Buy I Bonds Over TIPS: I Just Did, You Have 14 Days To Buy Your $10K Limit

by: Jim Sloan

Summary

In my view I Bonds - inflation indexed U.S. Savings Bonds - should be considered for the first $10,000 added annually to everybody's fixed income portfolio.

You buy I Bonds yourself by setting up an account at Treasury Direct which can draw funds from your bank account; if I could do it, any of you can.

I Bonds currently provide a better deal than TIPS out to almost 8 years, the point where the real return of TIPS reaches .10%.

Because of the way they are constructed, I Bonds provide not only inflation protection but deflation protection, and an obvious haven against possible negative interest rates.

I Bonds also have potentially favorable tax options and a duration of 1 to 30 years at your choice; they are highly competitive in yield to short term Treasury funds.

For my money I Bonds are the best first fixed income investment there is - and that's true for almost everybody. They are risk free, being the inflation adjusted version of U.S. Savings Bonds, and they are astonishingly flexible. If it's inflation you are mainly worried about their real return beats any maturity of TIPS up to almost 8 years. I just bought my annual limit of I Bonds, $10,000. I'm thinking of doing the same for my wife.

I Bonds are one of those little things investment advisors often forget to mention, perhaps because they can't make money from them. I never forgot to explain them to my clients. When I was an investment advisor all my clients were urged to buy their limit as the first annual money into their fixed income portfolio.

Let me first try to explain how I Bonds work. You buy them yourself on the Treasury Direct site. You set up for Treasury Direct to pull cash from your checking account. There is no charge of any kind at any point. The Treasury site is set up to walk you through the process. I went through this process the year they changed from paper bonds which you could buy at some banks. I did it entirely by myself. Let me reassure you: no matter how inept you feel about doing things on line, you cannot possibly be as much of a dimwit as I am. If I managed to do it successfully, you will have no trouble.

I Bonds produce returns with two components. The first is a permanent real rate, currently (until May 1) .10%. This rate will remain the same for thirty years. Every six months this rate resets for new buyers, on May 1 and November 1, but the fixed rate, just to repeat, remains whatever it was at the time you bought the bond.

The second component of I Bond return is derived directly from the past six months of the Urban CPI. A new rate is set for that component every six months, also on May 1 and November 1. There is a difference in its impact, however, in that the amount of your return based on inflation updates every six months. The subtlety of this update is that no matter when you buy, you will receive the rate then in effect for six months before the amount updates to the then-current rate for the following six months. As I will explain later in this piece, this is why it might be highly advantageous to buy by April 30: you will get the current inflation rate through September before switching to the new (and in this case, lower) rate. The interest and inflation adjustment compounds, and becomes a part of your principal.

You are required to hold an I Bond (like any Savings Bond) for one year. After that year you may opt out with the sacrifice of one quarter of return. After five years you may opt out without any sacrifice.

And one other thing: even if inflation goes negative, in which case your return may be zero for that period, your principal does not decline. This happened in 2009.

And one more small detail: you can buy up to the last day of any month and receive the full interest payment for that month.

These properties produce a number of advantages which in combination no other fixed income asset shares. Why do I love I Bonds? Let me count the ways.

1) I Bonds beat TIPS as an inflation hedge. The Treasury is currently about to issue 5-year TIPS at a negative real rate. When you think about it, it's almost like having your money in a Swiss or German bond, where there is negative interest rate and they will return you less money than you put in. Why would anyone do that? Don't ask. I know several convoluted versions of the answer, but they aren't worth going into. Luckily we don't have to. Yet. Except in the real return offered by TIPS.

You can sell TIPS on the open market, of course, at the whim of the market, but you can get out of your I Bonds too after a year, and with certainty about what you will get.

I Bonds are the ultimate inflation hedge. The inflation rate as measured by the Urban CPI is in fact exactly what they will pay you, for up to thirty years, plus that small rate of "real" return (currently .10%). Nothing spectacular, you are thinking. But once you consider the other options it starts to look pretty good. In this recent piece, I wrote about reasonable goals for investing, I said that the major goal was to store the purchasing power of money for future use (not so much to shoot the lights out with risky investments). I Bonds are the lowest risk vehicle you can use as part of a strategy to meet this goal.

2) I Bonds are also, oddly enough, a hedge against deflation. That's right, deflation! Here's how that works. Remember that your principal at any give moment is sacrosanct. A negative number for inflation may wipe out your return for that period, but it doesn't touch the principal you started the period with. I have seen this in action in my own I Bond portfolio.

Whenever there is a deflationary period, a given sum of money, by definition, enjoys a return in real (that word again) purchasing power to the extent of the deflation. Money in I Bonds is also a protection again negative interest rates, which seem to me unlikely here in the U.S. but not entirely impossible. You will still keep your .10% return and your inflationary return, if any.

(And I should say at this point that I really expect neither actual deflation nor a troublesome level inflation in the near to intermediate term. Over the thirty years until the maturity of the bond I am less certain. Inflation has been pretty low for over a decade, usually under 2%, but it could ratchet up somewhat over the next decade, or do more than ratchet in the event of a radically stimulative monetary policy. Buying inflation (and deflation) protection right now is like buying insurance when you are young and healthy. I Bonds are cheap insurance.)

