A new year brings a new quota for I Bonds. In the past few years buying the full quota was part of my ritual in January. That’s $10,000 for me, $10,000 for my wife, and another $5,000 from tax refunds later in April. You can also buy more for trusts if you have them.
The reason for the enthusiasm was that I Bonds at 0% fixed rate plus inflation were a much better deal than TIPS at negative real yields. Yields on 5-year TIPS were as low as -1.5%. Now that PenFed Credit Union extended the 3% rate on 5-year CDs to January, I’m not so sure whether I should still buy I Bonds as usual or just buy more 3% CDs from PenFed.
I Bonds bought now pay 1.38% composite rate for the first six months, and then 0.2% plus inflation afterwards.
Compared with CDs, I Bonds still have some small advantages:
- tax deferral
- no state income tax
- low early withdrawal penalty
- tax free if used on higher education, subject to income limit
These advantages are very small to me. Tax deferral doesn’t add much when the composite rate is below 2%. The same for no state income tax. You are not paying much tax when you are not earning much interest to begin with.
If I need cash I can draw from other sources. The tax free treatment when used on higher education can be more easily obtained by contributing to a 529 plan. No income limit there.
The large factor is of course the rate. For I Bonds, that’s driven by future inflation. What will inflation be in the next five years? No one knows. We can look at estimates though.
TIPS-Treasury Breakeven Rate
According to US Treasury, 5-year nominal Treasury yield is 1.73%. 5-year TIPS yield is 0.04%. The 1.7% difference is more or less the market’s expectation for inflation in the next five years, plus or minus small factors for inflation risk premium and nominal Treasury liquidity premium.
Cleveland Fed Estimate
Federal Reserve Bank of Cleveland publishes estimates for inflation expectations every month. It uses
a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the “break-even” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates.
The web page only shows the 10-year estimate. The linked spreadsheet at the bottom of the page shows the 5-year estimate (column F). That number is 1.6% in the latest estimates.
I Bonds Composite Rate
I’m not going to quibble whether the inflation expectation should be 1.6% or 1.7%. Add 0.2% fixed rate, I will call it 2%. That would be the best estimate for the average annual composite rate on I Bonds in the next five years at this moment. After all, what do I know about inflation that the market doesn’t know?
If I buy I Bonds now, versus PenFed CDs, I would expect to give up 1% a year for inflation protection. Inflation protection is important, but it’s not worth 1% a year in the current environment.
I decided to break my ritual and not buy I Bonds this month. Actually I’m going to redeem my 0% fixed rate I Bonds bought in previous years and put them in PenFed CDs.
Note I’m treating I Bonds and PenFed CDs as long-term holdings. If you just want to park some money for a year or two or have a cash reserve, I Bonds are still good.
[Photo: paper I Bond from my own collection.]
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