What Should I Do with My Treasury I-Bonds?

Post-Mortem on My Past I-Bond Recommendations

A Quick Review of My Past Articles

I first alerted our subscribers and website article readers to the attractiveness of I-bonds in December 2021 with the headline “Treasury I-Bonds are Paying 7.12%!” That was followed-up by another website article in May 2022 entitled “Treasury I-Bonds are Paying 9.62%!” These two articles were written at time when nominal Treasury yields were 0%-2%, and TIPS bonds (the closest comparison) were paying negative spreads over CPI.

Later in 2022, the Fed finally decided that inflation wasn’t “transitory” after all, and that they should do something about it. They began to raise interest rates very aggressively, far faster than ever before in Fed history.

Fed interest rate policy shows up most clearly on the short end of the Treasury yield curve. At the end of 2021, the three-month T-bill yield was .05% (green line above). Since then, it has climbed to 5.4% as of August 31, 2023.

Because I-bonds impose a penalty of three months’ interest if not held for at least five years, in some respects they are a five-year instrument. The graph above shows the yield history of the five-year Treasury bond in blue. Moreover, since I-bonds offer a yield over the CPI rate, they are an inflation-adjusted bond, making five-year TIPS an even better comparison. Unlike I-bonds which pay a spread over the CPI of 0% or more, TIPS bonds can be priced to offer a spread that is above or below the CPI. The orange line above shows the TIPS real yield (over CPI). It was negative until mid-2022. As of August 31, 2023, the yield on 5-year TIPS is 2.1% over CPI.

The TreasuryDirect website indicates that starting May 1, 2023 (and until November 1, 2023), I-bonds offer a "fixed rate" spread over the CPI of only .9%. As shown above, short-term TIPS (using the 5-year TIPS rate as a benchmark) currently offer a yield spread of 2.1% over the CPI. Short-term TIPS are a much more attractive option, and this is unlikely to change much on the next I-bonds rate reset on November 1.

Was I Wrong to Have Recommended I-Bonds?

If you bought I-bonds over the past couple of years, was that a mistake? Absolutely not! The yields were not only far above anything else available, they were spectacular purchases in hindsight, especially given the continued rampant inflation and the abysmal performance of the bond market in 2022. The offering yield for I-bonds is reset on May 1 and November 1 each year. The graph below looks back at the historical returns garnered by these six-month purchase cohorts, and compares them with the purchases of 5-year Treasury bonds and 3-month Treasury bills. Clearly, I-bonds have had far superior returns.

A Quick Review of I-Bond Basics

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.

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 on the CPI, is applied to the principal value every six months. The coupon rate, which is fixed at issuance, is multiplied by the new principal amount and paid every six months. The real yield-to-maturity (often simply called the “yield”) calculation incorporates the principal value, the coupon rate, and the time to maturity. Only the real yield can be calculated ahead of time because future inflation is unknown. “Yield” (real 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.

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

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.

The inflation adjustment for I-bonds is made twice yearly, on May 1 and November 1. The inflation rate for the preceding six months (lagged by a month) is annualized, added to the fixed rate, and a final tiny adjustment is made to apply the latest CPI rate to the fixed rate to get the new combined rate.

It is important to note that the fixed rate stays the same for the life of the I-bond. It never changes. The inflation rate is reset every May 1 and November 1, and is added to the fixed rate to get a new combined rate for that particular bond based upon when it was first purchased. I refer to these as six-month purchase “cohorts.”

You can count on your initial combined rate being good only for the first six months. The inflation rate will be reset every six months thereafter, but the fixed rate will remain the same. For example, if you bought I-bonds on January 1, 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.”

Why You Should Prefer TIPS over I-Bonds Now

The history of the fixed rate is shown in the blue line in the graph below. The real yield of the 5-year TIPS bond is shown in green. After a long period of having been negative, the 5-year TIPS yield had climbed to 1.6% as of November 1, 2022, well above the I-bonds fixed rate of .4% set on that date. As of May 1, 2023, the fixed rate for I-bonds was set at .9%. That was still well below the 1.4% real yield of TIPS bonds on that date. Now (as of August 31) it is even further below.

As long as the real yield of 5-year TIPS remains above the I-bond fixed rate, I would recommend investing in short-term TIPS rather than I-bonds. TIPS bonds have several advantages over I-bonds. Unlike I-bonds which are limited to purchases of $10,000 per year, TIPS purchases are unlimited. And unlike I-bonds which impose a 3-month interest penalty for withdrawal within the first five years, TIPS bonds are completely liquid. Finally, unlike I-bonds, which must be purchased through the rather clumsy Treasury Direct website, short-term TIPS bonds can be owned through two (virtually identical) convenient and very low-cost ETFs:

Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) - .04% expense ratio
iShares 0-5 Year TIPS Bond ETF (STIP) - .03% expense ratio

What to Do with the I-Bonds You Already Have

The graph below shows the rate history of I-bonds since 2020 by six-month purchase cohorts. There were some very attractive historical rates because the inflation rate (CPI) was so high.

It is important to remember that once you purchase it, the fixed rate for an I-bond never changes. For example, all of the purchase cohorts shown above that are before November 1, 2022, have a fixed rate of zero. That is, now and forever, they yield CPI + 0%.

