI number will be released. This will complete the six month period from April through September enabling potential I Bond investors to make decisions with full information on the variable component of the Nov. 1 reset. How would you like have the opportunity to buy a stock for whatever it was selling for a year ago? From Oct. 12 to the end of the month - you should probably act a couple of days earlier to avoid any issues that come up - you can do pretty much the same thing with I Bonds. You know what you will get for the first year's inflation adjustment of your investment and if you like it you can buy. The table below lays out what we know while waiting for that September number:
Apr23 | May23 | Jun23 | Jul23 | Aug23 | Sep23 | |
Index | 303.363 | 304.127 | 305.109 | 305.691 | 307.026 | TBD |
M/M | .51 | .25 | .32 | .19 | .44 | TBD |
Y/Y | 4.9 | 4.0 | 3.0 | 3.2 | 3.7 | TBD |
Five Month Percentage Change: 1.72% (3.44% annualized)
Oct22 | Nov22 | Dec22 | Jan23 | Feb23 | Mar23 | |
Index | 298.012 | 297/711 | 296.795 | 299.170 | 300.840 | 301.836 |
M/M | .41 | -.10 | -.31 | .80 | .56 | ,33 |
T/Y | 7.7 | 7.1 | 6.5 | 6.4 | 6.0 | 5.0 |
Six Month Percentage Change: 1.69% (3.38% annualized)
Apr22 | May22 | Jun2 | Jul22 | Aug22 | Sep22 | |
Index | 289.109 | 292.296 | 296.311 | 296.276 | 296.172 | 196.808 |
M/M | .56 | 1.10 | 1.27 | -.01 | -.04 | .22 |
Y/Y | 8.3 | 8.6 | 9.1 | 8.5 | 8.3 | 8.2 |
Six Month Percentage Change: 3.24% (6.48% annualized)
The third period in the above table shows returns that are now in the past. What might interest readers is the fact that the high point in inflation came in June 2022 exactly a year before the current low point so far. Year-over-year inflation then declined for two months but only slightly suggesting that the larger year over year change in 2022 was derived from the denominators established a year earlier in 2021. Something similar may be at work in the most recent 2023 figures suggesting that the year over year changes of the past two months don't really imply a strong kick back up in inflation. Time will tell.
Once the September number is available on Oct. 12 investors will have all the information available before May 1. The fixed rate will not be available until the May 1 announcement so it will be necessary to make a best guess. The options are as follows:
- Buy now accepting an inflation rate in the area of 3.4% annualized plus .9% fixed, a combined annualized rate of 4.3%.
- Or bet for a significant fixed rate increase on Nov. 1, perhaps to 1.5%, and hope that this will add up to an immediate combined rate of 4.9%. By doing this you will forego the outgoing October-March rate of 1.69% (3.38 annualized). You will hope that that you get a nice boost to fixed rate that will justify your decision even if the inflation rate falls in the next six months.
- My personal choice is the latter one: hope for the 1.5% fixed rate and grab it.
The Fed would undoubtedly like to have an inflation rate close to the 2% that ruled in the decade ending five years ago. In my view this produced a ruinous distortion in capital allocation which produced strange relative and absolute pricing in the markets. Over the very long term, as mentioned above, the average inflation rate has been 3.3% and bond rates have been over 4%. This made it possible to put together well diversified stock/bond portfolios. Economic growth did very well.
What About The Gift Box?
A helpful comment from a reader a little over a year ago made me look more closely at what you could do with the Gift Box option in which you could not only make generous Gifts but make reciprocal gifts with trusts friends or relatives. Luckily I have both and worked out $10K Gift swaps while educating them to the workings of I Bonds in general. The swaps are perfectly level although for the six month period in which the rate was 4.81% (9.62% annualized) the rush to buy basically swamped TreasuryDirect. So now what should you do if you were lucky to buy one or two "Gifts" while having friends buy one or two for you?
The short answer is that it seems to be too late to buy, adding a Gift purchase to your regular annual purchase limit, but it's also too early to take "Delivery" on past gifts while foregoing you annual purchase limit. My thinking when doing the Gift swap was that it would probably take two or three years at a minim for the return available for ordinary annual purchases to fall low enough to produce a good time to forego the regular annual purchase and have Gift Box purchases Delivered. In my case it will take two separate years to have two Gifts Delivered. The TreasuryDirect site has a fuller explanation of the rules governing the Gift Box and Harry Sit at The Finance Buff provides helpful answers to pretty much all the questions that come up.
Conclusion
I Bonds have made a round trip to the place where they started before the large inflation burst beginning in 2021. They're what they were before: A valuable piece of insurance to be sure that one absolutely safe piece of your investments gives you assured defense against inflation. Ideally your I Bond portfolio should be sweetened with a meaningful fixed real rate to help offset the taxes you or your heirs will have to pay at some point in the future. The current year is ideal for this purpose, and I plan to play the odds that there will be a bump up in fixed rates on May 1.
I invite commenters to give their own point of view and/or ask questions or request clarification. I will read every comment as I always do and respond to questions.
For further details see:
I Bonds: TIPS Offer A Higher Fixed Rate But Maybe Not The Better Overall Deal