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Rekenthaler Report

Run, Don’t Walk, for I Bonds

Now is the perfect time to buy today’s investment darlings.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

Under the Radar

Until very recently, Series I Savings Bonds, which have been sold by the U.S. Treasury since 1998, have gone virtually unnoticed. (A notable exception has been a string of reports from journalist Susan Tompor running all way the back to 1999.) Run a Google search for “Series I Bonds 2015,” and you will find no article written during that year about the subject (although you will see several references to a certain other Bond). Ditto for 2020. But not in 2022! There has been a bull market in stories about I Bonds. (One of which, “How to Hedge Against Inflation Using I Bonds,” appeared on this site courtesy of Katherine Lynch.)

There is good reason for both the omission and the sudden rise in popularity.

The omission occurred because these bonds were designed for obscurity. Investment professionals pay them no heed, as the Treasury restricts annual purchases of I Bonds to a paltry $10,000. (For those with federal income-tax refunds to spend, the limit increases to $15,000.) Moreover, the government prevents trading in I Bonds, as it will send payments only to at-issue buyers.

Those conditions have squashed research on I Bonds. Besides deterring portfolio managers, their terms also place them outside the purview of investment databases, which typically omit assets that do not trade on secondary markets. (For example, Morningstar does not track the rates of bank CDs.) Nor do I Bonds appeal to financial-services firms, which neither sell nor service them.

A Benefit No Longer

That said, now that I have studied the topic, I am surprised that I Bonds have not previously received at least some attention. As with Treasury-Inflation Protected Securities, they possess two components of return: 1) a fixed annual rate, determined at issuance, and 2) an inflation rate, updated every six months. The latter alone qualifies as an acceptable investment. Over the past century, the real return on 30-day Treasury bills has almost exactly matched that of total inflation.

However, when I Bonds debuted, they delivered far more than the inflation rate. The fixed rate for the initial offering was a handsome 3.4%. If inflation was nonexistent, the bonds yielded 3.4%. If inflation was 3%, they paid 6.4%. And if deflation struck, the I Bond would continue to distribute 3.4%, because the Treasury pledged that its inflation adjustment would never be negative. (Correction: I misstated. The Treasury pledged that the total yield on I Bonds will never be negative. For I Bonds issued with fixed rates of zero, which is currently the case, that effectively means that the inflation adjustment cannot be negative. However, with the originally issued bonds, which have a fixed-rate payment of 3.4%, their yields can indeed be reduced by deflation, albeit not below zero.) For early investors in I Bonds, the proposition was win-win-win.

That train has long since left the station. A decade after I Bonds were launched, the fixed rate for new purchases had disappeared entirely. With few exceptions, it has remained that way. The last occasion on which the fixed rate on I Bonds exceeded zero was spring of 2020, and that rate was a mere 0.20% per year. For all practical purposes, then, today’s investors in I Bonds can expect merely to receive the second of the bond’s two return components, the inflation rate.

Ideal Conditions for I Bonds

But what a “merely” that is! Both the spike in inflation and the details of the Treasury’s inflation-rate calculation have created a perfect storm for I Bond yields. To start, the department uses a measure of inflation, the Consumer Price Index for All Urban Consumers, or CPI-U, that includes food and energy. That increases the payout on I Bonds because food and energy costs have increased especially rapidly. In addition, the Treasury calculates its inflation rate not by considering 12-month changes, but instead by doubling the six-month figures. That approach boosts the current yield on I Bonds, because it eliminates the inputs from summer 2021, during which inflation was relatively low. (The average price for a gallon of gas in August 2021 was $3.16. Ah, the good old days!)

Here are the specifics: The current payout on I Bonds comes from dividing the value of the March 2022 CPI-U by the value from September 2021. The more recent amount was 287.504, while the prior figure was 274.310, leading to a percentage change of 4.81%. Doubling that figure leads to an annual rate of 9.62%, which is indeed today’s payout for I Bonds. (Thank goodness for reverse engineering, as the Treasury’s website sometimes skips the particulars.)

The saint lies very much in the details! The highest 12-month core inflation rate has been 6.5%. Thus, thanks to two fortunate accidents, those being the Treasury’s decision to use 1) raw rather than core inflation computations and 2) semiannual rather than annual changes, I Bond investors are now receiving 300 basis points more of yield than they would be under different construction rules.

A Happy Lag

The best news is yet to come. The Treasury’s inflation-rate payments sharply lag contemporary events. The current inflation rate for I Bonds is based on price changes that occurred from October 2021 through March 2022. When the yield on I Bonds is reset, on Nov. 1, that adjustment will include this spring’s price surges, thereby creating a fat payout. Even if inflation were to suddenly disappear, the yield on the I Bond would reset to 6.13%, based solely on the amount of inflation that occurred from this past April though June. Of course, inflation will not abruptly vanish. Almost certainly, the next I Bond yield will also surpass 9%.

There is a second lag in I Bond calculations, aside from determining the inflation rate. The Treasury also takes its time implementing the new rate. For example, those who buy an I Bond today, in August 2022, will receive the current 9.62% inflation rate for the first six months that they hold the security, until Feb. 1. Only then will they transition to the new rate, which was calculated on the period from April through October 2022. That rate will then apply until Aug. 1.

After that, who cares? In slightly less than 12 months, the I Bond will have paid something north of 9% of its purchase price, while being fully guaranteed by the United States government. It is true that if investors decide at that point to take their money and run, they must forfeit three months’ worth of income (a rule that applies to all redemptions of I Bonds that have been held for less than five years). But doing so would still make for a final, guaranteed profit of about 7%.

A Rare Sighting

To be sure, this tactic is not for everyone. In a $5 million account, a $10,000 purchase occupies 20 basis points of the portfolio—one fifth of 1%. For such investors, I Bond accounts are effectively immaterial. But for most retail investors I Bonds are very much worth pursuing. Free investment lunches almost never occur. The present opportunity in I Bonds is not large enough to qualify as a lunch, but it is something of a free investment snack. That is plenty good enough.

Postscript

Ha! Immediately after I wrote that inflation can’t possibly be flat for July through September, the July CPI-U report, nonseasonally adjusted, was flat. Nostradamus, I am not. But remember, even if the next two months are also flat, an I Bond that is purchased today will pay 6% from February through July of next year. Combined with its 9.62% payout until February, that would make for a one-year rate of almost 8%. Which is why I bought my I Bond this morning, after publishing the article. My wife purchased one, too—I should have been clearer in the article, the $10,000 annual purchase limit ($15,000 if applying federal tax refunds) applies to each person in a household, not to the total household. Including children. So for families with a large brood, the limit can be quite substantial.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.