I Bond confusion: Understanding how the 0.0% rate rolls out

Back on May 1, I wrote an article about how the new  I Bond inflation adjusted variable rate had fallen into the deep negative, -1.60% (annualized). And this meant any Series I Savings Bond with a fixed rate of  1.6% or less would pay 0.0% for six months.

Since then several readers have commented that they aren’t seeing the 0.0% rate in the Savings Bond Wizard. Others have cursed me and told me I have it all wrong, believing that the fixed rate is ‘fixed’ and can never be reduced. Others are just confused.

If you use the Treasury’s Savings Bond Wizard, you are going to see some misleading numbers for awhile, but they aren’t wrong. (I love the Wizard, by the way, it is an excellent tool.) If you have it, open it up today and get the latest update, which provides interest rates through November 2015.

But first, read this …

How is that rate calculated? The Treasury Direct site has a lot of great information on I Bonds, including a very good Rates & Terms page. This chart showing the I Bond rate formula is drawn from that page:

I Bond formulaOK, it’s obvious if the fixed rate is 0.0% and the inflation rate is negative, the composite rate is going to drop to 0.0%, the lowest possible. But what if your fixed rate is 3.0%, as it was back in the good old days (May to November 2001)? What will happen to your fixed rate under that formula? Here is the calculation:

[0.0300 + (2 x -0.0080) + (0.0300 x -0.0080)]
[0.0300 + -0.0160 + – 0.00024]
0.01376
resulting in a composite rate of 1.38%

So, according to the Treasury formula, your fixed rate will be lowered by the negative inflation rate. It will result in a composite rate of 1.38% for six months.

But … my Savings Bond Wizard shows a higher rate! It might, and it isn’t wrong. The I Bond composite rate rolls out across six months, depending on the month when you first bought the I Bond. The Treasury has another nice chart that shows this:

I Bond rate rolloutSo the Savings Bond Wizard will continue to show a higher rate, based on the last period’s 1.48% variable rate, until the new rate kicks in – depending on the month when you first bought the I Bond. If you bought an I Bond in October 2003, the new rate will begin in October 2015 and continue for six months. If you bought in November 2003, the new rate started May 1 and will continue for six months.

I have updated my Savings Bond Wizard and here is what is it showing for May 2015 and November 2015 for the I Bonds I currently own:

May November

FYI: Rate is the current six-month composite rate, yield is the annualized yield over the lifetime of the I Bond.

That is almost crystal clear, isn’t it? As the new composite rate rolls out over the next six months, all my I Bonds will be affected by the -1.6% variable rate, and the yield – the annualized interest paid over the life of the I Bond – will also decline.

Take a look at the two I Bonds issued in October 2001. They have a fixed rate of 3.0% (nice!) and so they fit the formula that I posted above:

[0.0300 + (2 x -0.0080) + (0.0300 x -0.0080)]
[0.0300 + -0.0160 + – 0.00024]
0.01376
resulting in a composite rate of 1.38%

If you look at the November 2015 rate, it is 1.38%.

And another thing. I am totally, 100% recommending hanging on to all your I Bonds through this six months of reduced returns. Inflation fell at an annual rate of -1.60% from September 2014 to March 2015. Even if you are getting a return of 0.0%, you are beating inflation by 1.6%. You’ll survive.

Because you can buy only $10,000 per person in I Bonds each calendar year (plus the IRS refund trick), they are an asset to hold. I Bonds are part of a strategy of pushing inflation-protected, tax-deferred money into the future. The only reason to sell them is if you need the cash right now.

I hope this helps clear up some of the confusion circling around I Bonds in these strange months of post-deflation 2015.

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U.S. inflation remains muted, increasing 0.1% in April

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% in April on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, inflation declined 0.2%.

Falling energy prices were a key factor in April’s mild inflation. Gasoline prices, for example, fell -1.7% after rising in the two previous months. Gas prices are down -31.7% over the last 12 months. Fuel oil prices were down a very strong -8.4% in April, the BLS reported. Balancing off those declines were increases in medical care services (0.9%), shelter (0.3%) and used cars and trucks (0.6%). Overall food prices were unchanged in April.

Core inflation – which strips out energy and food – was up 0.3%, its largest increase since January 2013. Core inflation is up 1.8% over the last 12 months.

Holders of TIPS and I Bonds are also interested in non-seasonally adjusted inflation, which is used to determine the principal adjustments for TIPS and future interest rates for I Bonds. In April, the inflation index rose 0.2% to 236.599, but over the last 12 months inflation was negative at -0.2%.

