Let’s handicap the I Bond’s fixed-rate equation

May 2, 2022 update: Treasury holds I Bond’s fixed rate at 0.0%; composite rate soars to 9.62%.

By David Enna, Tipswatch.com

Back in December 2021, I wrote an article contending there was a “slim chance” that the fixed rate for the U.S. Series I Bond could rise at the Treasury’s next reset on May 1, 2022. The point of that article was to demonstrate that even if the fixed rate did rise, an investment before May 1 would make more financial sense than one after May 1.

Pre-publication, I ran that article idea by a few inflation-watching experts and got responses like you see on Twitter with the meme of the laughing woman spitting out water. Basically: “Are you crazy? There is no way the Treasury is going to raise the I Bond’s fixed rate in May. Not going to happen!”

At the time, understand, the Federal Reserve was only hinting it might begin raising interest rates in 2022. And the 10-year TIPS had a real yield of -1.08%, giving the I Bond a huge 108-basis-point advantage.

But things have changed, as I speculated could happen in that December article:

Eventually, both real and nominal interest rates should begin rising, ending nearly two years of absurdly low rates, at a time when inflation has surged to a 30-year high. Finally, will investors see a reasonable return on safe investments? That’s my hope.

As of Friday’s market close, the real yield of a 10-year TIPS had increased to -0.08%, jumping 100 basis points higher in just five months. The I Bond now has only an 8-basis-point advantage over a 10-year TIPS. Yet, I’d say the possibility of a higher fixed rate remains very slim — for the May reset. In November, much more likely.

How is the fixed rate set?

The Treasury has no announced formula for setting the I Bond’s fixed rate, and everything you read here is informed speculation. The Treasury sometimes does weird things. I’ve been handicapping the fixed-rate adjustments for 11 years, and my best speculation is that the yield of a 10-year TIPS needs to be above zero for the Treasury to even consider raising the fixed rate. Once the 10-year TIPS real yield rises to about 0.50%, a fixed rate above zero becomes likely. We are still a bit away from that.

I don’t think the fixed rate is going to rise at the May 1 reset. (The announcement will come at 10 a.m. EDT on May 2, because May 1 falls on a Sunday.)

Here is a chart showing every instance where the I Bond’s fixed rate was set higher than zero, going back to 2008, and comparing that fixed rate with the then-current real yields of 5- and 10-year TIPS:

Notice that over the last 13 years, there is no case when the I Bond’s fixed rate was above zero and the 10-year TIPS yield was negative to inflation. The closest was the May 2016 reset, when the 10-year TIPS was yielding only 0.12%. At that time, annual inflation was running at only 1.1%, so the Treasury may have been using the 0.1% fixed rate to spur interest in I Bonds.

Today, U.S. inflation is running at 8.5% and investors are flooding into I Bonds. Over the past six months, nearly $11 billion in I Bonds have been issued, compared with around $1.2 billion during the same period in 2020 and 2021, the Wall Street Journal reported last week.

The I Bond’s next composite rate is going to be 9.62%, even with the fixed rate at 0.0%. The Treasury doesn’t need to spur sales. By all logic, it will be holding the I Bond’s fixed rate at 0.0%. Am I totally certain of that? Nope, more like 98.5% certain. The Treasury sometimes does weird things.

Why buying before May 1 makes the most sense

Let’s say the Treasury surprises us and raises the fixed rate to 0.2% for May to October purchases of I Bonds. That would be a shocker! (It won’t happen, but let’s pretend … ) On a $10,000 investment, that 0.2% bonus is worth $20 in the first year, and will compound slightly higher in future years.

If you invest before May 1, you lock in earnings of $356 in the first six months, and then you will earn $498 in the second six months, for a total of $854 in the first 12 months. If you buy after May 1 and get a fixed rate of 0.2%, you will earn $491 in the first six months and then an unknown amount in the second six months.

If you buy after May 1, you miss out on the initial boost of $356, which is equal to about 13 years of the 0.2% fixed-rate bonus, even if you calculate in compounding. So if you buy in May and luck out with a higher fixed rate, it will still take you 13 years to catch up with the person who bought in April.

Here are the numbers, based on my projection of a gradually declining inflation rate over the next 15 years:

Inflation assumptions in this chart, after Year 1, are just for illustration and are not predictions.

And if the fixed rate doesn’t rise?

A lot of readers have been asking me why it doesn’t make more sense to wait until May and jump directly into the 9.62% rate instead of the current rate of 7.12%. The rationale for buying in April is simple: You get a full six months of 7.12% (annualized) and then a full six months of 9.62% (annualized). With compounding that works out to an annual return of 8.54%.

If you buy after May 1, you get 9.62% annualized for the first six months and then an unknown rate for the next six months. When the variable rate resets in November people who bought in April and those who bought in May will get that new rate for six months. There is no advantage to buying in May, for people who intend to buy I Bonds for the mid- to long-term.

