By David Enna, Tipswatch.com
Note: I posted an updated I Bond analysis on April 14:
Update, April 28, 2023: Treasury raises I Bond’s fixed rate to 0.9%; new composite rate is 4.30%
After a year of raging-high demand, where do we stand today on U.S. Series I Savings Bonds? Are they still an appealing asset? Are they a worthy investment for 2023? Is the variable rate likely to fall at the May reset? Should you hold out for a higher fixed rate later in 2023?
Last year, in January 2022, I titled my year-ahead guide “I Bonds: A very simple buying guide for2022.” At the time, I Bonds had an annualized rate of 7.12%. By comparison, a 1-year Treasury bill was yielding 0.40%. See? My advice was simple: Buy I Bonds, in January or April or anytime between. But buy I Bonds.
This year, things are more complicated. Yields on nominal Treasurys are much higher. Real yields for Treasury Inflation-Protected Securities have soared to levels we haven’t seen in 15 years. Even bank CDs and online savings accounts are getting attractive. I Bonds have competition.
Before we get into those issues, here’s a quick primer for investors who are new to I Bonds:
The basics
- The fixed rate of an I Bond will never change. Purchases through April 30, 2023, will have a fixed rate of 0.4%, which means their return will exceed official U.S. inflation by 0.4% until the I Bond is redeemed or matures in 30 years.
- The inflation-adjusted rate (often called the I Bond’s variable rate) changes each six months to reflect the running rate of inflation. That rate is currently set at 6.48%, annualized, for six months. It will adjust again on May 1, 2023, rolling into effect for all I Bonds, no matter when they were purchased.
- The current composite rate is 6.89% annualized for six months for purchases from January to April 2023.
I Bonds are an extremely safe and conservative investment. Interest accrues monthly and can never decline, even in times of deflation. Investments are limited to $10,000 per person per calendar year for electronic I Bonds held at TreasuryDirect. There is also the option to get $5,000 a year in paper I Bonds in lieu of a federal tax refund. There is also a “gift box” strategy some investors use to stack purchases for future years.
I Bonds are a unique investment with many positives. For example, earnings are free of state income taxes and federal taxes can be deferred until the I Bond is redeemed or matures. Also, I Bonds are a simple investment to buy and track, much simpler than a TIPS with a constantly changing market value and inflation accruals that update daily.
The purchase limit is the reason people ponder timing their I Bond purchases; once you hit $10,000 per person per year, you can’t purchase more, at least in the traditional way.
Are I Bonds still attractive?
I Bonds purchased from January to April 2023 will pay an annualized composite rate of 6.89% for six months, which includes the fixed rate of 0.4%. Is 6.89% attractive? Definitely. But let’s look at the alternatives:
- A six-month Treasury bill has a nominal yield of about 4.76%.
- Best-in-nation 6-month bank CDs are yielding about 4.4%.
- A 1-year Treasury bill has a nominal yield of about 4.73%.
- Best-in-nation 1-year bank CDs are yielding about 4.75%.
- A 5-year Treasury note now yields about 4%.
- A 5-year TIPS has a real yield of about 1.58%.
As a six-month investment, an I Bond definitely looks attractive. But keep in mind that an I Bond has to be held for at least 12 months, and redeeming before 5 years forfeits your last three months of interest. That brings uncertainty into the equation.
Short-term investment
If you are aiming to redeem the I Bond after one year, this still looks like a contender, but with complications. You are guaranteed to earn an actual return of 3.445% in the first six months (6.89%/2), and then some undetermined return in the next six months, depending on inflation from October 2022 to March 2023, plus the fixed rate of 0.4%.
And there is the problem: We can’t accurately project U.S. inflation for the October to March period. The first two months, October and November, are already in, and inflation ran at 0.30% over that period, averaging just 0.15% a month.
So I’d guess the variable rate at the May reset will be lower than the current 6.48%, but most likely will still be at least 1.8%, based on 0.15% monthly inflation on average over the six months. That’s a conservative estimate.
Add on the fixed rate of 0.4% and you can conservatively estimate an annualized return of about 2.2% in the second six months. That creates a total return of about 4.54% for one year (6.89% + 2.2% / 2 = 4.54%) Remember, this is a conservative estimate. If inflation runs higher, your return would be higher. If inflation runs at 0.4% from December to March, the new variable rate would be 3.8%. Add on the fixed rate and you get to 4.2%. Your total return after one year would be about 5.5%.
But … redeeming an I Bond after 12 months will incur a three-month interest penalty, wiping out more than 1% of that return.
Does all this mean that I think U.S. inflation has been tamed? Definitely not. But we are heading into a several-month period where the year-ago numbers will be very hard to match and exceed. So inflation should appear to “moderate” during that period. Take a look at the numbers: December 2021 at 0.31% is reasonable, but then you get January 2022 at 0.84%, February at 0.91% and March at 1.34%.
Conclusion. If your only interest in I Bonds is a quick one-year investment, you might want to look at competitive nominal investments like one-year bank CDs, online savings accounts or one-year Treasury bills. If inflation moderates, the returns could be similar but without the three-month interest penalty. The advantage of an I Bond is long-term inflation protection. If you aren’t concerned about inflation in the long term, look elsewhere.
But if you remain interested in the I Bond for one year, then I’d suggest using TreasuryDirect to set a purchase date later this month, maybe Jan. 27, to lock in January as your starting month. You could then redeem early in January 2024.
