The stock market has produced extremely strong long-term returns for investors who stick with stocks through thick and thin. Even the occasional bear market has left stock investors with returns that put most other asset classes to shame.
Nevertheless, rising interest rates have made other parts of the investing universe interesting again for the first time in years. Last year, the U.S. Treasury-guaranteed 9.62% annualized rate on Series I Savings Bonds breathed new life into the decades-old fixed-income investment. Even though those high rates are now history, there’s a possibility that the longer-term prospects for I Bonds could get even better in 2023.
How interest rates on I bonds work
I bonds have a trait that’s rare in the investment world: Their value is tied to the rate of inflation. When I bonds briefly paid investors a 9.62% annualized rate for the first six months after purchase, it was because the Consumer Price Index had gone up by 4.81% in the six-month measuring period that the Treasury used to determine the latest rate. Similarly, when the rate on those bonds subsequently falls to 6.48%, it’s because the rate of inflation eased lower to 3.24% in the six months following that prior measuring period.
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Yet it’s important to remember that when inflation isn’t a serious concern, the return on I bonds isn’t nearly as attractive. For instance, on I bonds issued in 2020 between May and October, the annualized rate of return was only 1.06%. Even lower inflation rates in mid-2016 led to a six-month period in which I bonds yielded just 0.26%. There has even been a period during which the CPI declined, and for that period, the Series I savings bonds offered no return at all.
Why I bonds could get better in 2023
Most economists are hopeful that inflationary pressures will subside in the coming year. That’s a big part of why the I bond rate fell by more than two percentage points in the most recent readjustment. If inflation gets back into the neighborhood of the Federal Reserve’s 2% long-term target, then I bond rates of 7% to 9% won’t be back.
Yet focusing too much on the nominal interest rate that I bonds pay missed the point of owning them. The primary purpose of I bonds is to guarantee preservation of purchasing power, potentially with a slight amount of additional return on top. In the most recent readjustment of I bond rates, investors got good news, because I bonds issued between November 2022 and April 2023 will include a fixed rate component of 0.4%. That will give long-term investors a return equal to 0.4 percentage points above whatever the inflation rate ends up being between when you purchase your I bond and when you redeem it.
There’s reason to believe that the 0.4% fixed rate in I bonds could go even higher in 2023. Currently, the real interest rate on five-year Treasury Inflation Protected Securities (TIPS) is above 1.5%. Although the U.S. Treasury doesn’t typically match what TIPS investors receive when it sets its fixed rate on I bonds, the move in November to take the fixed rate from its previous level of 0% and raise it to 0.4% was partially in response to TIPS rates going from negative to positive during the preceding six-month period.
What to do
At this point, I bond investors are in a bit of a quandary. Buy between now and April, and you get can an initial rate of 6.89%, including both the inflation adjustment and the 0.4% fixed rate. Wait until May, and you’ll miss out on the initial six months of 6.89% returns. However, the fixed rate might rise, giving you superior returns over the entire life of the savings bond.
The right decision depends on your goals. If you just want to use I bonds as a short-term savings vehicle, then capitalizing on the 6.89% rate immediately makes a lot of sense. However, if you intend to hold your I bonds longer as an inflation hedge, then it’s worth considering whether you want to roll the dice and hold off on your I bond purchases until later in 2023.
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