Treasury Inflation-Protected Securities

As a short-term investment? Yes. But for the long term? I Bonds are still attractive.

By David Enna, Tipswatch.com

Just one year ago, U.S. Series I Savings Bonds were still paying 9.62% annualized for a full six months, followed by an almost-as-attractive 6.48%. Demand was so strong from small-scale investors that the TreasuryDirect website crashed under the flood of orders and new-account creations.

A lot has changed. Back in October 2022, annual inflation was running at 7.7% and a 1-year Treasury bill was yielding about 4.5%. At that time, the I Bond’s yield of 9.62% was irresistibly attractive. Today, annual inflation has slipped to 3.7% and the current I Bond has a composite interest rate of 4.30%, much lower than the yield on a 1-year T-bill at 5.41%.

As a short-term investment — meaning a holding period of about 1 year — the I Bond is no longer the shining star. However, as a longer-term investment, I Bonds are actually more attractive than a year ago, because the permanent fixed rate has increased from 0.0% in 2022 to 0.9% currently and probably higher than 1% at the Treasury’s next rate reset on November 1.

The short-term

The Treasury limits conventional purchases of I Bonds to $10,000 per person per calendar year, plus allows an option for $5,000 in paper I Bonds in lieu of a federal tax refund. I am assuming most I Bond investors have already bought their full 2023 allocation — either before May 1 at the 0.4% fixed rate, or after May 1 at 0.9% — but I have been hearing from people still waiting to make a decision: In October or after?

As I noted in an Oct. 8 article, I believe the I Bond’s fixed rate will be rising at the November 1 reset, probably to something around 1.2%, but even higher is possible. If that’s true, then both the permanent fixed rate and the six-month variable rate will be rising at the reset. So waiting until November or December to purchase makes the most sense, in my opinion.

Investors who have purchased their full allocation in 2023 also have the option to use the “gift-box” strategy, if they have a trusted partner to make the swaps. I have noted that the gift-box strategy is most effective when the fixed rate is high, since that rate is permanent.

If the fixed rate rises to 1.2% at the November 1 reset, here is how the new six-month composite rate will be calculated:

• Fixed rate: 1.2%
• Semiannual inflation rate: 1.97%
• Composite rate formula: [0.012 + (2 x 0.0197) + (0.012 x 0.0197)]
• Composite rate: 0.012 + 0.0394 + 0.0002364
• Adding the parts: 0.051636
• Rounding gives: 0.0516
• Composite rate = 5.16%

So we could be looking at an annualized composite rate of 5.16% for six months for I Bonds purchased from November 2023 to April 2024. The rate would be higher if the fixed rate is set higher, of course. At a fixed rate of 1.4%, the composite rate would be 5.37%.

While 5.16% or 5.37% are attractive, these annualized yields will only last for six months, and the next variable rate is uncertain. The I Bond’s yield might be able to get close to the 5.41% yield of a 1-year T-bill, but there is a problem: Redeeming an I Bond after 1 year would incur a penalty of three months of interest. That’s not a problem with the T-bill.

Conclusion: As a short-term investment, a 1-year Treasury bill is the superior investment.

The long-term

On my “Q&A on I Bonds” page I have a list of all I Bond fixed rates going back to September 1998. The current fixed rate of 0.90% is the highest for any I Bond going back to November 2007. Before that, fixed rates of 1.0% or higher were the norm, occurring at each reset from September 1998 to November 2007. Here is that information:

So, if my analysis is correct, and the I Bond’s fixed rate rises to 1.2% or above at the November 1 reset, we will be entering a new era for I Bonds. The higher the fixed rate the better, because the fixed rate remains with an I Bond for 30 years or until it is redeemed. The variable rate is important for a short-term investor, but less important in the long term.

Any long-term investor in I Bonds has accumulated a collection of issues with 0.0% fixed rates. Those 0.0% I Bonds will be paying 3.94% after the November reset, rising from the current 3.38%. (The starting month depends on the month you originally purchased the I Bond.) That is well below current nominal yields on short-term Treasurys, bank CDs, even good money market funds.

A fixed rate of 1.2% or 1.4% is much more desirable than a fixed rate of 0.0%.

So, if you are committed to investing in I Bonds as a tax-deferred, inflation-protected savings strategy, the next I Bond is going to be desirable — either as an addition to your current holdings, or as a replacement for a set of 0.0% fixed rate I Bonds. Redeem the 0.0% bonds, buy the new I Bonds with a higher rate.

Should you immediately trash all your 0.0% I Bonds? I don’t think so. But I can see rolling over some issues — year by year — to either fund needed spending or to buy more attractive investments, such as an I Bond with a fixed rate of 1.2% or above.

Conclusion: An I Bond with a historically high fixed rate remains an attractive investment. Why? It creates a super-safe, tax-deferred, compounded-interest savings account with a flexible maturity date. I Bonds have rock-solid deflation protection and can’t ever lose a cent of accumulated value. I Bonds expand your tax-deferred investments and as a bonus the interest you earn is exempt from state income taxes.

But what about TIPS?

Any numbers-savvy financial nerd knows that Treasury Inflation-Protected Securities — right now — offer returns superior to I Bonds. There is a new 5-year TIPS being auctioned Thursday that should get a real yield to maturity of around 2.40%, possibly 100+ basis points over the I Bond’s new fixed rate.

So … 100 basis points? That is a big deal. TIPS are a strongly attractive investment right now. If you told me I could only have one inflation-protected investment, I would go with the TIPS in these market conditions. But you can have both, and I like having both.

My plan, again, for I Bonds is create a tax-deferred, inflation-protected savings account that can never lose a penny of accumulated value. That is a plus over a TIPS, which will rise and fall in market value every day and can lose value in a deflationary period. Although I am holding all my TIPS to maturity, I have to time their maturities to meet my needs. With I Bonds, after 5 years I have access to part or all of the accumulated holdings, with never a risk of losing value.

Conclusion: At times in the recent past, I Bonds with a 0.0% fixed rate were much more attractive than a TIPS with a real yield deeply negative to inflation. Back then, I bought I Bonds but shunned TIPS. Now the reverse is true. I am still buying I Bonds because of the simplicity and flexibility.

In fact: If the Treasury raises the I Bond’s fixed rate to 1.4% or higher, I would likely add to my holdings in 2023 with a “gift-box” swap with my wife, and then most likely buy again before the end of April 2024.

• I Bond’s fixed rate should rise at the Nov. 1 reset

• Confused by I Bonds? Read my Q&A on I Bonds

• Let’s ‘try’ to clarify how an I Bond’s interest is calculated

• Inflation and I Bonds: Track the variable rate changes

• I Bonds: Here’s a simple way to track current value

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.