Unique Opportunity: I Bonds As An 11-Month Investment

Everyone knows I am a big fan of U.S. Series I Savings Bonds, an investment offering returns that will track inflation closely with total safety, tax-deferred interest and solid protection against deflation.

And in almost all cases, I recommend buying I Bonds up to the Treasury’s $10,000 per person purchase cap every year and then holding them until you really need the cash. That’s the only way to build a sizable allocation in this inflation-protected security. But right now, in our interest-rate-suppressed environment of October 2020, I Bonds have become an attractive short-term (meaning 11-month) investment, while retaining the option to hold them much longer, up to 30 years.

U.S. inflation is currently running at an annual rate of 1.4%. Look around, and try to find a very safe, short-term investment that currently is offering returns anywhere near 1.4%.

  • Vanguard’s Treasury Money Market Fund (VUSXX) is yielding 0.06%.
  • A 4-week Treasury bill is yielding 0.09%.
  • A 1-year Treasury note is yielding 0.13%.
  • Best-in-nation online savings accounts are yielding 0.75%.
  • Best-in-nation 1-year insured bank CDs are yielding 0.80%.

You can do better than all of those with an 11-month investment in I Bonds.

But first … what is an I Bond?

An I Bond is a U.S.-guaranteed Savings Bond that earns interest based on combining a fixed rate and an inflation rate.

  • The fixed rate will never change. So if you bought an I Bond in April 2020 with a fixed rate of 0.2% (smart move), it will continue to have a 0.2% fixed rate for the life of the bond. Purchases through Oct. 31, 2020 will have a fixed rate of 0.0%. Treasury will reset the fixed rate on November 1, but it is highly likely it will stay at 0.0% for purchases throughout 2021.
  • The inflation-adjusted rate changes each six months to reflect the running rate of inflation. That rate is currently set at 1.06% annualized. It will reset after November 1 to 1.68%, for all I Bonds, no matter when they were purchased. But keep in mind that when you purchase an I Bond, you get a full six months of the current interest rate before the new interest rate takes effect.

And why are they an intriguing investment?

  • I Bonds are the most conservative and most safe of all investments. Your principal is 99.999% safe and it will never decline, ever. If inflation falls to below zero, the composite rate will fall to zero, but not below zero.
  • You can buy an I Bond near the last day of the month (say on Oct. 30, 2020) and get credit for a full month’s interest. And then you can redeem it on Oct. 1, 2021, because the 1-year holding period will have been fulfilled. That means you can get one year of investment returns in only 11 months.
  • 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.
  • I Bonds protect you against unexpected inflation. If inflation in the next 30 years suddenly soars to 7%, 10%, 15%, your principal will increase by that amount because of the inflation-adjusted interest rate.
  • I Bonds allow you to defer federal income taxes until you redeem them, so you pay zero in taxes until they are sold. Interest is also free of any state income tax.

Could the Treasury raise the fixed rate on Nov. 1?

That is highly improbable. In “normal” times, the I Bond’s fixed rate tends to lag about 50 to 75 basis points behind the real yield of a 10-year TIPS. Right now, a 10-year TIPS has a real yield of -0.96%, or a whopping 96 basis points lower than the I Bond. There is no way the Treasury would see a need to raise the fixed rate above 0.0%. (Of course, the Treasury sometimes does weird things, but I just don’t see it this year.)

Here are numbers tracking these fixed-rate resets dating back to 2008:

Another question I get from readers is: “Would the Treasury ever set a negative fixed rate for the I Bond?” The Treasury doesn’t have a stated policy on this, and I think setting a negative fixed rate on an investment used by small-scale savers would send a devastating message. I don’t think it will happen.

But could it happen? I hope not. In the chart above, note that the 5-year TIPS real yields in November 2012 and May 2013 dipped well below where they are today, and the Treasury still set the I Bond’s fixed rate at 0.0%.

My conclusion is: The I Bond’s fixed rate will remain at 0.0% for the November 2020 to April 2021 purchasing period, and probably beyond.

Should you buy before or after Nov. 1?

Most I Bond investors who are reading this have probably already purchased their full $10,000 allocation for 2020, because the fixed rate remained at 0.2% through April 30. Buying in April was the right move.

But let’s say you haven’t yet purchased up to the cap — which is $10,000 per person per calendar year. If you are buying an I Bond as a long-term investment (a holding period of at least five years), I don’t think it matters, because the fixed rate is likely to hold at 0.0%. You can buy in October and get a one-year return of about 1.37%. Not bad.

I’d probably pull the trigger and buy in October. But waiting until November would also be fine. Just make a purchase before 2020 runs out.

I Bonds as an 11-month investment

I rarely advise using I Bonds as a short-term investment, because the best strategy for I Bonds is to buy every year, hang on to them, and build a sizable allocation. Also, other short-term options (bank CDs or online savings accounts) often offer similar or even better returns. But that’s not the case now, with the best-in-nation CD rates dropping well below 1%.

OK, remember that the 11-month strategy is to purchase I Bonds near the last day of the month, and redeem them near the first day of the same month a year from now. You will get one year of returns in only 11 months.

If you buy in October, you will know exactly the return you will receive over the next year, because the fixed rate is 0.0% and we know both the current and next inflation-adjusted variable rate. You will receive a nominal return of 1.37%. If you redeem the I Bond in one year, your return drops to 0.95% because of the three-month interest penalty.

That return — 0.95% — is better than you are going to find with any other safe investment of this term.

But by waiting until November, you might be able to do better.

By waiting, you will earn an annualized return of 1.68% for six months, and then a new, unknown inflation-adjusted variable rate for the next six months. As the chart shows, the worst-case scenario is that inflation comes in at 0.0% for the October 2020 to March 2021 rate-setting period. If that happens, you will earn a nominal return of 0.84%, and the three-month interest penalty will be zero, because you earned zero interest in the last three months.

I’ve also included a “more likely” scenario, with inflation running at 0.50% from October to March, similar to what we saw from October 2019 to March 2020, when inflation ran at 0.53%. Under that scenario, your nominal return would be 1.09%, even after the three-month interest penalty.

My “even better” scenario has inflation running about 1.00% from October to March, which isn’t unreasonable. Then your total return would be 1.34%, even after the three-month penalty.

What if you already hit the 2020 purchase cap?

If that’s true, I am hoping you purchased I Bonds in January to April 2020, when the permanent fixed rate was 0.2%. That was a great move.

But in January, you will start a new year with a clean purchase cap, and you can use these same strategies — either buying I Bonds as a long-term investment (my recommendation) or as an 11-month investment, taking advantage of the attractive current terms.

The great thing about I Bond purchases is that after a year, you can decide to hold them or redeem them. You always have both options.

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.

Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.