I-bonds in 2023? Check my decision math

[ChpBstrd]

6.89% is a very good risk-free rate, so I've been thinking about buying I-bonds in January. I've even pondered sending a tax overpayment to the IRS so that I could buy an additional $5k with my refund (for a total of $15k per person x 2).

The Dilemma
Markets expect a recession to start in 2023, and usually these bring rapidly falling inflation. Thus I expect the interest rate on I-bonds to fall throughout 2023 and 2024 until we reach a point where there are more attractive opportunities elsewhere. I must pay my last 3 months of interest to exit my I-bonds, which is maybe not as bad as it sounds if the bonds are not earning much interest at the time I cash out.*

On the other hand, one could argue that if I'm expecting falling interest rates, then I'd be better off locking in a rate with a nominal bond. If I went longer-duration, a nominal bond could appreciate as interest rates fell, or provide years of above-market yield. Moreover, if I spent a couple years in an I-bond, I might end up with a low-yielding I-bond and a market full of low-yielding alternative investments.

What's needed is a financial model where I can input my forecasts and receive an equivalent nominal yield.

The Question:
Given the forecast below, what is the equivalent yield I could have earned in a nominal bond?

Variables:

Jan'23 - April'23 interest rate: 6.89%
May'23 - Oct'23 interest rate (est): 5%
Nov'23 - April'24 interest rate (est): 3%
Rate at which I'd cash out rather than hold: 3.75%

So in this specific forecast, I would read in Nov'23 that my new rate was 3%, then would wait 3 months and exit the position in Jan'24. I'd therefore give up 3 months of interest at 3%**. The duration of the investment would be 13 months. Different forecasts or minimum rates would output a different duration.

Method
There are 3 distinct periods when interest is paid at different rates: 6.89% for 4 months, 5% for 6 months, and 0% for the last 3 months because interest is forfeited. Interest from the previous period is added to the principal at the beginning of each new period. Rates are quoted on an annualized basis, so the interest earned is pro-rated for the number of months that rate is earned. The time@rate column represents the percentage of a year that the annualized rate is applicable for. The amount of interest earned is balance*rate*time@rate.

Results
           Time @ Rate   Balance   Rate             Int. Pmt. Reinvested
Period 1   0.33~           $10,000    6.89%       $229.67
Period 2   0.5                $10,230    5%            $255.74
Period 3   0.25              $10,485    0%            $-   

In the end, after 13 months I'd end up with 4.85% more than I started with (4.48% annualized). Based on this math, I'd be slightly better off in one-year treasuries, which yielded 4.61% on Friday.

Check my math and assumptions. Do you get the same result that I-bonds are nothing to get excited about any more?

Discussion:
For those who bought I-bonds when the yield was >9%, this same method could be used to decide when it's time to exit.

Footnotes:
*In a strategic sense, a seller of I-bonds also gives up the opportunity to build a large I-bond hedge against inflation, accumulated over multiple years. I will ignore this argument for the sake of simplicity, and assume I do nothing but chase the best deals on stocks or bonds at any given time. But there is a case to be made that people should build up an inflation hedge as part of their AA instead of hopping in and out of small denominations of I-bonds during periods of inflation. A seller of I-bonds would also lose the option value of the I-bonds becoming a lotto ticket in the event of a prolonged and out-of-control period of inflation.

**You may be wondering what if the behavior was to exit the I-bonds on Oct 31, 2023 after hearing the new rates would be 3% instead of waiting until Jan 31, 2024? Then the annualized return for my 10 month holding period would be 4.29% because I'd give up 3 months of yield at the 5% rate and shorten the holding period to make those 3 zeroes a bigger proportion of the annualized average.

[EchoStache]

Possible correction in your math.  The initial rate you get on Ibonds will be a full 6 months at whatever rate is in place when you make the purchase.  So the date of *your* rate changes will lag the date that the rate is changed, but you will always get each rate for the full 6 months other than when you sell.

[NotJen]

**You may be wondering what if the behavior was to exit the I-bonds on Oct 31, 2023 after hearing the new rates would be 3% instead of waiting until Jan 31, 2024? Then the annualized return for my 10 month holding period would be 4.29% because I'd give up 3 months of yield at the 5% rate and shorten the holding period to make those 3 zeroes a bigger proportion of the annualized average.

You can’t sell before 1 year.

[ChpBstrd]

Possible correction in your math.  The initial rate you get on Ibonds will be a full 6 months at whatever rate is in place when you make the purchase.  So the date of *your* rate changes will lag the date that the rate is changed, but you will always get each rate for the full 6 months other than when you sell.

I checked this out and you are correct @UltraStache ! That does change the math. Now it looks like this for a 15-month holding period:

           Time @ Rate   Balance   Rate            Int. Pmt. Reinvested
Period 1   0.5                   $10,000    6.89%    $344.50
Period 2   0.5                   $10,345    5%            $258.61
Period 3   0.25                   $10,603    0%            $-   

A yield of 6.03% divided by 15/12 is a roughly annualized return of 4.824%. If I cashed out at the 12 month mark, giving up 3 months interest at the 5% rate, my annual return would be 4.74%. That's pretty close to what a bank CD would pay, though the I-bond is exempt from state taxes.

