December 6, 2023 5:30 am
December 6, 2023 5:30 am

The I Bond Fixed Rate Offered Through April 2023 is One of the Most Attractive in a Decade

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I Bond composite rates for new issues dropped from 9.62% to 6.89%. Despite the decrease in the composite yield, I Bonds are more attractive than they were in October. In fact, I Bonds might be among the most attractive as they have been in the last 15 years. This is because the fixed rate on I Bonds purchased between November 2022 and May 2023 increased from 0% to 0.4%. Other than a brief period in 2018, the fixed rate has been below 0.4% since 2008.

Understanding I Bond Yields

Treasury Direct displays an Offered Interest Rate offered for new issues of I Bonds. This rate is a composite value calculated using the fixed rate of a particular bond issue and the variable/inflation adjusted rate applied to all I bonds regardless of when they were issued. The composite rate is applied to the principal balance semiannually and the principal and interest payments compound to product higher returns. There are several attractive I Bond attributes that are worth noting. First, I bonds are protected from negative interest rates. If deflation were to create a composite value below zero, then the calculated rate will be overwritten with a 0% rate. Second, these bonds are backed by the full faith and credit of the United States and therefore have negligible credit risk. The bonds can be held until maturity (30 years) or redeemed for the full return of principal any time after 12 months. If the investor requests repayment between 12 and 60 months, then they forfeit the three most recent months interest payments. I bonds are backed by the full faith and credit of the US government and therefore have minimal credit risk as compared to other bonds.

Definitions and explanations

Offered Interest Rate – A composite rate that combines the fixed rate with the variable rate component tied to the CPI

Fixed Rate – Portion of the composite rate that does not change for the life of the bond. The fixed rate for new bonds changes when announced in November and May of each year

Variable Rate – Portion of the composite rate that is tied to the CPI-U, the consumer price index for urban areas. The variable rate is updated in November and May of each year and the new rate is applied to all outstanding I Bonds

Semi-annual Compounding – As investors you receive cash payments (typically referred to as coupons or coupon payments) every six months. Whatever you earn in one period can immediately begin

Deflation Protection – a negative CPI can reduce any interest from the fixed rate portion of the composite rate but only down to 0%. I Bonds will never earn negative interest

Credit Risk – Risk that a creditor defaults on their loan and is unable to pay you back. I bonds are backed by the full faith and credit of the US Government

Maturity – I Bonds can be held for up to 30 years from the date they are issued

Putable – As the bondholder you can demand immediate repayment of principal and interest before the full 30-year maturity once the investor holds the I Bond for 12 months. If this option is exercised prior to holding the bond for 60 months, then the last three months of interest is forfeited as a penalty

No Interest Rate Risk – Most bonds, treasury bills included, are exposed to interest rate risk. When interest rates rise, the value of existing bonds decreases. Conversely, when rates drop, the value of existing bonds rises. This is because these bonds are traded on the secondary market. In contrast, the option to request repayment of interest and principal at par value means that the I bond investor is not exposed to interest rate risk

A higher fixed rate is significant when compounded

A 40bp change in the fixed rate may seem small, but it has the benefit of time. The fixed rate is good for the life of the bond which has a maturity of 30 years and that time can deliver significant differences. For example, consider a scenario in which you invest $10,000 in I Bonds with a 0% fixed rate and assume inflation of 2.5% annually. Since there’s no fixed rate, you’ll earn a composite rate of 2.5% and have $21,072 at the end of 30 years. However, if you instead have a fixed rate of 0.4% then you’ll earn a composite rate of 2.905%. This higher rate means that after 30 years you’ll have a balance of $23,756, a difference of over $2,500. And you’ll get to keep more of those gains as well since you do not pay state or local income taxes on gains from I bonds.

One of the primary limitations of I bonds though is that the returns are typically smaller than investing in an ETF or index mutual fund. While the rate bump is welcome, I bonds have had low single digit returns for the majority of the last 15 years. This is because both the fixed rate has been low in new issues of bonds and because, up until recently, inflation was low. In contrast to the low single digit returns of I bonds, other asset classes like equities can have much higher returns. For example, the S&P 500 has historically averaged returns of around 10%. Investors who have a longer time horizon and don’t mind the volatility of stocks can earn much higher returns in equities The higher returns of equities have made the asset class a staple of investors, especially for younger individuals who have a longer time horizon.

Use Case for I Bonds

As someone who still considers themself young at 32, I’m more focused in growing my wealth over time than preserving my existing wealth. In order to reach financial independence low single digit returns aren’t going to cut it. Even if I wanted to stick all my savings into I bonds I’d still be prevented due to annual contribution limits of $10,000 annually for electronic bonds and $5,000 for additional bonds purchased through a tax refund. In order to maximize my returns almost all of my retirement accounts use index funds or real estate investment trusts (REITS). What I bonds are great at though is providing steady, inflation adjusted returns with minimal risk and strong liquidity outside the first year of the investment. These qualities make the I bond a great candidate for an emergency fund.

Outside of the 12-month lockup period following purchase of the I bond, I see very little downside to using these bonds as an emergency fund. I expect that it will take a couple of years to 1) Get enough funds into I bonds to fully migrate the value of our existing emergency fund to Treasury Direct given the contribution limits and 2) wait an additional year for the funds to be available in case of an emergency. At this point I’m seriously considering mapping out a timeline of what a conversion of my family’s emergency fund conversion would look like.

Readers, are there any reasons I haven’t considered for why I bonds couldn’t be used in place of a traditional emergency savings account? And one last question:

Inspired by my daughter’s latest obsession following Moana and the Lion King
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