I have updated my Tracking Inflation and I Bonds page to reflect these new numbers.

Although overall inflation remains very muted, April’s core inflation number could give the Federal Reserve something to ponder. The Fed adopted a 2% inflation target in April 2012. Core inflation of 1.8% is approaching that number, but I still can’t see the Fed acting to raise short-term interest rates in the near term.

Here is the inflation trend for the last 12 months:

inflation trend

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10-year TIPS reopening auctions with a real yield of 0.358%

The US Treasury just announced that its reopening of a 10-year TIPS – CUSIP 912828H45 – auctioned with a real yield (above inflation) of 0.358%. This is a 9-year, 8-moth Treasury Inflation-Protected Security with a coupon rate of 0.250%.

Because the auctioned yield ended up higher than the coupon rate, buyers got this TIPS at a discount – an adjusted price of about $98.62 per $100 of value. The discount was a little greater because this TIPS has an inflation index of 0.99633, meaning it remains slightly below par value after several months of deflation. So technically buyers are paying $98.62 for $99.63 of value as of May 29, the issue date.

Inflation breakeven rate. Comparing the yield of 0.358% with the current yield on a 10-year nominal Treasury (2.21%), we get a 10-year inflation breakeven rate of 1.852%. This means that if inflation average higher than 1.852% over the next 10 years, this TIPS will outperform a nominal Treasury. This is a historically low number, but reflects the muted level of inflation over recent years.

Six months ago, a similar TIPS reopening resulted in a real yield to maturity of 0.497% and a very similar inflation breakeven rate of 1.853%. This indicates that TIPS yields are tracking closely with those of traditional Treasurys.

Reaction to the auction. In the minutes after the auction, the TIP ETF, which holds a broad range of maturities, had minimal reaction. TIPS had been trading slightly higher all morning, indicating that yields were trending slightly down.

Bloomberg’s Alexandra Scaggs noted that the auction “attracted the lowest demand since September 2014.”

“We’re just simply not too wrought up about inflation expectations at the moment,” said Jim Vogel, interest-rate strategist with FTN Financial in Memphis, Tennessee. …

’’There was some concern that the market was beginning to doubt the Fed’s ability to get inflation back up, but that fear has dissipated a little bit,’’ said Joshua Feinman, New York-based global chief economist with Deutsche Bank Asset & Wealth Management, which oversees $1.3 trillion. But now, “most of the impact has already been priced into the market.”

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Checking in on today’s 10-year TIPS reopening

Treasury logoNoncompetitive bids close at noon for CUSIP 912828H45, a 9-year, 8-month Treasury Inflation-Protected Security with a coupon rate of 0.210%. Competitive bids close at 1 p.m. when the auction ends. Here’s what we can say at 10:06 a.m.:

  • Bloomberg’s Current Yields page shows this TIPS trading this morning with a real yield (after inflation) of 0.34% and a price of about $99.15 per $100 of value. This TIPS will go at a discount because its yield is higher than the coupon rate.
  • The Wall Street Journal’s Closing Prices page shows this TIPS – which matures in January 2025 – closed Wednesday with a yield of 0.336% and a price right around $99.19.
  • The US Treasury’s Real Yields Curve page estimates that a full-term 10-year TIPS closed Wednesday with a yield of 0.38%
  • Finally, the TIP ETF is trading this morning at $112.69, up about 0.3%, which indicates that yields are declining slightly.

All of this information seems to point to an auction yield today of about 0.33%, well below the 0.497% that a similar auction drew six months ago.

I’ll return after the auction closes at 1 p.m. to post the results and then later to add some reaction.

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Up next: 10-year TIPS reopens at auction May 21, 2015

It’s been an interesting couple of weeks for Treasury Inflation-Protected Securities, and all government bonds. Yields are rising – the 10-year German bund, for example, is currently yielding 0.73%, up from 0.07% just three weeks ago. In that same time, the yield on a 10-year US Treasury rose from 1.87% to 2.27%. And the yield on a 10-year TIPS rose from -0.02% to 0.41%.

So rates are on the rise, and while this makes TIPS more appealing as an investment, it strikes hard at TIPS mutual funds. The price of the broadly invested TIP ETF, for example, has fallen from $115.49 on April 17 to $112.16 on May 13, a decline of 2.9%.

