Keeping up with Inflation
After languishing as a somewhat obscure instrument since its introduction in 1998, U.S. Series I savings bonds (“I Bonds”) started drawing meaningful attention last year thanks in large part to inflationary pressures and media coverage highlighting its substantial yield for a nearly risk-free investment. The first article I recall seeing was from the Wall Street Journal’s Jason Zweig in May 2021 pointing out features like the 3.54% annualized yield at that time, inflation protection, tax advantages, and the backing of the US. Government. Since then, given inflation readings that have only recently come slightly off 40-year highs, I Bonds purchased through October now promise a 9.62% annualized yield over the next six months. The attractiveness of a government guaranteed instrument generating such a high current yield has driven significant inflows to I Bonds over the past year, and the subject continues to pop up in conversations I have with friends and family. I felt an overview of I Bonds might be helpful for those who were either curious or perhaps remained unaware of their existence.
I Bonds look to be a reasonably attractive investment given the risk/reward tradeoff, but it is worth understanding both the basics behind the bonds and the details of how the variable yield is calculated. The bonds are available to U.S. Citizens, residents, and government employees and are subject to annual purchase limits. You can purchase up to $10,000 per person each calendar year electronically. Another $5,000 in paper I bonds can also be purchased each year using federal income tax refunds. There are ways to stretch the limits, for example, bonds can be purchased for spouses and children, and Treasury also allows the purchase for trusts and estates, which are essentially treated as separate individuals.
I Bonds mature in 30 years but can be redeemed following a one year holding period after incurring a penalty equal to the last three months of interest. Bonds held at least five years do not incur any penalty for early redemption. From a tax perspective, interest paid on the bonds is exempt from state and local income tax. For federal income tax purposes, you can defer declaring interest until maturity or the bond is redeemed. Even the federal liability can potentially be waived if proceeds are used for qualified education expenses and you meet other criteria including income limitations.
Electronic I Bonds are available exclusively from the U.S. Treasury Department’s website, TreasuryDirect.gov. They can’t be purchased by an investment advisor or held by custodians such as Schwab. Unfortunately, the TreasuryDirect.gov site is antiquated, and many users have found it somewhat clunky and challenging to navigate. If you don’t already have an account at TreasuryDirect, you will need to set one up – be sure to have your Social Security or taxpayer identification number ready as well as bank information for the account you plan to use to pay for the bonds. The website says account setup takes 10 minutes, but this appears to be on the optimistic side. For its part, the Treasury Department is in the process of modernizing the website to make it more user-friendly but counting on that update to be rolled out soon is probably similarly optimistic.
Be aware some attempting to purchase electronic I bonds have received requests for additional identity verification. Other attempts have resulted in a requirement to fill out a paper account authorization form, which needs to be signed at a financial institution with a signature-guaranteed seal or stamp, requiring additional time and effort.
It is worth digging into the details of how the variable yield on the bonds is calculated. Though the yield on I Bonds is currently 9.62%, this rate resets semiannually. The interest rate paid on I Bonds is made up of two components: the first is a fixed rate throughout the life of the bond and is set by Treasury twice a year. This fixed component for newly issued I bonds has been 0% since May 2020. For historical perspective, the fixed rate peaked at 3.6% in 2000. Ever since it has been a fairly steady progression lower, and the fixed rate hasn’t exceeded 1.0% since early 2008.
Given the 0% fixed rate, the entirety of the yield for I Bonds purchased today is driven by the second component, a variable semiannual inflation rate based on changes in the Consumer Price Index. More specifically, it is based on the non-seasonally adjusted Consumer Price Index for all Urban Consumers for all items, including food and energy. CPI data is released monthly but the change in inflation that determines the yield for I Bonds is measured on a six-month basis and is announced each May and November. The inflation rate announced in May is based on the change in CPI from the preceding September-March period, and the rate announced in November is based on the change between the CPI from the preceding March-September period.
To calculate the variable rate applicable to I Bonds, the Treasury doubles the percentage change in the six-month rate. As an example, the March 2022 CPI index was 287.504 while the September 2021 index was 274.310. The percentage increase between those two readings was 4.81%. Doubling this six month change leads to the current 9.62% yield.
Though the applicable variable inflation rate is set every May and November, the change is only applied every six months from the issuance date for the bond. Interest compounds semiannually, as every six months interest earned is added to the principal value. Also, the combined rate on I Bonds will never be less than zero, so with a current fixed rate component of zero if there is deflation there would be some protection. Given current circumstances deflation seems unlikely, but 30 years is a long time, and this protection carries at least some value.
An I Bond purchased through October will receive the 9.62% yield for six months before the rate resets. Worst-case for a bondholder, the rate resets to 0% for the subsequent six months. Given the recent July CPI reading that was essentially flat versus June, I suppose such a scenario is possible but also unlikely. The last time I Bonds paid 0% was in 2015. If month-on-month changes remain flat for August and September, the variable rate would still reset to over 6%, so we would have to see prices come down meaningfully in August and September to get to 0%. Even in a scenario where the variable rate resets to 0% that’s still a 4.8% yield over a one-year period, superior to savings accounts or CDs. That nearly 5% rate would remain unchanged even if you chose to redeem the bond after one year, forfeiting the last three months of 0% interest.
Investments should be judged on their risk/ reward characteristics, and it is challenging to find an investment with a similar risk profile currently offering a return comparable to I Bonds. Furthermore, as Zweig points out in his Wall Street Journal piece, investment isn’t just about capital appreciation; it’s also about capital preservation. I Bonds look like a reasonable vehicle to preserve purchasing power in an environment where inflation remains a focal point. The challenge is the $10,000 limit and whether that size investment justifies the work involved.
James M. Skubik, CFA