Treasury Inflation-Protected Securities

Last week I posted on both the Series I Savings Bond (which I have been buying for years) and the Series EE, which I haven’t bought – or even thought much about – since 1992. But that post on the EE Bond got me thinking: How is this not a good investment?

My advice last week was to buy the EE Bond before Nov. 1, because the Treasury might alter a key term of the bond: That your investment is guaranteed to double in value if held for 20 years. When the announcement came on Monday, the Treasury retained the double-in-20-years policy, but it dropped the permanent EE Bond’s fixed rate from 0.3% to 0.1%.

At the same time, it raised the fixed rate for inflation-adjusted I Bonds purchased from now to April 30, 2106, to 0.1% from 0.0%.

EE Bonds, really? This investment only makes sense if you are 99.999% sure you can hold it for 20 years. If you do, you will earn 3.5% on your money. If you don’t, you will earn 0.1%. So I am assuming anyone buying an EE Bond is committed to holding it 20 years. And remember, this money compounds tax-deferred. There is no tax liability until you sell.

[Update: One more thought on EE Bonds; a chart explains it all …]

Back in 1992 … The last time my wife and I bought EE Bonds was in August 1992, after we sold a house and had cash to put away. At the time, EE Bonds were guaranteed to double in value in 18 years, creating a yield of 4.0%. Because of a complex dual-track rate system on EE Bonds at the time, our EE Bonds have actually yielded 5.04% over 23 years. They are still earning 4.0% a year until maturity in 2022.

It’s was my wife’s idea to buy the EE Bonds. I thought it was a horrible idea. I argued but, hey, I had to admit it was a no-risk investment. Today, $10,000 of those EE Bonds are worth $31,432, and they are still growing at 4.0% a year, all tax deferred. Good move, wife.

One more fact to complete this idea: In August 1992, a 30-year nominal Treasury was yielding 7.64%, 364 basis points higher than the official yield of the EE Bond and 260 basis points higher than the resulting effective yield.

And in 2015? EE Bonds purchased today earn a pitiful 0.1% for 19 years, 11 months, and then one month later suddenly double in value, creating an effective yield of 3.5%. How does that compare with a 20-year nominal Treasury? It is yielding 2.65%, 85 basis points below the yield on an EE Bond. Even a 30-year nominal Treasury has a yield of 3.00%, 50 basis points below the EE Bond.

So in fact, in 2015, EE Bonds are a much more attractive investment versus Treasurys than the were in 1992.

EE Bonds versus I Bonds. I remain a huge fan of I Bonds was a way of pushing inflation-protected, tax-deferred money into the future. But I think EE Bonds could make a nice addition to the super-safe allocation of your retirement portfolio.

Think of it this way: I Bonds have a fixed rate of 0.1%, meaning they will out-perform inflation by 0.1%. EE Bonds held 20 years have a yield of 3.5%. So inflation will have to average higher than 3.4% over the next 20 years for I Bonds to beat EE Bonds as an investment. Will inflation average higher than 3.4%? Who knows! It could, and that is why I like I Bonds. It might not, and that is why I like EE Bonds.

I say, buy them both.

I Bonds, of course, are a much more flexible investment. They can be sold after one year with only a 3-month interest rate penalty (same with EE Bonds), and then after five years with no penalty. No need to hold an I Bond for 20 years.

And so, I’m making a weird move. Since the I Bonds I bought in 2013 with a fixed rate of 0.0% have been composite yielding 0.0% since July 2015, I decided to sell out of that position in Treasury Direct. The 3-month interest penalty is $0. When that money comes into my savings account (within a week?) I will then purchase the new I Bonds with a fixed rate of 0.1%, up to the limit ($10,000 per person).

And … I’ll be buying EE Bonds up to the limit for the first time since 1992.