All of this is leading up to a reopening auction next week of CUSIP 912828H45, which first auctioned on Jan. 22 with a real yield to maturity (after inflation) of 0.315% and a coupon rate of 0.250%. It reopened on March 19 with a real yield of 0.2%, the lowest yield for an 9- to 10-year TIPS at auction since May 2013.

Thursday’s 9-year, 8-month auction will be the final reopening of this TIPS, and it could end up being a fairly attractive offering. Here is where things stand today:

  • This TIPS is currently trading on the secondary market. Bloomberg’s Current Yields page shows it trading at 0.37% this morning – with a price of about $98.88 per $100 of par value. It is priced at a discount because the yield is higher than that coupon rate of 0.250%.
  • The Wall Street Journal’s Closing Prices page shows this TIPS – which matures on Jan. 15 2025 – closed Wednesday with a yield of 0.370% and the same price, about $98.88 for $100 of par value.
  • You can also see on that WSJ chart that this TIPS has an inflation index of 0.993, which means it hasn’t yet risen to par value after several months of deflation. This index will rise to 0.996 on the auction closing date of May 29, which will also slightly lower its adjusted price at auction. View detailed index data.
  • Finally, the US Treasury’s Real Yields Curve page, which estimates the yield of a full-term 10-year TIPS, showed a yield of 0.41% yesterday.

This auction is a week out, and a lot can happen in a week. But at this point it looks like this TIPS could end up with an after-inflation yield in the 0.35% to 0.45% range, and it will be priced at a discount.

Inflation breakeven rate. If we peg this TIPS at 0.37% and the 10-year nominal Treasury at 2.27%, we get an inflation breakeven rate of 1.90%, still in the cheap range but creeping toward the neutral area (2.0% to 2.5%). This means if inflation averages more than 1.9% over the next 10 years, this TIPS will outperform at traditional Treasury. And I’d say that number will make this TIPS attractive for many investors. Here is a five-year chart of breakeven rates for the 10-year TIPS:

breakeven ratesKey question. Are higher yields coming? Who knows. The Treasury will offer a new 10-year TIPS in July and that one will reopen in September and November. An investor who thinks yields will be rising can afford to wait for that new July issue.

Here is the history of all 9- to 10-year TIPS auctions since January 2008. Study this chart, and you can see it has been a wild ride. Is 0.40% a ‘normal’ after-inflation yield for a 10-year TIPS? It might be today, but not in the past.

10-year TIPS auctions

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Can a TIPS investment go bad? Yes, it can. An ugly example.

My philosophy for investing in Treasury Inflation-Protected Securities is to buy them at auction when the yield is attractive, and then hold them to maturity. At the very least – in almost every case –  you will get the original investment back at maturity, along with the biannual coupon payments.

But there are cases where a TIPS investment can backfire. Although rare, this generally involves buying a TIPS at a reopening auction where the yield is set well below the coupon rate. Or, buying a new TIPS at auction where the yield is strongly negative to inflation. Since TIPS carry a coupon rate of 0.125% at the very least, buying TIPS at a time of negative yields can be expensive, and create added risk.

An example. Take the most recent auction of a new 5-year TIPS on April 23. The yield at auction was -0.335% and the coupon rate was 0.125%, so buyers wanting to invest $10,000 in this TIPS paid about $10,252 for $10,000 of par value and a 0.125% coupon rate, which generates about $12.50 a year in income.

So, roughly, five years of coupon rates are going to pay the investor $62.50 (this will rise slightly with inflation). That leaves a shortfall of about $189.50 that the investor needs to make up in the next five years. In theory, rising inflation will push up the principal balance and will make up the difference. But if it doesn’t, the investor will never make back that original investment. Remember, par is $10,000, and that is all the investor will get back if there is zero inflation or deflation during the five-year term.

An extreme case. While working on an analysis of that April auction, I noticed a particularly ugly example: The 4-year, 4-month reopening of CUSIP 912828SQ4 on Dec. 20, 2012. This TIPS has a coupon rate of 0.125% and auctioned with a yield to maturity of -1.496%. Here’s the fact sheet.

Back on December 20, 2012, I looked at this TIPS and wrote: “I mean, who really cares? Who is actually buying this thing?” On December 10, 2012, I advanced the auction and tried to steer buyers toward I Bonds instead. In other words, I wasn’t a fan. But I had no idea how much of stinker this would become, because it was issued just before a period of deflation in the US economy.