**You may be wondering what if the behavior was to exit the I-bonds on Oct 31, 2023 after hearing the new rates would be 3% instead of waiting until Jan 31, 2024? Then the annualized return for my 10 month holding period would be 4.29% because I'd give up 3 months of yield at the 5% rate and shorten the holding period to make those 3 zeroes a bigger proportion of the annualized average.

You can’t sell before 1 year.

Correct @NotJen . So much for that footnote!

I knew in the back of my mind there were some errors in my process. The rules around I-bonds are so unique it's hard to shift gears that way.

[chillyphilly]

Thanks for posting this, I have been pondering the same thing. After maxing out the family’s I Bonds this year, I had originally planned on purchasing more in Jan ‘23. I, too, am coming to the same conclusion: with falling interest rates and forfeiting 3 months interest on the backend, one could do just as well (and possibly better) by shifting to Treasuries. I had considered CD’s, but with Treasuries yielding about the same interest, plus being exempt from state and local taxes, I am thinking Treasuries are where it is at short term.

[MustacheAndaHalf]

ChpBstrd - in another thread you mentioned ZROZ.  For those not familiar, it is a "zero coupon" bond ETF, where the bonds do not pay interest.  Instead, the bond is bought at a discount, and pays the face value at maturity.  If a 30 year zero coupon bond effectively pays out 5% interest at the end, that is 30 years at 5%.

Your goal is to exit I bonds when interest rates fall far enough.  Yet when interest rates fall, ZROZ has bonds at the old rate, and makes a big profit off the drop.  As an alternative to I bonds, have you considered ZROZ or buying zero coupon bonds?

ZROZ has a distribution yield of 2.6%.  ZROZ is also the riskiest bond investment I know about - it has lost 35% YTD, and had lost more before it started to recover.
https://www.pimco.com/en-us/investments/etf/25-year-zero-coupon-us-treasury-index-exchange-traded-fund

[blue_green_sparks]

Probably won't be buying I-bonds this next year but I do have a few in gift baskets. I hope I understand correctly; the 1 year holding period starts the month of purchase, so no big rush to get them delivered.

[Mariposa]

For I-bonds, you can also wait until late April, when inflation data is in, and the next 6 months' interest rate is known. We bought a set of gift I-bonds in late October, at 9.62% for 6 months and 6.49% (fixed rate of 0%) for the next 6 months.

With the gift option, we bought a total of $80k I-bonds within our family to take advantage of the 9.62% rate. I-bonds was the entirety of our bond contribution this year. I looked a little into the tax refund option but decided I couldn't deal with paper bonds.

Until April, you could keep your cash in VMFXX, which has a yield of about 4% (and going up) & is completely liquid.

[hdatontodo]

Probably won't be buying I-bonds this next year but I do have a few in gift baskets. I hope I understand correctly; the 1 year holding period starts the month of purchase, so no big rush to get them delivered.

I am going to give my minor son's to him as soon as possible in Jan so there are no estate / paperwork issues if something happens to me. I imagine it would be a headache to handle.

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[ChpBstrd]

ChpBstrd - in another thread you mentioned ZROZ.  For those not familiar, it is a "zero coupon" bond ETF, where the bonds do not pay interest.  Instead, the bond is bought at a discount, and pays the face value at maturity.  If a 30 year zero coupon bond effectively pays out 5% interest at the end, that is 30 years at 5%.

Your goal is to exit I bonds when interest rates fall far enough.  Yet when interest rates fall, ZROZ has bonds at the old rate, and makes a big profit off the drop.  As an alternative to I bonds, have you considered ZROZ or buying zero coupon bonds?

ZROZ has a distribution yield of 2.6%.  ZROZ is also the riskiest bond investment I know about - it has lost 35% YTD, and had lost more before it started to recover.
https://www.pimco.com/en-us/investments/etf/25-year-zero-coupon-us-treasury-index-exchange-traded-fund

ZROZ is worth considering as a speculative play for those expecting a disinflationary recession. It’s one of the few bond funds that can move 20%+! Unfortunately its options market is not very liquid and doesn’t go out past about 7 mos, so the only real choice is probably to own it.

The thing blocking me from going further with this idea is that I don’t have a clue what a post-inversion yield curve looks like, especially on the very long-duration end where ZROZ lives. It depends on whether or how much the Fed cuts short rates, but it especially depends on the steepness of that future yield curve. Will it be 2019 all over again or will it be more historically normal? I have no good reasons to believe anything about it, but I’m interested in hearing others’ thoughts.

According to NASDAQ, the 25-30y zeroes that ZROZ plays with are yielding about 3.7%. Buying these is a very bold bet that inflation will never be a problem again. That steamroller crushed a lot of penny-pickers in 2022.

[Scandium]

Markets expect a recession to start in 2023, and usually these bring rapidly falling inflation.