Long-term investment
Long-time fans of I Bonds buy them every year, up to the annual $10,000 per person purchase limit, to build a large cache of inflation-protected savings. After 5 years, an I Bond effectively becomes an inflation-protected, tax-deferred cash account you can draw from without penalty. (See the I Bond Manifesto for more on this.)
I am a long-time, devoted I Bond fan, and I will be buying I Bonds up to the limit this year. I want that higher fixed rate. But when to buy? The key factors in this decision are 1) potential changes in the I Bond’s variable rate, and 2) potential changes in the I Bond’s fixed rate.
Buying anytime from January through April will result in exactly the same return on your investment. That is because when you purchase an I Bond, you lock in the current composite rate (6.89%) for a full six months before the next rate reset. So a long-term investor has no urgent need to buy in January. In 2022, I bought in January to go ahead and grab the 7.12% variable rate. This year … I will wait.
Key date: April, 12, 2023. At 8:30 a.m. ET on April 12, the Bureau of Labor Statistics will release the March inflation report, setting in stone the I Bond’s next variable rate reset, going into effect May 1. At that point, you will also have an idea of where the I Bond’s fixed rate could be heading. And you will have about 15 days to decide: Buy in April, or in May?
As I said earlier, I think the variable rate could be heading lower, somewhere in the range of 1.8% to 4.0%. That’s a guess, not a projection. If the variable rate is going to fall, buying in April makes more sense, to capture 6.89% for six months.
But then there is the issue of the fixed rate. Long-term investors in I Bonds know that a higher fixed rate is always more desirable, because it stays with the I Bond for the entire 30-year potential term. Could the fixed rate rise on May 1? My guess is yes, it is possible if real yields continue holding at current levels, with the 10-year TIPS trading with a real yield of 1.58%.
(Update on January 9: The 10-year real yield has fallen to about 1.3% in trading today, dropping about 28 basis points in a week. Not a good indicator for a higher fixed rate for the I Bond, but a lot of time remains.)
Oddly enough, 1.58% is exactly where the 10-year TIPS was trading on Oct. 31, 2022, the day before the Treasury raised the I Bond’s fixed rate from 0.0% to 0.4%. My opinion: The fixed rate should have been higher, but I was pleased with the decision to raise it at a time when TreasuryDirect was overwhelmed by demand for I Bonds.
The Treasury has no public formula for setting the I Bond’s fixed rate, but I have contended for years that the 10-year real yield is the best indicator of where the fixed rate is heading. At the November reset, the yield spread was 1.18%, the highest since November 2008. The fixed rate could have been higher.
What about waiting until the Nov. 1 rate reset? I’d say no because you could risk losing the above-zero fixed rate if the Fed changes course, plus the attractive composite rate (6.89%) for six months. Anything can happen though. On Jan. 1, 2022, a higher fixed rate did not look all likely at the November reset — the 10-year real yield was -0.97%. Ten months later it had increased 255 basis points.
Conclusion. A higher fixed rate is a possibility on May 1, even as the variable rate might be going lower. For a long-term I Bond investor, I think it makes sense to wait until April 12 to make a purchase decision. And even then the decision might be to divide your purchases, half in April and half in May, if a higher fixed rate looks at all possible.
Redeem I Bonds to purchase I Bonds?
If you are a long-time investor in I Bonds, you probably have some issues with a 0.0% fixed rate and have hit the 5-year mark so they can be redeemed without penalty. For example, I have I Bonds issued in April 2017 that qualify. If I wanted to step up to the higher fixed rate, I could sell the April 2017 I Bonds and buy the April 2023 I Bonds, getting the 0.4% fixed rate.
The negative to this strategy is that I would owe taxes on the $1,704 interest I’ve earned. That would be costly. However, the strategy still makes sense for an investor that doesn’t want to raise additional money this year to buy the 2023 allocation.
Another alternative would be to redeem I Bonds with a fixed rate of 0.0% that you’ve held just a year or two. That would cost you three months of interest, but if you delay redeeming until three months after the 6.48% variable rate cycles off, you could lower the penalty (possibly). Plus, the total taxable interest for the shorter holding shouldn’t be too painful.
I’m not a fan of rolling over I Bonds, but I can see the need for investors who need to raise the cash for a more attractive purchase.
Obvious alternative: TIPS
The one investment most similar to an I Bond is a 5-year TIPS, especially one held in a tax-deferred traditional IRA account. The I Bond can be redeemed without penalty after 5 years; the TIPS matures in 5 years. They are equally safe if you hold the TIPS to maturity. But at this point, the 5-year TIPS has a huge above-inflation yield advantage: 1.66% for a 5-year TIPS vs. 0.4% for the I Bond. This is why I recently wrote that current yields make it “advantage TIPS.”
But TIPS can be a confusing and even frustrating investment, and many investors prefer the simplicity of the I Bond, which has better deflation protection, never goes down in value, and can be redeemed in the year of your choice. I Bonds work much better as a cash alternative and can add to your tax-deferred holdings without creating worries about future required minimum distributions.
I have been buying TIPS aggressively since mid-2022 and I will keep buying the 5- to 15-year maturities as long as real yields continue at high levels. But I will also buy I Bonds in 2023. Inflation protection is a handy thing, as shown in the last two years when inflation suddenly and unexpectedly ran at 7+% annually.
Both investments can work in your portfolio.
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• Let’s ‘try’ to clarify how an I Bond’s interest is calculated
• Inflation and I Bonds: Track the variable rate changes
• I Bond Manifesto: How this investment can work as an emergency fund
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• TIPS in depth: A primer
• Upcoming schedule of TIPS auctions
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
