I Bond Investors: Act Now, Don't Delay

Summary

• I Bonds issued before November 1 will carry a permanent fixed rate of 0.50%, creating a real return higher than that of a 5-, 10- or 20-year TIPS.
• The Treasury will reset this fixed rate on November 1, and it is very likely to go lower.
• With interest rates sliding lower, this could be a "last chance" opportunity (for years?) to get a good fixed rate on an excellent inflation-protected investment.

It pains me to say this: The market's best inflation-protected investment could go "poof" on November 1. That's the date the U.S. Treasury will reset the fixed rate on its U.S. Series I Savings Bonds. And the news isn't likely to be good.

If you don't know what an I Bond is, here's a quick primer: It is a U.S. Treasury security that earns interest based the combination of a fixed rate and an inflation rate that accurately tracks official U.S. inflation.

• The fixed rate will never change for each I Bond purchased. So if you bought an I Bond in 2014 with a fixed rate of 0.2%, it will continue to have a 0.2% fixed rate for the life of the bond. Purchases through October 31, 2019, have a fixed rate of 0.5%; on November 1, that rate will be reset.
• The I Bond's inflation-adjusted rate changes each six months to reflect the running rate of inflation. That rate is currently set at 1.4% annualized. It will adjust to 2.0% on November 1 for all I Bonds, no matter when they were purchased. (Although the effective start date of the new interest rate can vary depending on the month you bought the I Bond, a Treasury oddity).
• As of today, the I Bond's composite rate is 1.9%, a combination of the fixed rate (permanent) and inflation-adjusted rate (changing every six months).

Here is the important thing: The I Bond's fixed rate is far more important than the inflation-adjusted rate. It indicates the I Bond's "real return," meaning the amount an investor will earn above inflation. It is equivalent to the "real yield to maturity" of Treasury Inflation-Protected Securities.

I Bonds historically have had a fixed rate well below the real yield to maturity of 10-year TIPS, generally about 50 to 100 basis points lower. There's a reason for that: 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.

Also, 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 have rock-solid deflation protection. In times of deflation, the principal balance of a TIPS will decline. The accumulated value of an I Bond will never decline.

And one more thing: The Treasury limits I Bond purchases in electronic form to $10,000 per person per year (along with the chance to get $5,000 in paper I Bonds in lieu of a federal tax refund). I Bonds are a very popular investment as a form of capital preservation (see: rich people) but investors have to buy them every year, at $10,000 a shot, to build a meaningful portfolio.

Why are I Bonds attractive right now?

As I noted, the I Bond historically has a fixed rate well below the real yields of 5- and 10-year TIPS. But that isn't the case today, with the I Bond's fixed rate of 0.50% topping the current yield of the 5-year TIPS (0.25%), the 10-year TIPS (0.20%), the 20-year TIPS (0.40%) and running quite close to the 30-year TIPS (0.59%).

This chart shows how these yields have compared over the last 11 years, with the I Bond (fixed rate shown in blue) becoming the superior investment at times when the real yields of TIPS dived deeply negative. At other times, TIPS yields were sharply higher:

(Source: TIPSWatch.com)

This chart shows the situation on each May 1 and November 1 since 2008, just as the Treasury was about to set the I Bond's new fixed rate for future purchases. In general, when 5- and 10-year TIPS have positive yields, the I Bond's fixed rate is set lower. When the TIPS yields hit zero or go negative, the I Bond's fixed rate is set at 0.0%. It can't go negative.

At this point, in October 2019, the I Bond is the best inflation-protected investment in the world, offering ultimate safety, a high real yield, a flexible maturity and tax-deferred earnings.

But that could change November 1.

The Treasury does not disclose how it sets the I Bond's fixed rate, and it surprised everyone on May 1 when it held the rate at 0.50%, despite a sharp decline in market real yields. (I predicted the rate would fall and I was wrong). But heading into the November 1 rate reset, market conditions have changed drastically.

Projecting the fixed-rate possibilities

I have tracked the real yields of 5- and 10-year TIPS versus the I Bond's fixed rate for many years, and I do think there is a correlation in these numbers and the Treasury's rate decision. Here are the projections, along with historical data back to 2008:

OK, there are a lot of numbers here, but I want to point out a few interesting resets of the past:

• A year ago, on November 1, 2018, the 5-year TIPS was yielding 1.08% (83 basis points higher than today and the 10-year was at 1.10% (85 basis points higher. The Treasury set the fixed rate at 0.50%, where it remains today.
• I think the most important column in the chart is the 10-year yield spread. It reached as high as 2.44% in November 2008, and dipped as low as -0.78% in November 2012, as real yields plummeted well below zero. In more recent times, when the 10-year TIPS yield climbs above 0.50%, the spread is usually in the range of 40 to 60 basis points, which is probably a "fair" spread given the I Bond's advantages over TIPS.
• If the Treasury decides to hold the I Bond's fixed rate at 0.50% on November 1, it would create a spread of negative 30 basis points, and that seems highly unlikely.
• In fact, I think the Treasury won't create a negative spread between the I Bond's fixed rate and the TIPS 10-year real yield.
• That leads me to conclude: The I Bond's fixed rate will fall to a range of 0.0% to 0.2% on November 1.

My misgivings...

Six months ago, I was highly confident that the I Bond's fixed rate would fall from 0.5% to a range of 0.2% to 0.3%. But the Treasury surprised me, and it's possible that will happen again on November 1 - holding the fixed rate at 0.50% - a move I would greatly welcome because it would open the door to I Bond purchases in January at that level. (I bought my I Bond allocation for 2019 way back in April).

But I don't see that happening. I believe the fixed rate is going to fall.

An action plan

If you haven't yet already purchased I Bonds up to the maximum, $10,000 per person in 2019, I highly recommend purchasing them before November 1, ensuring that you will lock in the 0.50% fixed rate for potentially 30 years.

So, if you buy before November 1:

• You will lock in the 0.50% fixed rate, along with the current variable rate of 1.40%, for a composite rate of 1.9% for a full six months.
• Then you will transition to the new variable rate of 2.00%, plus the fixed rate of 0.50%, for a composite rate of 2.5% for six months.
• Over a full year, you will earn a combined rate of about 2.2%.

Will we see a higher fixed rate in the future? Maybe. Or maybe not.

Keep this in mind: That 0.50% fixed rate is the highest for I Bonds since May 2009, more than 10 years. It is a good fixed rate. When you add the inflation variable rate on top of that fixed rate, plus tax-deferred compounding, you have an investment that is highly likely to outperform inflation, even after taxes.

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.