How To Improve The Yield On Your I Bond

You may be buying the wrong kind of inflation bonds. Here are two ways to get the good stuff.

Inflation Bond: the ultimate protection against rising costs of living. If you know what you’re doing, you can get a real yield of 1.9% on these US Treasuries. If you don’t, you get a lousy deal, a bond that pays 0%.

Why on earth would people buy a 0% bond when the 1.9% alternative is right at hand? Because they follow the advice of naïve financial commentators.

The naive love I-bonds. These are savings bonds that reflect the cost of living. There are downsides: they have a $10,000 per year purchase limit, they have early repayment restrictions, and they can’t be funded into a brokerage account.

The worst thing is that I-Bonds have a real yield of 0%. Your interest consists of a Nothingburger return plus an adjustment for inflation. You are balanced in purchasing power.

Smart money is flowing into the other type of inflation-adjusted government bonds called TIPS (Treasury Inflation Protected Security). TIPS have no buy limit, no constraint on your ability to exit early, and no issues accessing your brokerage account.

Best of all, TIPS have a positive real rate of return. Those due in five years pay 1.92% annually. You gain 9.6% in purchasing power over the five years.

I can forgive the pundits who were still gushing about I-Bonds back in January. At that time, the five-year TIPS had a real yield of -1.6%. At 0% for real yield, the I-Bond was clearly the better buy, barring the inconveniences that come with getting and holding the thing.

Since then there has been a Bond crash. Yields on marketable bonds have skyrocketed. The I-Bond yield hasn’t moved. There’s no excuse for recommending an I-Bond buy today.

I-Bonds can be held for 30 years, after which they no longer earn interest. You cannot redeem them in the first year. In years two through four, a repayment carries a penalty of three months of inflation adjustment. After the five years you can redeem at any time and receive your full 0% return (ie full compensation for inflation).

Where do you get these TIPS? You have two choices. One is to own a bond. The other is to own a retirement fund. There are pros and cons to each.

For the bond, arrange with your bank or broker to make a non-competitive bid at the next five-year TIPS auction just before the deadline. The Treasury Department’s tentative schedule, due to be finalized on October 13, calls for the auction to take place on October 20.

At Fidelity Investments there are no fees for an online auction order; The maximum purchase is $5 million. Other financial institutions have similar offers.

TIPS yields could rise or fall over the next two weeks. If they go up, hooray. If they go down badly, you can choose not to participate.

By holding this bond to maturity, you can rest assured that you will receive the redemption rate at auction. If you make money early by selling in the secondary market, you could expect either a windfall capital gain or a windfall loss, depending on whether interest rates are falling or rising. It’s a fair bet, but selling it would mean getting swiped by a bond dealer paying a little less than the bond is worth. I wouldn’t recommend buying bonds outright unless there’s a pretty good chance you can last five years.

The alternative is owning shares in a TIPS bond fund. Two I like are these Schwab US TIPS ETF (Ticker: SCHPExpense ratio 0.04%) and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP, 0.04%). The Schwab fund has bonds with an average remaining term of 7.4 years; The average maturity of the Vanguard portfolio is 2.6 years. A 50:50 mix of the two funds would give you the same interest rate excitement as a single bond maturing in five years.

The advantage of the funds is that they are very liquid. The discount from the trade is typically a penny per share (that’s the bid-ask spread), a tiny percentage of a $50 stock.

The downside of the funds is that there’s no telling what actual return you’ll see by October 2027. The funds continually redistribute proceeds from maturing bonds into new bonds. The portfolios never mature.

That means you could end up doing better or worse with the funds than with a single bond that matures in five years. It depends on which path interest rates take. Again, it’s a fair bet, but you might not like that kind of uncertainty.

I’ll now address two alleged advantages of I-Bonds: that you can’t lose money and that you can defer taxes on the interest.

Can’t lose? Just in the sense that an ostrich can’t lose with its head in the sand. Savings bonds are not valued at market value. You can’t see your loss.

Buy a $10,000 I-Bond today and you’ll be instantly poorer. If you plan to stay for five years, your investment should now be worth $9,100. That’s all your future US Treasury claim is worth given where TIPS yields are. If you have the sanity to get out as soon as possible (12 months from now), then the damage is less, but it’s still damage.

The other supposed benefit of I-Bonds is the deferral of income tax on inflation adjustment. This isn’t the gold mine you might think. Our current tax law expires at the end of 2025. After that, tax rates go up.

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