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Are Treasury I-Bonds Still a Good Buy? Thumbnail

Are Treasury I-Bonds Still a Good Buy?

Inflation-Indexed Treasurys

The U.S. Treasury offers two types of bonds that are indexed to inflation:  1) TIPS (Treasury Inflation-Protected Securities) and 2) Series I Bonds. They are different in many respects. TIPS pay a yield equal to the CPI plus or minus a certain percentage. I-bonds, on the other hand, never pay less than the CPI. The I-bond terms are simpler, and designed to appeal to the small investor. Right now, I-bonds are paying a yield of 6.89%  That figure will hold until May 1, when it will be reset again based on the CPI rate between September 30, 2022 and April 1, 2023.          

TIPS

TIPS provide investors of any size with a liquid, tradeable Treasury bond tied to inflation. The principal value of TIPS rises with inflation, and falls with deflation (should that rare event happen).  At maturity the principal value will be the greater of the inflation-adjusted principal or the original principal. The inflation adjustment, which is based in the CPI, is applied to the principal value every six months. The coupon rate, which is fixed at issuance, it multiplied by the new principal amount and paid every six months. The yield-to-maturity (often simply called the “yield”) calculation incorporates the principal value, the coupon rate, and the time to maturity. “Yield” can be negative even if the coupon rate is positive if the current price is high enough. Thus, TIPS pay the CPI rate plus or minus a certain percentage. (Click here for an in-depth article about TIPS.)   

I-Bonds

Unlike TIPS, I-bonds are non-marketable, meaning that they cannot be bought or sold in the secondary market. They must be purchased directly from the Treasury and redeemed by the Treasury. An I-bond must be held for a minimum of 12 months. Any I-bond redeemed in the first five years is subject to a penalty of three-months of accrued interest. I-bonds mature and are automatically paid out after 30 years, but may be redeemed without penalty if held between 5 and 30 years.

Interest is accrued monthly and compounded semi-annually. That is, interest is not paid in cash but is added to the value of the bond. The interest rate is the sum of two components (called the “combined rate”):

  • A fixed rate, which remains the same throughout the life of the I bond.
  • A variable semiannual inflation rate based on changes in the CPI.

Right now, the fixed rate is .4% (and has been since November 1, 2022). It had been zero for a couple of years before that. The latest 6-month increase in the CPI (3.24%) was an annualized rate of 6.48% (3.24% x 2).  Adding the fixed rate of .4% results in a sum of 6.88%. A tiny final adjustment is made to apply the CPI increase to the fixed rate (.4% x 3.24%), which adds another .01296%, which rounds to an extra .01% in yield. Thus, the overall “combined rate” is a yield of 6.89% for I-bonds. That rate will stay in place until May 1, 2023.

Although the combined rate is reset every May 1 and November 1, these resets are applied to bonds based on when they were purchased or “issued.” You can count on your initial combined rate being good for the first six months. It will be reset every six months thereafter. For example, if you buy I-bonds in January 2023, your combined rate will be reset on July 1, 2023, and every July 1 and January 1 thereafter.


I-buys can never lose money, even if the CPI turns negative. Here is how the TreasuryDirect website explains it:


Because inflation can go up or down, we can have deflation (the opposite of inflation). Deflation can bring the combined rate down below the fixed rate (as long as the fixed rate itself is not zero). However, if the inflation rate is so negative that it would pull the combined rate below zero, we don't let that happen. We stop at zero.

I-Bonds vs Nominal Treasurys

The interest rate environment has changed dramatically over the past year. I-bonds are not the slam-dunk compelling buy that they were in 2022.

The graph above compares the nominal I-bond yield (blue) with the 6-month Treasury bill yield (green). Both are reset every six months. The combined rate of I-bonds peaked at 9.62% on May 1, 2022. At that time, the yield on the 6-month Treasury bill was only 1.41%. The “yield pickup” from buying I-bonds instead of the nominal Treasury bill was a whopping 8.21%!

At the next reset of the I-bonds combined rate on November 1, the fixed rate was increased from zero to .4%. By this time, the six-month change in inflation had decreased from 4.81% to 3.24%. Consequently, the combined rate on November 1, 2022 moved down to 6.89%. At that time, the 6-month Treasury bill yield was 4.55%. So, the yield pickup had declined from 8.21% to 2.34%.

It is reasonable to expect I-bonds to have a higher yield than nominal Treasury bills—the latter are extremely liquid and can be purchased in any size. I-bonds must be held at least one year, and at least five years to avoid a penalty. And investors can only purchase $10,000 in I-bonds.

I-Bonds’ vs TIPS

Although I-bonds compete for investors with nominal Treasurys, they more directly compete with Treasury Inflation-Protected Securities (TIPS). As mentioned above, whereas TIPS yields can be above or below the CPI rate, I-bonds always pay at least the CPI rate. The spread over CPI for I-bonds is currently .4% (the “fixed rate”), but the spread over CPI for the 5-year TIPS bond is now 1.62% for the 5-year TIPS bonds and 1.64% for the 30-year TIPS bonds. In 2020 and 2021, these spreads had been negative, meaning that they would not even have kept up with inflation. However, bond market pricing is completely different than it was a year ago.

I-bonds (blue) were quite competitive when 5-year TIPS (green) were offering a lower yield than the CPI and the 30-year TIPS (dark green) had a spread to the CPI of close to zero. These conditions prevailed in 2020 and 2021. Now, however, 5- and 30-year TIPS bonds sport yield spreads over CPI of 1.62% and 1.64%, respectively. Compared to the I-bond fixed rate of .4%, TIPS are a much more attractive option, and will be unless and until the Treasury increases the fixed rate for I-bonds to something that is competitive with TIPS bond real yields.  

Owners of I-bonds are required to hold them for at least one year. If they are surrendered within the first five years, owners will forfeit one quarter’s worth of interest. Consequently, the most applicable comparison is between I-bonds and the 5-year TIPS, since the both are essentially five-year commitments. (TIPS owners are free to sell at any time, of course, unlike I-bond owners.)

Will the Treasury raise the fixed rate for I-bonds enough to make them competitive with TIPS? Government bureaucracies tend to be slow moving and are reactive. Market rates, such as TIPS yields, are proactive and seek to anticipate the future. So, it should not be surprising that TIPS real yields have moved up more quickly than the I-bond fixed rate. However, unless the fixed rate for I-bonds moves up close to the real yield for the 5-year TIPS at the May 1, 2023 reset, I would recommend that investors avoid buying I-bonds this year. 

And current owners of I-bonds (like me) may even want to consider selling them once the required one-year holding period has been reached and instead buy either the 5-year TIPS directly on TreasuryDirect or a low-cost short-term TIPS ETF such as iShares 0-5 Year TIPS Bond ETF (STIP) or Vanguard ST Inflation Protected Securities ETF (VTIP). Selling the I-bond before the five-year holding period means giving up a quarter's worth of interest, so it will be important to compare the two yields net of the penalty.