The US Treasury just announced that it is raising the the fixed rate on Series I Savings Bonds to 01.%, up from 0.0%. This creates a composite rate of 1.64% for I Bonds purchased from today through April 30, 2016. Here is the announcement:

The composite 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. The 1.64% composite rate for I bonds bought from November 2015 through April 2016 applies for the first six months after the issue date. The composite rate combines a 0.10% fixed rate of return with the 1.54% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 236.119 in March 2015 to 237.945 in September 2015, a six-month change of 0.77%.

Although no one will get rich earning 0.1% above inflation, this is welcome news for I Bond investors. The fixed rate has been 0.0% since November 2014. In the six months ending Oct. 31, the inflation-adjusted rate for I Bonds was -1.60%, resulting in a composite rate of 0.0%.

Also, the Treasury said that EE Savings Bonds issued from today through April 30, 2016,  will earn a permanent fixed rate of 0.1%. This is down from 0.3% offered for the last six months. Most importantly, however, the Treasury retained its policy of double-principal if held for 20 years, creating a 20-year term that pays 3.5%, very generous in today’s market. Here is the announcement:

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 bonds will continue to earn interest at their original fixed rate for an additional 10 years unless new terms and conditions are announced before the final 10-year period begins.

Today’s announcement adds to the appeal of I Bonds and retains the appeal of EE Bonds. Pretty good news for investors.

I’m not much an expert on Social Security (I am not collecting it at the moment), but I was planning to use the widely-encouraged ‘file and suspend’ strategy when my wife reached age 66 in a few years.

Under that strategy, at full retirement age, the higher earner in a couple would file for Social Security benefits, then immediately suspend benefits. The other spouse could then claim the ‘spousal benefit’ – half of the filing spouse’s benefit. That would continue until both spouses reach age 70 and both collect the highest-possible benefit.

While I considered ‘file-and-suspend’ to be a questionable loophole, it was legal and a lot of savvy people were planning to use it to maximize Social Security benefits. There was even a recent book that used file-and-suspend as a core strategy: ‘Get What’s Yours: The Secrets to Maxing Out Your Social Security.‘

But in the new two-year budget deal just hammered out by Congress, this strategy will be gutted. This is from the story in the Wall Street Journal:

Congress is putting an end to two Social Security filing strategies that many couples have used to add tens of thousands of dollars to their retirement incomes. ….

The strategies under fire—known as file-and-suspend and a restricted application for spousal benefits—have made it possible for both members of a couple who are 66 or older to delay claiming benefits based on their own earnings records while one pockets a so-called spousal benefit based on the other’s earnings.

While the new law shuts down the two strategies, some people can still take advantage of them—provided they act fast. For those for whom the strategies will be off limits, meanwhile, claiming decisions may become less complicated but also less lucrative.

I’d advise reading more on this topic, because if you and your spouse are currently 66 (full retirement age) you may have a six-month window to use the strategy. Otherwise, it looks like the loophole is closing.

I am sure we will be hearing more about this in coming days.

As I noted in my previous post, I’m going to be buying my 2015 allocation of I Bonds next week, even if the fixed rate rate remains at 0.0%. But if I were considering buying EE Bonds, I would do that this week, before any possible change in Treasury policy on Nov. 2.

EE Bonds are an overlooked but very interesting investment, but only if held for 20 years. They currently pay a fixed rate of 0.3%, and that won’t change for 20 years. And then at 20 years, the Treasury guarantees your principal balance will double:

EE Bonds issued on and after May 1, 2005, will reach original maturity at 20 years. These bonds also are guaranteed to double in value from their issue price no later than 20 years after their issue dates. This is the bonds’ original maturity. If a bond does not double in value as the result of applying the fixed rate for 20 years, the Treasury will make a one-time adjustment at original maturity to make up the difference.

Doubling after 20 years means that EE Bonds effectively pay 3.5% interest. That is very generous in today’s market, because a 20-year Treasury is currently paying 2.50%, 100 basis points lower. That is a huge margin on a 20-year investment. (In fact, even 30-year Treasurys are yielding only 2.87%, 63 basis points lower.)