As of November 1, 2022, the fixed rate was boosted to only .4%. (Again, that means the total yield is CPI + .4%.) The current I-bond cohort (May 1, 2023 to November 1, 2023) has a fixed rate of .90% (the last blue bar above). The latest six-month inflation rate was 1.69%, so the total annualized composite yield is 4.3%. Not very competitive when five-year TIPS have a yield of CPI + 2.1%.

Sell, but Not Too Early

The obvious question is, should you sell? You are not allowed to sell your I-bonds until you have held them for at least a year, so those who purchased the two most recent I-bond cohorts must wait to sell. Unless you have owned your I-bonds for at least five years, if you sell you will incur a penalty by giving up three months of interest. The optimal strategy is to wait until your I-bond is three months into the current low-yielding CPI reset of 1.69% (annualized at 3.38%). You do not want to be giving up three months of yield at the previous CPI reset of 3.24% (annualized at 6.48%)!

Assuming that the fixed rate on your I-bonds is zero (you purchased before November 1, 2022), your three-month interest penalty will be .845% (3/12 x 3.38%). The current real yield for the five-year TIPS bond is 2.1%. The real yield (fixed rate) on your I-bond is zero. So you would immediately be 2.1% better off with the five-year TIPS bond as long as your interest penalty is less than 2.1%.

As shown below, all of the recent I-bond cohorts with a zero fixed rate should be sold. Even after the .85% three-month yield penalty for selling in the first five years, the real yield spread of five-year TIPS bonds is still enough higher to make the switch worthwhile.

Those who bought in the November 1, 2022 to April 30, 2023 cohort will of course have to wait until at least November 1, 2023 (or later), to sell. Unless the real yield on five-year TIPS bonds declines materially, it will probably be worthwhile selling even those I-bonds and switching to short-term TIPS.

The Mechanics of Selling Your I-Bonds

It can be a bit confusing trying to keep track of the current interest rate on your I-bonds. You will not want to sell your I-bonds yet if they are still paying the interest rate set in the previous reset cohort (November 1, 2022 to April 30, 2023). If your fixed rate is 0% (zero), under that reset cohort you will be getting a composite rate of 6.48% (twice the 6-month CPI rate of 3.24%) until the next rate reset date for your particular I-bond. You want to wait until three months into the latest reset cohort, with an inflation rate of 1.69%, which (assuming a zero fixed rate) would be a yield of 3.38%. Typically, a bond will be issued on the first day of the month following your purchase.

The TreasuryDirect website has a table that is helpful in keeping track of the dates when your I-bond interest rate will change:

Interest rate changes depend on when we issued the bond

Although we announce the new rates in May and November, the date when the rate changes for your bond is every 6 months from the issue date of your bond. Use this table to understand when each new rate begins to apply to your I bond.

If we issued your bond in Your interest rate changes every

January July 1 and January 1

February August 1 and February 1

March September 1 and March 1

April October 1 and April 1

May November 1 and May 1

June December 1 and June 1

July January 1 and July 1

August February 1 and August 1

September March 1 and September 1

October April 1 and October 1

November May 1 and November 1

December June 1 and December 1

Again, The optimal strategy is to wait until your I-bond is three months into the current low-yielding CPI reset of 1.69% (annualized at 3.38%). Consequently, if you bought your I-bond on or before January 1, 2022, it is time to sell them (in my opinion). That is, you have passed the three-month mark of having to give up a yield (3.38%) that is fairly low. For example, using the table above, if your bought on January 1, 2022, your monthly interest rate changed on July 1, 2023. If you put your sell order in during September (the optimal strategy), your three-month penalty for early surrender will be the interest payments for July 1, August 1, and September 1, all of which were at a yield of only 3.38%.

If you bought your I-bond after January 1, 2022, you will want to redeem when you have held the I-bond for three months after the latest interest rate reset date from the table above. For example, if you bought on February 1, 2022, your latest reset date was August 1. So you will want to redeem after October 1. (I am assuming that no one bought after November 1, 2022, when I-bonds became unattractive relative to short-term TIPS.)

When the time is right to redeem your I-bond, here are step-by-step instructions:

Have your Username, password, and account number ready
https://treasurydirect.gov/
Select Log in
Enter account number and select Submit
Go to your email address to retrieve your one-time passcode
Copy and paste your one-time passcode (note that it is case sensitive) and Submit
Enter your password and select Submit
You will be taken to the “My Account” page
You should see your holdings listed there under Current Holdings
Select Current Holdings from the menu at the top
Select the type of security you want to see (Series I Savings Bonds) and select Submit
You only want to redeem securities that have been paying the latest rate (3.38% or 3.79%) for three months (the penalty period)
If you see a higher rate (such as 6.48%), you will want to wait until later to redeem
Note the Issue Date listed
Your yield will only change every six-month issuance anniversary
You can only sell securities that were issues more than a year ago
If you want to redeem, select the security you want to redeem
You will taken to the Redemption Request page
You will given the option to Redeem
You should recognize the bank account listed in the Redemption Instructions
You will be given a chance to Review and Submit the Redemption Instructions