This TIPS matures on April 15, 2017. Let’s see how it has performed so far:

CUSIP 912828SQ4Because of the spread between the coupon rate and the negative yield to maturity, the buyer of this TIPS paid $10,918 for adjusted principal of $10,184 and a par value of $10,000. When this TIPS matures on April 15, 2017, only the par value is guaranteed.

So far, the combination of months of deflation and inflation has caused the inflation index to rise from 1.o1844 in December 2012 to 1.03898 in May 2015, but that isn’t enough to make up for the initial $733.60 extra cost of this TIPS. Adjusted principal has risen from $10,184 to $10,390, still far below the initial cost of $10,918.

This particular TIPS is a ‘horror story’ – it was expensive and purchased just before an extended time of deflation. Even if inflation averages 2% a year for the next two years – best case scenario? – its principal value will rise only to about $10,810, still a bit below the original cost.

The lesson. Be wary of buying TIPS when the yield to maturity is well below the coupon rate. In today’s market, with a 5-year TIPS yielding -0.11%, the risk is minimal and acceptable.

Posted in Investing in TIPS | 11 Comments

May 1 update: Series I Savings Bonds to pay 0.0% interest; EE Bonds bump up to 0.3%

Savings-Bond-IThe US Treasury just announced that the fixed rate on Series I Savings Bonds will remain at 0.0% from May to October, meaning I Bonds purchased in this period will earn a composite rate of 0.0% for six months. In addition, the Treasury raised the EE Bond fixed rate to 0.3% and left intact the guarantee that EE Bonds will double in value if held for 20 years.

The earnings rate for Series I Savings Bonds is a combination of a fixed rate, which applies for the 30-year life of the bond, and the semiannual inflation rate, also called the variable rate.

The new I Bond variable rate of -1.60% (annualized) was set in stone when the Bureau of Labor Statistics released the March inflation number. This May 1 adjustment is determined by non-seasonally adjusted CPI-U for September to March. Here are the numbers, from my Tracking Inflation and I Bonds page:

six monthsThe composite I Bond rate is determined by adding the variable rate (-1.60%) to the fixed rate (depends on when the I Bond was issued). Any I Bond with a fixed rate of 1.60% or less – and that is every I Bond issued in the past 13 years – will get a composite rate of 0.0% for six months. This is because I Bonds cannot pay negative interest; the lowest they can go is 0.0%. The starting date of that 0.0% period depends on which month you purchased the I Bond, but they will all get six months of it.

One point to consider: Since inflation fell at an annual rate of 1.60% over the last six months, your I Bond paying 0.0% is beating inflation by 1.60%. This is one of the benefits of I Bonds: They lose no value in times of deflation, which isn’t true of the principal balance of TIPS, which declines with each deflationary month.

Should you dump your I Bonds paying 0.0%? One word answer: No. Since you are limited to I Bond purchases of $10,000 a year per person (plus $5,000 as a tax refund), I don’t think selling your I Bonds is a good idea. Unless: 1) you need the money today to meet current expenses, or 2) the I Bond has reached its 30-year maturity (none have as of yet, of course). The idea in I Bond investing is to build as large a cache of inflation-protected money as possible, to use as a resource in the future. Selling out of I Bonds will keep you from reaching that goal. Just be patient; wait out the six lousy months.

Should you buy I Bonds paying 0.0%? One word answer: No. It makes no sense to buy I Bonds in this May to October period. Instead, wait until the November 1 adjustment, which could bring a positive variable rate and the possibility of a fixed rate higher than 0.0%. You’d still have two months to buy your 2015 allocation. Inflation has already started ticking up, rising 0.6% in March on a non-seasonally adjusted basis. There is a good chance I Bonds will be paying a decent variable rate starting November 1.

What about EE Bonds? The Treasury’s decision to pump the fixed rate from 0.1% to 0.3% was a nice gesture, but in effect it is meaningless. The key to EE Bonds is this clause:

All Series EE bonds issued since May 2005 earn a fixed rate in the first 20 years after issue.  At 20 years, the bonds will be worth at least two times their purchase price.

The Treasury kept intact the 20-year doubling of value, which in effect creates a 20-year, tax-deferred Treasury bond paying 3.5%. This is an outstanding value, given that a 30-year traditional Treasury is currently paying 2.75%, and a 20-year is paying 2.49%, more than 100 basis points lower. That is a huge difference in a 20-year investment.

EE Bonds are the investment of choice in mid-2015, if … and only if … you can afford to hold them for the full 20 years.

Posted in Investing in TIPS | 11 Comments