Eyes Off I Bonds?

Bottom Line Up Front

• Bond ETFs are an appealing choice for retail investors looking to invest in fixed-income markets.
• They offer potential inflation protection and higher yields compared to savings accounts.
• Bond ETFs provide easy access to fractional trading with high liquidity.
• Strategic reinvestment of dividends can result in significant long-term gains.

I Bonds, a savings bond issued by the US Treasury Department, enjoyed a recent resurgence as they guaranteed a hefty locked-in yield for buyers. Despite the annual $10,000 limit, many found creative workarounds to snatch up as many as possible while the yield lasted.

But the wheels are about to fall off I Bonds, leaving many fixed-income enthusiasts and diversified investors planning their portfolio’s next move.

Ins-and-Outs of I Bonds

Most are aware of I Bonds, if only peripherally, as news media and investment gurus hyped the asset to no end the past year or two. I Bonds have some unique features compared to typical debt securities, though, so a quick overview is in order.

I Bond Interest

I Bonds accrue interest monthly and compound twice a year. As a savings bond, I Bonds differ from typical Treasuries as your interest is paid as interest rather than as an income-producing coupon.

I Bond interest rates reset every six months (May and November) based on a fixed rate and a rate tied to inflation. Added together, they determine the total composite rate. Your I Bond’s fixed rate remains for the entirety of its life, and you lock the current composite rate in for six months from your purchase date. The Bond maintains a six-month recurring realignment schedule from that point forward. That’s doubtlessly confusing, so here’s a breakdown from Treasury Direct:

I Bond Maturities and Maxes

I Bond maturities are pinned at 30 years but are redeemable before; however, cashing out before maturity comes with penalties and there isn’t a secondary market for I Bonds (unlike Treasuries).

An early redemption is an option as early as 12 months from purchase, but if you cash in before it’s five years old, you forego the previous three months’ interest.

You’re (as an individual) capped at $10,000 annually in I Bond buys, although you can redeem up to $5,000 of your annual tax return refund as I Bonds.

Past Performance

I Bonds became a go-to investment in 2021 as I Bonds issued between November 1st and April 30th, 2022, returned more than 7%. But the asset hit a high water mark the following six months (May to October 2022) as new issues generated a whopping 9.62%.

That’s an excellent yield no matter the market, but especially attractive for investors as the S&P 500 limped along, losing 6% over the same period:

Source: Morningstar

What will I Bonds Return in May?

I Bonds fell a bit after bumping up against double-digit returns; today’s rate sits at a respectable 6.89%.

However, May 2023 represents a new reset as the US Treasury realigns fixed-rate and inflation-based rates to find a new composite.

Upcoming I Bond returns aren’t a complete guessing game: Treasury Direct discloses the rate formula, although confusing. The fixed rate, as we said, is active for the life of the bond and is determined by the US Secretary of the Treasury. The fixed rate is the wildcard; defined by a bureaucrat using esoteric means, we cannot definitively know what it’ll look like next month.

The inflation rate, though, is more manageable. Based on the Consumer Price Index, a glance at this chart shows a stark difference between May 2022’s inflation rate, which set a high standard for the I Bond, and today:

Source: FRED

Although not a part of the actual calculation, this graph best demonstrates the stark difference in inflation over the past year. At a “paltry” 5% today compared to nearly double that last year, I Bond yield calculations will reflect the reduced inflation, even if we don’t feel its effects in our wallets.

The fixed rate isn’t likely to rise and meet the occasion, either.

Let let’s look at what to expect based on a presumed 0.50% fixed rate.

I Bond composite rate formula

The formula isn’t too tough; it’s just a matter of defining variables that’s tricky:

We’ve first got to ballpark the semiannual inflation rate using CPI data as a function of the percentage change from six months ago:

Source: FRED

At around 301 today compared to September 2022’s 296, we’re looking at about a 1.7% increase.

Plugging that into our formula, we see:

0.50%+(2 × 1.7%)+(0.50%× 1.7%=3.9%)

New I Bonds issued after April 30th, 2023, will likely fall below 4%.

The fixed rate could, in theory, climb to compensate, but that isn’t a likely scenario. Instead, we’ve got to consider alternatives.

I Bond Options

If you aren’t gambling on the chances that a bump in the fixed rate keeps the composite high, and haven’t hit your annual $10,000 cap yet, now is likely the best time to buy before rates reset in May.

If you have, though, a few options exist and primarily revolve around when you bought into the Bonds.

The first option is to hold until maturity – where rates fall between now and then is anyone’s guess. Still, you’re faced with the magic of compounding interest over a long period and are effectively guaranteed a decent chunk of change in exchange for patience.

The other option is to pull out, when able, and plug the capital back into other (better?) fixed-income products with superior yield. You could, of course, buy back into equities as a dollar-cost averaging strategy, but we’ll assume you’d prefer to stick with something safe.

We’ll look at two of my I Bonds as an example – the rightmost is the rate you’d get today, with a 0.40% fixed rate for the bond’s life. I bought the other when variable rates peaked, trading a temporary 9%+ return for a permanent 0% fixed rate. Here’s what we’re looking at after a year for my first I Bond:

12 months of I Bond returns

I’ve got an 8.2% annualized return – not bad, and we can keep the party going by simply leaving it in Treasury Direct’s hands, although returns will likely continue diminishing. If we pull out, though, we forego the last three months’ interest and see a net ~$650 gain, a 6.51% annualized return.

Sticking the new, compounded principal into even the lowest-yield assets like a 5% CD or high-yield savings account (although only the CD locks a rate) for a year sees $11,183 compounded, which pushes our net yield to 11.83%, or 5.92% annualized. 

Reinvesting in a secure, relatively low-yield security after sacrificing three months’ interest

Short-term Treasuries like the three-month T-Bill yield comparable returns, so short-term bond laddering may be a viable strategy as rates continue rising. 

If we take on a bit more risk, investing in a junk bond ETF like SHYG can juice a bit more yield and take advantage of bond ETF benefits as rates remain high and bond prices stay suppressed.

If you bought the bond at 6.89%, here’s the same scenario repeated: 

12 months of I Bond returns

Your I Bond’s worth is $10,442 after one year and a realignment to lower interest rates (remember, our fixed rate is 0.40%, so a bit lower than we projected for new issues). Cutting out the last three months’ interest when we withdraw nets us $10,442 withdrawn, a 4.43% return.

Likewise, buying into a safe fixed-income CD or similar gives us a 9.65% total return, annualized to 4.82%:

Reinvesting in a secure, relatively low-yield security after sacrificing three months’ interest

Conclusion

Nothing groundbreaking here, and you may even be wondering why I bothered. 

“Of course, pulling out and reinvesting in a higher-yield CD is better than letting it ride at 4% or lower,” you might think. And you’re right, of course.

But running the stats and seeing what your money might be worth in both circumstances is useful. There’s no shortage of online experts advocating for letting the bond mature fully, but that course of action might not be best for you.

You may prefer a more liquid asset or add the total to your brokerage and increase your margin limits.

You may need the cash or want to squeeze as much yield from your fixed-income investments – any alpha is good alpha, right?

Only you can determine what’s best for your I Bond, but it’s important to understand the implications and options available as we continue navigating high rates and higher inflation alongside a shaky stock market and uncertain labor economy. 

What’s nearly guaranteed, though, is that I Bond interest rates are set to plummet in a few weeks – so if you haven’t, get in while the getting remains good.