Series I savings bonds, or ibonds as they’re commonly referred to, are having a moment. The US treasury recently announced record sales for ibonds. The yield on ibonds is linked to the growth rate of inflation. Because inflation exploded higher starting in the summer of 2021, ibond yields have jumped accordingly. That’s why, one year ago, we recommended taking advantage of the increased yield and buying ibonds. We reiterated that call in May of this year after ibond yields jumped to more than 9%. However, now that ibond yields are falling they’re no longer the no-brainer investment they were earlier in the year.
How ibonds yield is determined
First, it’s important to remember that ibonds offer a variable interest rate that resets every six month based on the following equation:
ibond yield = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]
The Treasury recently set the fixed rate at 0.40%, up from 0.00%. The semiannual inflation rate is measured by the Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 287.504 in March 2022 to 296.808 in September 2022, a six-month change of 3.24%. Therefore, we plug the fixed rate (0.40%) and the semiannual inflation rate (3.24%) into the equation and get a current yield of 6.89%:
So, investors who buy ibonds today are guaranteed to earn 6.89% for six months. That sounds pretty good… until we start to consider what the yield might be six months from now and annualize that out. And then compare that annualized ibond yield to current yields available from other risk-free treasuries. For example, if the yield on ibonds falls to 2% six months from now, then an annualized ibond yield looks like this:
(6.89% X 0.50%)+ (2% X 0.50%) = (3.45%) + (1%) = 4.45% annualized yield where the investor earned 6.89% for six months and then 2% for six months.
That hypothetical 4.45% yield for ibonds over the next 12 months is less than the current yield of 1, 2, and 3 year treasury bonds. So the key factor is in trying to determine what the ibond yield will be after the next reset on May 1st, 2023.
Projecting out to May 2023
The next ibond reset takes place on May 1st, 2023 and will be based on the CPI-U growth rate from September 2022-March 2023. September’s CPI-U came in at 296.808. Any March 2023 CPI-U reading below 296.808 will result in a negative growth rate for CPI-U. Thus, the semiannual inflation rate in the ibond yield equation would be 0% (the Treasury limits figures at 0% and will not use negative numbers). In that scenario, we would plug in the fixed rate (0.40%) and the semiannual rate (0%) into the ibond yield equation:
[0.0040 + (2 x 0.00) + (0.0040 x 0.00)] = 0.40%.
The ibond yield would fall to 0.40%! If we plug that into an annualized return… where we earn the current yield of 6.89% for six months and then 0.40% for six months after that, our annualized return is just 3.645%. Such a rate is substantially lower than yields currently available on every part of the treasury curve.
In order for the ibond yield to maintain its current 6.89% yield in May 2023 after the next reset, CPI-U needs to come in between 306-307 in March 2023. That would translate to 3.10%-3.40% growth in CPI-U versus the September 2022 CPI-U figure. If CPI-U comes in above 306 in March 2023, that would qualify for the highest CPI-U currently ever recorded. We believe the odds of that happening are low.
The chart below shows what the ibond yield will look like based on varying CPI-U readings in March 2023 (click here for an interactive chart):
Growth of inflation, not inflation itself
The key consideration with ibonds is that the future yield is based on the growth rate of inflation at a specific date. In this case, the March 2023 CPI-U figure versus the September 2022 CPI-U figure. Therefore, all of the CPI-U readings from October 2022-February 2023 are essentially irrelevant. Even if inflation figures continue to come in hot in the near term, but have subsided by March 2023, the ibond yield could fall towards 0%.
The Federal Reserve is projecting inflation to fall sharply in 2023. Other indicators we follow are also suggesting that inflation will moderate quickly in the coming months. Keep in mind, for ibonds, we could be stuck with all of the inflation we’ve already experienced and the yield could still fall towards 0%. Because, and we can’t emphasize it enough, the ibond yield is tied to the growth rate of inflation, not inflation itself.
Our best guess is that inflation will stay stubbornly high, but that the growth rate of inflation will be slowing dramatically as we come up on high comparable figures. This makes ibonds a less than ideal investment right now.
Buy treasury bonds instead
People flocked to ibonds because of their safety and high interest rate. But that interest rate is likely heading lower. As an alternative, we recommend investors focus on Treasury bonds with maturities of 1-5 years. Such bonds are currently offering interest rates between 4.0%-5.0% and, unlike ibonds, your interest rate won’t change after you buy it. In addition, these types of bonds do not come with the $10,000 purchase limit that ibonds do. So you can invest much more of your money.
Lastly, the real yield on these types of bonds, that is, yield minus the inflation rate, has a chance of being positive. If inflation falls towards 3% next year as the market currently expects, treasuries will provide a real rate of return of 1-2% depending on the maturity. Ibonds will only guard against a negative real rate of return, but, by design, they cannot provide a meaningful positive real rate of return. If you want a more effective hedge against inflation than ibonds, consider TIPS, which are currently yielding 1-2% and offer payments that adjust with inflation.
Add it all up and our advice is simple: if you did not buy ibonds prior to the latest reset you are likely better off parking that money in treasuries or TIPS instead. Current clients can take advantage of our no-fee treasury only accounts if they would like assistance with these purchases.
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