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7% Risk free? New Series I Savings Bonds come with a catch

By November 15, 2021 No Comments

The United States Department of Treasury (i.e. “The Treasury”) recently announced new rates on Series I Savings Bonds issued through their Treasurydirect.gov website. Usually, these announcements don’t warrant much attention, as the rates have been very putrid for the better part of 15 years. However, with inflation surging, their new Series I Savings Bond is currently yielding 7.12%. That’s an extremely attractive interest rate on an essentially “risk-free” security, so it’s worth analyzing in more detail.

What are Series I Savings Bonds?

Series I Savings bonds are government savings bonds that earn interest based on combining a fixed rate and an inflation rate to get the composite rate. The fixed rate does not change for the life of the bond but the inflation rate is reset every six months. There are only two ways to buy these bonds, through the TreasuryDirect.gov website or through your tax return by including an IRS Form 8888 when you file.

Individuals can purchase up to $10,000 worth of these bonds through Treasury Direct and up to $5,000 per year through their tax return ($15,000 total). These bonds have a 30 year maturity and the interest rate earned resets every 6 months. They will never yield less than 0% but they can (and have in the past) yield 0% depending on the rate of inflation.

Because the fixed rate on these bonds is currently 0%, the interest rate the bond pays is exclusively dependent on inflation, as measured by the Consumer Price Index for all Urban Consumers (CPI-U).

The composite equation

To figure the bond’s yield the Treasury uses the following equation:

Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]

For example, the CPI-U increased from 264.877 in March 2021 to 274.310 in September 2021, a six-month change of 3.56%. Therefore, we plug the fixed rate (0.00%) and the semiannual inflation rate (3.56%) into the equation:

[0.0000 + (2 x 0.0356) + (0.0000 x 0.0356)] = [0.0000 + 0.0712 + 0.0000000] = 0.712 = 7.12%.

The current interest rate is 7.12%. But, remember that this rate can and likely will change in six months when the semiannual inflation rate is recalculated. The next change will occur in May 2022 and will be based on the semiannual inflation rate from September 2021-March 2022.

Anyone buying these types of bonds will want to pay attention to future releases of the CPI-U, which is next scheduled for release on December 10th @ 8:30 am EST.

So is this a good investment?

So should you be running out to buy this Savings I Savings bond currently yielding more than 7%? The answer, as usual, is it depends. That 7% figure is highly likely to change in six months time. And if inflation has moderated by then, the interest rate on the bond is certainly going to be lower. In order to maintain the same 7.12% interest rate during the next reset in May 2022, CPI-U would have to come in at 284 in March 2022. That isn’t impossible by any means, but it would mean that currently soaring inflation has gotten even worse.

Here is what the Series I Savings bond interest rate will look like in May based on a range of different CPI-U outcomes (mouse over chart for figures):

The bond will never yield less than 0% (the Treasury keeps a floor at 0%), but if the change in CPI-U is negative during the Sep 2021-Mar 2022 period, the interest rate will fall to 0%. In fact, even if inflation has risen another 1% during the period, the interest rate on the Series I Savings bond will fall to 2%. On the plus side, if inflation does indeed keep spiraling out of control, this I bond offers an effective hedge. Say CPI-U soared to 300 in March 2022, the interest rate on the I Bond would climb all the way up to 18.73%!

Keys to consider

There are few key considerations before buying these bonds. First, keep in mind that the interest rate is reset semiannually based on the change in CPI-U. Therefore, the current yield of 7.12% is only 1/2 of the annualized yield. The true annualized yield depends on where the next yield is set in May 2022. If that rate is set at 4%, and the bond is held for 12 months, the annualized yield would be around 5.50% [(7.12% x 1/2) + (4% x 1/2)].

Remember, if CPI-U comes in at 274 (the September reading) or lower in March 2022, the Series I Savings bond interest rate is going to be 0% (refer to the equation and chart referenced in earlier paragraphs). In that case the annualized rate would be 3.56% [(7.12 x 1/2) + (0% x 1/2)]. The change in inflation is the driving force of the bond’s yield.

Furthermore, the Series I Savings bonds can only be redeemed starting 12 months after you bought them. And if you cash the bond within five years of buying it, you lose the last three months of interest. Because these are essentially risk-free vehicles you can still view them as an effective way to generate some extra savings on some spare cash.

Even if we assumed the rate falls back to 0% in May 2022, and you redeemed on the 12th month, you would still have earned an annualized rate of 3.56%. That’s because you capture half of the 7.12% rate in the first six months. Then, you earn 0% for the next six months. Because you redeemed within five years, you lose the last 3 months of interest, but that is 3 months of 0%. When compared to the leading 12-month CD rates, which are currently between 0.40-0.65%, this Series I Savings bond is an excellent alternative. In addition, interest on these bonds is exempt from state taxes, unlike CDs which are taxed at the state level.

Should you buy these?

The Series I Savings bonds, currently yielding 7.12%, are a great investment if you are looking to earn interest well above what’s currently offered by the banks. The $10,000 purchase limit may dampen the appeal a little bit, but that’s still $10,000 you can effectively lock in a 3.56% return on, on a security backed by the US Treasury. A married couple can get $20,000 worth of these bonds now, and then purchase another $20,000 in January next year, when the annualized rate will still be 7.12% for at least a few months.

Basically, our view is that these bonds make for great CD alternatives for investors with a short-term time frame. If you are viewing these as a long-term investment vehicle, they may not be as attractive. That’s because of the risk that we are in a very high inflationary environment right now, and if that recedes in 2022-2023, these bonds could realistically yield 0%-1% for an entire year (or longer). That may not be a problem for some, but the risk of opportunity cost shouldn’t be ignored.

How to buy Series I Savings bonds

If you do want to pull the trigger and invest, you’ll have to go through the TreasuryDirect.gov directly. These are not something you can buy through your brokerage account. To get started, create an account on the TreasuryDirect website. You will need your personal information as well as your bank account information. After you fill everything out, you will receive an account number to your email. You’ll use that to login. After you login for the first time, you’ll see a tab to “BuyDirect” where you can purchase the Series I Savings, as shown in the screenshot below:

To recap, Series I Savings bonds are a type of savings bond backed by the US Treasury. They are extremely safe and are currently yielding 7.12%. This is a rate that we think investors should consider taking advantage of. While the rate will change in the future, the 12 month return profile is far more attractive than a CD. Depending on the change in inflation, these bonds may yield more or less in the future.

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