I like the idea of using EE Bonds in combination with I Bonds. If you are in the 55 to 65 age range, earning 3.5% on a 20-year investment is very attractive. With EE Bonds, you get a guaranteed return. With I Bonds, you are protected against unexpected inflation. With both, income is tax deferred until the bond is sold.

So why buy RIGHT NOW?

I don’t think the Treasury will change its policy on EE Bonds doubling in value after 20 years, but the edge they have over 20-year and 30-year nominal Treasurys must be giving Treasury folks the fits. That is out of whack.

So there is at least a small chance the Treasury could change the terms on EE Bonds, possibly stretching out the doubling period to 25 years (resulting in a return of about 2.8%) or even 30 years (about 2.3%).

Will the Treasury do that? I don’t think so. But just to be safe, buy your EE Bonds this week and don’t let the Treasury mess up a nice thing.

I Bond investors are going to be getting back in the game on Nov. 2, after suffering through six months of 0.0% returns, which effectively cut off all I Bond sales from May to October 2015. Only a sucker would sign up for 0.0%.

Series I Savings Bonds pay a composite interest rate comprised of two interest rates – the permanent fixed rate (currently 0.0%) and the variable inflation rate (currently -1.60% annualized). On Nov. 2, the variable rate will rise to 1.54% because of a 0.77% rise in inflation from March to September. We won’t know the new fixed rate until the Treasury announcement – probably coming at 10 a.m. on Nov. 2. Tip: This page will update on the Treasury site, you can watch it on Monday.

I will be buying I Bonds next week even if the fixed rate remains at 0.0%. A 1.54% return is decent for a super-safe investment that will track inflation into the future. I Bonds can be sold after a year with a small (three-month) interest penalty, or after five years with no penalty. Income taxes are deferred. I Bonds are deflation proof, too.

Because the Treasury limits us to buying $10,000 per year per person, I think it’s smart to continue building a cache of I Bonds, pushing inflation-protected money into the future. If the fixed rate rises in the future, sell some of your I Bonds with 0.0% fixed rates to buy new ones, up to the limit.

But is there a chance the fixed rate will rise?

Yes, there is a chance. I think it is fairly slim, maybe a 30% chance the fixed rate will rise to 0.1% or even 0.2%. Remember, the Treasury sold practically zero I Bonds from May to October. If it wants to give buyers an incentive, it should raise the fixed rate as a token gesture. That is what it should do, but the Treasury doesn’t come to me for advice.

Back in November 2013, the Treasury shocked everyone by raising the fixed rate to 0.2%. That move came out of the blue. At the time, a 10-year TIPS was yielding 0.5%, meaning it had only a 30 basis point spread over an I Bond. That is the lowest spread in history for any I Bond with a fixed rate higher than 0.0%.

Then, six months later, in May 2014, the Treasury lowered the I Bond fixed rate to 0.1%, resulting in a 33 basis point spread with a 10-year TIPS. Since then, the fixed rate has been 0.0%.

Here is a chart showing the historical spread of the I Bond fixed rate and 10-year TIPS yield. At the top is our current situation, and the resulting spreads for fixed rates of 0.0% to 0.3%.

The good news is that even at a fixed rate of 0.3%, the spread drops to only 33 basis points, which is in line with that November 2014 move by the Treasury. The bad news is that over the last 10 years, the Treasury has let the spread rise as high as 239 basis points. It also kept a fixed rate of 0.0% in May 2011, resulting in a spread of 75 basis points.

As a general rule, I think the Treasury would like to keep the I Bond spread 75 to 100 basis points below a 10-year TIPS. I Bonds have a lot of advantages over TIPS. Tax deferral is a big one, and they have a flexible term of 1 to 30 years.

But things have changed dramatically since the mid-2000s, and inflation fears have turned to deflation fears. The Treasury may want to give I Bonds a boost. I hope so.

Conclusion. Whether or not the fixed rate rises, I will be buying I Bonds next week, up the limit. If the fixed rate rises, I will also buy my 2016 allocation in January. If it stays at 0.0%, I will hold off purchasing them until later in 2016.