3) I Bonds are amazingly flexible. The right to get out after a year with a mere loss of a quarter's income, and after five years with no loss, is more powerful than meets the eye. So is the ability to hold them and let them compound for 30 years. What it means is that you can say "snap" at any point after a year and get your money back with all but three months of return. Lets say the markets twist around so that something clearly better is available. "Snap"! No muss, no fuss. Put in the technical language it becomes clear how great this property is: the final maturity and duration of your I Bonds is whatever duration you choose, anything between 1 and 30 years. Try finding that anywhere else!

4) I Bonds have favorable tax status. As Treasuries, they are exempt from state and local taxes. But even when it comes to Federal taxes, you may choose between paying your taxes on the annual accrual as you go along or waiting until maturity to pay the whole thing. If they are a retirement investment, this may well produce a significant advantage if you expect to be in a lower tax bracket after retirement. They can also be used under some conditions for educational expenses without taxation.

5) I Bonds are a very competitive "parking place" for cash. Even if your goal is funding the far end of an emergency cash reserve or a cash fund dedicated to another investment you just don't want to buy at this moment, I bonds may serve you very well. As little as .10% plus the inflation rate may have been in recent years, it soundly beat the return on EE Savings Bonds in recent years, a number largely based on the 5-year Treasury return. If you're beating that, you're getting something like the available safe 5-year Treasury return, but you're getting it in a holding that can work like a near-cash fund.

Just for the sake of comparison, let's compare the currently available I Bond return (until April 30) with the recent return of the Vanguard Short-Term Government Bond Index Fund (MUTF:VSBSX). Vanguard does a good job with funds of this type, by the way, with low expenses that make it a good measuring stick. Over the last year, the return of this fund was .89% before taxes. The return after taxes on disbursed income was .57%, and after selling your fund shares .51%, suggesting that perhaps 10% of that .89% return was from falling rates and rising bond prices.

The assured return for the next year for I Bonds bought by April 30, for reasons I will explain shortly, is .95%, with no taxes unless you opt out. Pretty close but I Bonds win, with no market risk.

What's The Catch?

The only catch is that you can only buy $10,000 of I Bonds per person in a calendar year. You can, however, buy $10,000 each for husband and wife, plus $10,000 in the name of each child (or other person you wish to name). The child, of course, will then be the owner.

When I first started buying I Bonds in 2000, they were even more advantageous in two ways. That year the "real" (permanent) rate was 3.6% with the inflation adjustment then added. There were times that after combining real yield and inflation adjustment those bonds yielded about 6%. For that year and a few years after, you could buy up to $30,000 per person per year. I did it that one year, and have kicked myself ever since that I didn't max the amount every year.

The Treasury seems to have wised up that the deal they were offering was too good - or so a few commentators said at the time they reduced the amount an individual could buy. I got over kicking myself, however, and resumed buying as much as I could regardless of the rate at the time. I have bought I Bonds several times when the real return number was zero. The good side was that I bought enough in the early days that my overall I Bond portfolio, now well into six figures, still has an overall real yield of about 2.2%. I don't miss a year. I just try to figure the smartest time of year to buy: on or before April 30, between May 1 and October 30, or on or after November 1. There are a few general principles to consider.

Why Buy Now Before The End Of April?

In general I think it is smart to wait until the last week or two when the inflation rate is announced and conditions in the shorter term Treasury market suggest whether there might be an increase or decrease in the fixed rate. If you act in late April it is possible that you may miss a better opportunity which might become apparent in late October (anticipating the November 1 reset), but if that is the case, you will get another chance to wait until the following April. I do not think I can make a reasonable estimate of the inflation rate or bond market conditions six months out and I prefer not to try to; this differs from the approach of economists who also can't make solid estimates but make predictions anyway.

Right now we know exactly what the inflation adjustment will be for the next six and twelve months. If you buy by April 30, you will get the annual rate currently in force, 1.64% as it is stated, divided by 2 as it will be paid for six months. For the six months following, beginning in October, you will get the annualized rate just announced, .26% divided by 2 over six months until next April. Your overall one year return will be the .95% mentioned in item (5) above. You could hunt for CDs that equal this amount, but they won't allow you to defer taxes and won't have the other desirable properties of I Bonds.

Current market conditions make it highly unlikely that the fixed rate will go up on May 1. With rates having fallen recently, there is reasonable chance that the rate will reset to zero if you wait until May 1.

The fixed rate dodged a bullet on Thursday when the non-seasonally-adjusted inflation rate came in at .43% for March. There had been five consecutive deflationary numbers in the preceding months, and a much smaller number would have led to a deflationary wipeout of the fixed return. I am indebted to Tipswatch, a Contributor to these pages, and owe him a shout out for his timely reminder in this recent article that April was here and the numbers bore close watching. He does excellent detailed work on inflation-indexed securities and inflation rates which most readers at SA could benefit from reading.

Conclusion

I have now been an annual buyer of I Bonds for 16 years. I Bonds are a part of investment "small ball," but should not be ignored. They have the rarest investment quality: guaranteed return which solves several investment needs. It's easy to dismiss scoring by walks, stolen bases, bunts, and the occasional single, but a run scored that way is just as much a run as a bases empty homer.

Good luck with your investing. Hit home runs when you can, but learn to play skillful small ball too.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Note that I have a portfolio of I Bonds. Purchases by others will have no effect on them.