Investors in U.S. Series I Savings Bonds have entered the last 'limbo period' of 2018 and it's time to make a decision: Are they going to buy I Bonds this year, or not?
I Bonds are a unique investment -- very safe and very conservative, and yet are followed with passion by some fairly wealthy investors. Why? Because they offer the opportunity to push tax-deferred, inflation-adjusted money into the future, with zero risk.
A quick primer on I Bonds
- Each I Bond carries a fixed rate that will never change. So if you bought an I Bond in 2013 with a fixed rate of 0.2%, it will continue to have a 0.2% fixed rate for the 30-year life of the bond, or until it is redeemed. The fixed rate is reset on May 1 and November 1 of each year.
- Each I Bond also has an inflation-adjusted rate, also called the variable rate, that changes each six months to reflect the running rate of inflation. All I Bonds get this variable rate for six months, but when it starts depends on the month when you bought the I Bond.
- The combination of these two rates creates the I Bond composite rate, which is currently 2.52% for I Bonds purchased through October 31, based on the current variable rate of 2.22% and fixed rate of 0.30%.
- I Bonds are the most conservative and most safe of all investments. Your principal is 99.9999999% safe and it will never decline. If inflation falls to below zero, the composite rate could fall to zero, but not below zero.
- I Bonds allow you fantastic flexibility. You can redeem them after one year, costing you three months of interest. Or redeem them after five years and pay no penalty, or just hold them for 30 years and cash out.
- I Bonds protect you against unexpected inflation. If inflation in the next 30 years suddenly soars to 7%, 10%, 15%, your principal will increase by that amount because of the inflation-adjusted interest rate.
- I Bonds allow you to defer federal income taxes until you redeem them, so you pay zero in taxes until they are sold. They also are free of state income taxes, an advantage over bank CDs.
But there is one sort-of-nagging problem with I Bonds: The U.S. Treasury limits purchases to $10,000 per person per year. Purchases must be made electronically through TreasuryDirect, but there is also the possibility of getting $5,000 a year in paper I Bonds in lieu of a federal tax refund.
This purchase limit vexes I Bond investors, who are intent on building a large cache of super-safe, tax-deferred, inflation-protected money for use in the future. So the question arises: When is the right time to buy?
(Disclosure: I bought my I Bond allocation back in May after the fixed rate rose to 0.3%. So did a lot of investors, but if you didn't ... )
The 'limbo period'
Each year, there are two 2-week periods - the weeks before May 1 and November 1 - where the new variable rate has been set and I Bond investors can compare their possible returns and decide: Buy before or after the rate reset?
We are in one of those limbo periods right now, because the September inflation report issued on October 14 set the new I Bond variable rate at 2.32%, up slightly from the current 2.22%. Here is how those numbers were calculated:
So for I Bond purchases made after November 1, the variable rate will be slightly higher. Obviously, anyone who has waited until now to purchase I Bonds will want to wait until November 1, right? Yes, but ...
The one risk in waiting is that the Treasury could decide to drop the I Bond's fixed rate below the current 0.3%. I Bond investors almost always will prefer a higher fixed rate over a higher variable rate, because the fixed rate sticks with the I Bond until it matures or is sold.
Think of it this way: The variable rate matches inflation. The fixed rate is the I Bond's 'real return above inflation.' Always go with the higher fixed rate.
And now the key question: What will the Treasury do with the fixed rate in the November 1 reset?
Forecasting the I Bond's fixed rate
The U.S. Treasury has never detailed how it sets the I Bond's fixed rate, and it has occasionally made some very strange decisions. So my forecast should be read in that context: I am guessing. Nevertheless, the data justify an increase in the I Bond fixed rate on November 1.
In my forecast, I track the spread between the I Bond fixed rate and the real yield of 5- and 10-year Treasury Inflation-Protected Securities. In the past, I have found that the 10-year spread seems more relevant, especially when the 5-year yield dipped well below zero. But now, with the 5- and 10-year TIPS yielding at very close levels, both are relevant. Here are the numbers, with the November 1 possibilities presented at the top:
I've highlighted years in the past when the I Bond fixed rate was at 0.30% or higher. As you can see, it hasn't happened often in the last 11 years. But take a look at the most recent reset to 0.30%, on May 1, 2018:
- The 5-year TIPS was yielding 0.69%, 32 basis points below the current yield of 1.01%.
- The 10-year TIPS was yielding 0.78%, 25 basis points below the current yield of 1.03%.
Now take a look at the 5- and 10-year yield spreads, which indicate very strongly that the Treasury will not lower the fixed rate to 0.2% on November 1. That would push the 5-year spread out to 0.81%, massively higher than any reset going back to November 2009 (ancient history). The 10-year spread would be 0.83%, also much higher than previous resets.
So, let's rule out a reset to 0.2%. It's not going to happen. (Ahem ... the Treasury is unpredictable. Cough. Cough.) If I am right, there is zero risk for I Bond investors to wait until the November 1 rate reset to make a purchase, capturing a higher variable rate and possibly a higher fixed rate.
Even at 0.3%, the spreads are out of line with past rate resets, with the 5-year spread at 0.71% versus 0.39% in May, and the 10-year at 0.73%, versus 0.48% in May.
My guess is that the fixed rate will rise to 0.4%, but I think the data support a rise even to 0.5%, where the 5-year spread would be 0.51%, still 12 basis points higher than the May 1 reset to 0.3%. The 10-year spread would be 0.58%, 5 basis points higher than the May 1 reset.
My one caution is that the Treasury has a tendency to hold to the status quo. If that happens, the fixed rate will remain at 0.3%, which isn't really justified by the data.
Conclusion: The fixed rate should rise, at least to 0.4%. Are you listening, Treasury?
A higher fixed rate benefits us all
Even if you have already purchased your I Bond allocation for 2018, this next rate reset with carry through to April 2019, so you will be able to purchase I Bonds next year with the potentially higher fixed rate.
The next 'limbo period' will begin April 10, 2019, at 8:30 a.m. EDT, when the Bureau of Labor Statistics releases the March inflation report, setting in stone the I Bond's next variable rate reset on May 1. So if the fixed rate rises, you could just buy in January and forget it, or wait until later in the year, or split your purchase into two or more parts.
Another thing to consider: If you are holding I Bonds with fixed rates of zero, you could consider selling those and reinvesting the money in an I Bond with a higher fixed rate. Realize two things, though: 1) you'll owe federal income taxes on the accrued interest, and 2) a repurchase still can't exceed your $10,000 a year limit, so your I Bond holdings will stay flat if you are selling $10,000 to buy $10,000.
I'll be taking another look at I Bond buying strategies early next year.
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.