The one exception is for an investor who wants to hold the I Bond exactly 12 months and then redeem it. For that person, buying in May does make some sense because it puts the 9.62% return in the first six months. If the I Bond is redeemed after 12 months, the three-month interest penalty will be applied to the next variable rate, which will probably be lower.

People who buy in April should hold the I Bond for 15 months before redeeming, to make sure the three-month penalty is not applied to the 9.62% rate.

Our fixed rate future

There is no way to predict if the Federal Reserve will have the courage to continue its very aggressive course of planned rate increases and balance-sheet reductions. If it follows through, interest rates should rise across the board. In the last tightening cycle beginning in 2015, the 10-year TIPS real yield rose as high as 1.17% in November 2018. In response, the Treasury set a fixed rate of 0.5% for the I Bond at both the May and November 2018 resets.

The first tick higher in the last tightening cycle came in November 2015, when the I Bond’s fixed rate increased to 0.1%. At that time the 10-year TIPS was yielding 0.63%.

We’ve got a ways to go, but if 10-year real yields rise anywhere close to 0.50% later this year, a higher fixed rate will be possible at the November 2022 reset. This would be positive for I Bond investors, because that fixed rate will continue into January 2023, when the purchase-limit clock resets.

But one more thing to consider: If you see 5- and 10-year TIPS real yields rise well above zero, you need to start considering TIPS as an investment. They will likely have a yield advantage over I Bonds for the first time in nearly three years.

* * *

Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

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 purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

About Tipswatch

Author of Tipswatch.com blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website.
This entry was posted in I Bond, Investing in TIPS, Savings Bond. Bookmark the permalink.

11 Responses to Let’s handicap the I Bond’s fixed-rate equation

  1. Joe says:

    That initial $356 head start is just too excellent for me to even worry about a POSSIBLE 0.1-0.2% fixed rate. I plan to hold the bond for as long as I can, especially to get rid of the 5 year penalty. However, if/when a financial crisis comes, I can have access to it within a year. One year isn’t too bad. A lot shorter than 13 years to just break even. Besides, I already made that decision back in late January so it’s impossible to worry about it now lol.

  2. Bob says:

    Another great article.
    Rather than purchasing the the tips outright, any thoughts on the various tips etf’s available with the various brokers? Are you aware of any tax benefits in doing so?

    • Tipswatch says:

      Buying a TIPS ETF — such as SCHP (all maturities) or VTIP (0 – 5 years) — makes life a lot simpler for tracking and tax purposes, but you do need to be prepared for volatility in the value of your holdings. SCHP has had a total return of -4.85% year to date. With an individual TIPS, if you are planning to hold to maturity, you can ignore the market swings and know that at maturity you will get par value + inflation.

      • Bob says:

        So, with the SCHP etf, is that negative 4.85% including the monthly dividends? What makes that fund so volatile?

        • Tipswatch says:

          Yes, that is the total return of SCHP, including dividends. The market value of every TIPS changes every day.When real yields go higher, the value of a TIPS declines, and real yields have climbed substantially so far this year. This is the same for all bonds and bond funds. It’s also true for individual TIPS, but if you are holding to maturity you don’t have to track daily price changes.

  3. keng1_98@yahoo.com says:

    Fantastic article, as usual. I enjoyed seeing the cumulative comparison in the table, and your inflation assumptions looked reasonable, based on what we know today (it could get worse). 😉

    I was thinking that since I Bonds are 30-year bonds, it might make sense to look at real yields on the 30-year TIPs. It appears that on Friday, this was at 0.30, and was as high as 0.38 last week. Could this become the basis for a new fixed rate above 0? In other words, has the correlation to the 10-year TIPs real yield been stronger than to the 30-year TIPs, with regard to the setting of a fixed rate above 0? Seems to me the government should think about matching durations, but I have no idea how they really do it!

    • Tipswatch says:

      I’d say the correlation to the 30-year TIPS is less relevant than the 10-year TIPS. For example, until 2 years ago, a 30-year TIPS had never had a negative real yield, but the I Bond fixed rate was set at 0.0% numerous times when the 30-year was above zero.

      In reality, since an I Bond can be redeemed after 5 years with no penalty, the most direct comparison as an investment would be a 5-year TIPS. But the fixed rate doesn’t seem to correlate well with the 5-year real yield, since the Treasury will raise it above zero even when the 5-year TIPS has a negative real yield.

  4. Clark says:

    Great perspective, especially the second table. As you have nicely educated us on your site, even if the I-bonds fixed rate does not rise “as expected” as TIPS yields rise (!?), I-bonds still carry value beyond the yield in terms of flexibility in holding period (after the initial 1yr/5yr periods) and inoculation against price risk. Of course, matching duration needs via a TIPS ladder can deal with some of those issues. But great to have a choice of both!

    • Tipswatch says:

      Very good points. I Bonds have the advantage of earning tax-deferred interest, so you can time your redemptions to meet your needs and your tax burden. Plus, they don’t lose any value in times of deflation. TIPS, in more normal times, have a yield advantage and there is no limit on your purchases.

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