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 made other parts of the investment universe attractive again for the first time in years. Last year, the 9.62% annualized rate guaranteed by the US Treasury on Series I Savings Bonds breathed new life into decades-old fixed income investing. Even if these high rates are now a thing of the past, it is possible that the longer-term outlook for I Bonds will improve further in 2023.
How I Bond Interest Rates Work
I bonds have a rare feature in the investment world: their value is tied to the rate of inflation. When I bonds briefly paid investors an annualized rate of 9.62% for the first six months after purchase, it was because the consumer price index rose 4.81% during the six-month measurement period that the Treasury used to determine the latest rate. Similarly, when the rate on these bonds subsequently falls to 6.48%, it is because the inflation rate has fallen to 3.24% in the six months following that previous measurement period.
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Still, it’s important to remember that when inflation isn’t a serious concern, the yield on I bonds isn’t as attractive. For example, 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 returned just 0.26%. There was even a period when the CPI went down, and during that period the Series I Savings Bonds offered no return.
Why I bonds could improve in 2023
Most economists hope that inflationary pressures will ease over the coming year. This is largely the reason why the I bond rate fell more than two percentage points in the last readjustment. If inflation returns to the vicinity of the Federal Reserve’s long-term 2% target, then I bond rates of 7% to 9% will not return.
Yet focusing too much on the nominal interest rate that bonds pay has missed the point of owning them. The main objective of I-bonds is to guarantee the preservation of purchasing power, possibly with a small additional return on top. During the last I Bond rate reset, investors received good news, as I Bonds issued between November 2022 and April 2023 will include a fixed rate component of 0.4%. This will give long-term investors a return equal to 0.4 percentage points above the rate of inflation between the time you buy your I bond and the time you redeem it.
There is reason to believe that the 0.4% fixed I bond rate could rise further in 2023. Currently, the real interest rate on five-year Treasury Inflation-Protected Securities (TIPS) is greater than 1.5%. Although the US Treasury is generally not what TIPS investors receive when it sets its fixed rate on I bonds, the decision in November to remove the fixed rate from its previous level of 0% and raise it to 0.4% was partly in response to TIPS rates going from negative to positive in the prior half year.
What to do
At this point, bond investors are in a bit of a bind. Buy between today and April and you get an initial rate of 6.89%, including both the inflation adjustment and the fixed rate of 0.4%. Wait until May and you’ll miss the first six months of 6.89% returns. However, the fixed rate can rise, giving you higher returns over the 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, capitalizing on the 6.89% rate immediately makes sense. However, if you intend to hold onto your I bonds longer as an inflation hedge, it’s worth considering whether you want to roll the dice and postpone your I bond purchases until later in 2023. .