Isn't this the big IF in your calculation? Because if "the market" expects say a 30% drop in 2023, everyone would sell off at 30% now. Basically if a recession is guarantied I don't see how it wouldn't happen already? So when it's reported that "everyone" expect a recession, I don't believe it.. Likewise, if there is a 50% chance of a 30% drop, then the market would drop 15% now. Thus the risk * amount of market downturn should already be priced in. If we assume anything above room temperature IQ of (active) market participant this should be the case (I guess there's always the alternative..)

[wageslave23]

Just to add perspective, we are talking about $700 interest after locking up $10k for a year. Then subtracting about $100 for withdrawing the money. And paying taxes on the remaining $600. I wouldn't spend much time analyzing it. Just put the money in a high yield savings account or money market at 3% until your predicted recession comes to pass and there are better stock buying opportunities.

[ChpBstrd]

Markets expect a recession to start in 2023, and usually these bring rapidly falling inflation.

Isn't this the big IF in your calculation? Because if "the market" expects say a 30% drop in 2023, everyone would sell off at 30% now. Basically if a recession is guarantied I don't see how it wouldn't happen already? So when it's reported that "everyone" expect a recession, I don't believe it.. Likewise, if there is a 50% chance of a 30% drop, then the market would drop 15% now. Thus the risk * amount of market downturn should already be priced in. If we assume anything above room temperature IQ of (active) market participant this should be the case (I guess there's always the alternative..)

Different markets are expecting different things. The stock market is expecting no recession, or a recession so mild it barely makes the cut, or else the PE ratio wouldn't be >20. Bond markets, like the nominal treasury versus TIPS market, appear to be expecting an event that would cause a rapid collapse in inflation. The inversions of the yield curve communicate an expectation that rates will be cut soon ... because... why else?

Maybe I'm inferring a lot from prices, and other scenarios are possible, but NLY might not have a dividend yield of 16.5% if a lot of market participants weren't expecting there to be a lot of mortgage defaults soon.

[Finances_With_Purpose]

You're overthinking this--and this is from someone who overthinks things. 

With i-bonds, the penalty after 1 year is simply giving back 3 months' interest.  That's trivial on the whole, so once the rate slips a little below your target (or gets just above it), let the bonds go.  You know you're getting 6.89%, so the average (set in May I think) would have to be almost zero to be below your first-year rate. 

So you're set for year 1, and then you can ditch it any time afterwards at no significant loss depending upon what rates do (or even if your ambient rate that you want to pull out at changes). 

Problem solved: no tough decisions or hard math needed. 

[The Hin]

I have an i-bond gift question: i bought $10K last April, stored in the TreasuryDirect Gift basket, so its Current Value is $10,356. Can I give that entire amount to the recipient this year without running afoul of the $10K per year per person i-bond limit? I suppose the safe thing to do would be to split up the transfer between 2023 and 2024.

[effigy98]

I like how I-bonds feel locked up. Keeps me from worrying about them. And I have little faith in the government to stop expanding like a plague and buy votes so inflation will continue over the next decade even if it slows down temporarily. I also think this is the long term plan of central banks to inflate the debt away, it is just they got noticed by the general voting population so have to slow the debasement down temporarily until the voters stop noticing again.

[iluvzbeach]

I have an i-bond gift question: i bought $10K last April, stored in the TreasuryDirect Gift basket, so its Current Value is $10,356. Can I give that entire amount to the recipient this year without running afoul of the $10K per year per person i-bond limit? I suppose the safe thing to do would be to split up the transfer between 2023 and 2024.

Yes, you give the entire bond to the recipient this year.  The interest earned thus far doesn't matter, just the initial purchase price.  In fact, I'm pretty sure you can't even give them anything other than the full bond + interest.

[blue_green_sparks]

In between the mandatory 1-year holding period and the 5-year no penalty period, the bond's valuation you see in your account is what you will get if you cash out that day. On the day your 5-year period is achieved, they simply add the last three months of interest to your bond's valuation.

[Finances_With_Purpose]

In between the mandatory 1-year holding period and the 5-year no penalty period, the bond's valuation you see in your account is what you will get if you cash out that day. On the day your 5-year period is achieved, they simply add the last three months of interest to your bond's valuation.

That's good to know. 

[Sanitary Stache]

Hi. I’m chiming in late but also maybe a good time to be thinking about I bonds. I am ready to buy some primarily to hold cash for more than a year but less than five.

I see buying late April is recommended because we have an idea of what the may inflation adjustment will be. Does anyone know what to expect for the may change? I am pretty on board with buying I bonds regardless but would like to know what to watch.

Also I am buying through treasury direct. I assume this is the only place to buy I bonds?

[McStache]

This is where I keep an eye on I body inflation and speculation: https://tipswatch.com/tracking-inflation-and-i-bonds/

[jpdx]

It looks like I Bonds will have around a 3.79% composite rate for the next six months.

[Finances_With_Purpose]

It looks like I Bonds will have around a 3.79% composite rate for the next six months.

Yep.  The good times are over.  At least for i-bonds.  I'm selling mine three months after that rate kicks in.