Treasury Inflation-Protected Securities

Note: Since I posted this article on Oct. 8, real yields have declined about 20 basis points. That could shift the fixed-rate reset lower than I predicted, if this trend continues.

By David Enna, Tipswatch.com

It’s clear to me that Treasury will increase the fixed rate on the U.S. Series I Bond at the November 1 reset. This is an easy call. But how high can it go?

I do these projections every April and October, but there is one piece of information you need to know: The U.S. Treasury has no announced formula for setting the I Bond’s fixed rate. TreasuryDirect provides this cryptic information:

The Secretary of the Treasury, or the Secretary’s designee, determines the fixed rate. The rate is based on market rates that have been adjusted to account for the value of components unique to savings bonds. These include the early redemption put option, tax deferral feature, deferred purchase feature, and Treasury’s administrative costs.

Translation: The Treasury looks at current real yields (such as market yields on Treasury Inflation-Protected Securities) and adjusts those yields to reflect the advantages of I Bonds: primarily tax-deferred interest and a flexible maturity.

In my projections I use the real yield of 10-year TIPS as a comparison. Not perfect, I admit. But in the 12 years I have been doing these projections, I have never seen a more compelling case for raising the I Bond’s fixed rate, which is currently 0.9%, a whopping 157 basis points lower than the 10-year TIPS real yield, now 2.47%. That spread is more typically around 50 to 60 basis points.

In refining these projections — based on good feedback from readers — I have more recently been looking at the average 10-year real yield over the November-to-April and May-to-October periods leading up to the fixed-rate reset. I think this gives a better prediction, because it smooths out any sudden rises or falls in real yields.

So here are my current projections, based on real yield data through October 6. Keep in mind that the half-year average is highly likely to rise in the next three weeks. But here is what we are looking at right now:

Half-year average: On the left is the projection using the half-year average 10-year real yield, which through Oct. 6 is currently 1.69%. I added a line showing an adjustment for the rest of October, with real yields remaining at 2.4%. That increases the average real yield to 1.78%.

In the last five rate resets, the average ratio of fixed-rate to real yield has been 0.63. If you apply that to the 1.78% half-year average, you end up with a projection of 1.12% for the November 1 rate reset.

Latest 10-year real yield spread: Here is where things get interesting. The current real yield for a 10-year TIPS is 2.47%, much higher than the half-year average of 1.78%. This is because yields have surged nearly 50 basis points higher in the last month.

In recent years, the typical spread between the fixed rate and the 10-year real yield has been in the range of 50 to 60 basis points. I used 55 basis points in this example. The result is a projection of 1.92% for the November 1 rate reset.

Adding this up

If you look at the May 1 reset, it appears the Treasury leaned toward a higher-than-expected fixed rate of 0.9% because the half-year average of 1.36% was higher than the then-current 10-year real yield of 1.26%.

But this month, the reverse is true, dramatically. The adjusted six-month average of 1.78% is going to fall well below the current real yield of 2.47%. Will the Treasury take that into consideration? I think so, because real yields are likely to remain elevated for some time. Without a competitive fixed rate, the I Bond will fall completely out of favor.

Looking way back

You have to go back to November 2007 to find an I Bond fixed rate reset that was 1.00% or higher. Usually, I exclude these earlier I Bonds years from my projections because the bond market changed dramatically after the financial crisis of 2008.

But let’s take a look at the yield spreads in those early years, going back to 2003, the last year with full data available:

The I Bond’s fixed rate was 1.00% or higher for each reset from May 2003 to November 2007, averaging 1.17%. In those years, the 10-year real yield averaged 2.05% (lower than today’s 2.47%) and the average fixed-rate versus 10-year yield spread was 88 basis points.

So, if you subtract 88 basis points from current 10-year real yield of 2.47%, you get 1.59%. This reinforces the case for a sizable increase in the fixed rate on November 1.

A projection + a caution

It’s early. October could be a volatile month. But my current thinking is that the I Bond’s new fixed rate should fall in the range of 1.40% to 1.70%, if the 10-year real yield continues at the current level of about 2.4%.

I am thinking that 1.40% is possible, but anything lower would be a huge disappointment for I Bond investors, putting the fixed rate (which is equivalent to a TIPS real yield) more than 100 basis points lower than the yield on 5- and 10-year TIPS, which are equivalent investments.

In my opinion, a 100-basis point spread is too high. The number should be closer to 60 to 70 basis points. Otherwise, forget I Bonds and buy TIPS. A spread of 70 basis points gets you to 1.77%. Acceptable.

But a caution: In November 2022, the Treasury set the fixed rate at 0.40% at a time when the 10-year real yield had climbed to 1.58%, a gap of 118 basis points. That occurred after a recent rise in real yields, just like we saw in September 2023. So it’s possible we could see a disappointing reset, something like 1.2%. I hope not.

And remember one of my North Star beliefs, repeated often: The Treasury sometimes does strange things.

Coming up

The I Bond’s new variable rate will be revealed on Thursday with the release of the October inflation report. A few days later, I hope to post some ideas on I Bond buying strategies for the rest of 2023 and into 2024.

• I Bonds: A not-so-simple buying guide for 2023

• 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

• I Bond Manifesto: How this investment can work as an emergency fund

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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.