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I-Bonds: Get Your “Free Lunch” While It’s Hot!

Just a Couple Weeks Left!

October is the final month to take advantage of a 9.62% annualized rate for six months by purchasing “Series I Savings Bonds” (or “I-Bonds”) from the U.S. Treasury. Basic facts on I-Bonds and information on how to purchase them are in our very first article from back in May (which is also the month the 9.62% rate was introduced).

With the September Consumer Price Index (CPI) figures having posted today, the new inflation-linked rate for I-Bonds will be about 6.47%. An investor who buys I-Bonds in October will receive 9.62%/2 = 4.81% for the first six months and 6.47%/2 = 3.24% for the second six months, or approximately 8.2%[1] overall in the first year.

Any I-Bonds purchased starting in November will get the new 6.47% rate for the first six months and then a rate derived from October 2022 through March 2023 inflation. Consequently, given the Fed’s aggressive stance against inflation, I-Bonds are likely much more attractive if purchased in the next couple weeks than they will be thereafter.

Okay, that’s the gist of this article, and the reason for the “Basic Reading” ranking. But I can’t resist adding a…

Superfluous Nerdy Afterword

As we discussed in this article, to the extent I-Bonds can be viewed as a “free lunch,” it is because they are direct contracts between the buyer and the government, rather than market-traded securities. One of the ways this benefit manifests itself is that the lag between actual inflation and inflation-linked I-Bond interest accruals creates “optionality.”

Optionality is a fancy financial term that, at its most basic, refers to having the ability to choose whether to do something (e.g., make an investment) only after it has become clear whether doing so will work out. The most obvious example in finance is a vehicle that is uncreatively but sensibly called an “option.” An option, in effect, allows the buyer to purchase an “underlying” investment (a stock, a commodity, etc.) if it subsequently goes up, but not if it goes down. Or alternatively, to sell if it goes down but not if it goes up.[2]

This may sound too good to be true, but there’s a catch: An investor must pay in advance for the privilege of this optionality. And in an efficient market, the price that is charged is such that the amount made on the option minus the amount paid upfront will be negative in expectation. (I.e., across the range of possible outcomes, the average outcome for an option buyer is a loss, which makes sense because the seller is taking risk away from the buyer and wants to be compensated for doing so.)[3]

But with I-Bonds, the government offers almost-free optionality, by paying out an inflation rate that has already occurred, with a significant lag. As we noted in this article, folks who buy I-Bonds in the next few weeks will still be accruing an interest rate next March that derives from inflation measurements stretching all the way back to last October, eighteen months prior! This also means an investor can get a read on a full twelve months of inflation (October 2021 through September 2022) before deciding whether to purchase I-Bonds to accrue those twelve months of inflation as interest. Although as noted, this leaves you just a couple weeks to decide.

Note I said “almost-free” optionality. There are three big caveats. First, if someone decides to buy, they are locked in for a year. Second, if they redeem any time within five years, they sacrifice the last three months’ worth of interest accruals. Where this could theoretically go mildly awry is if—heaven forbid!—inflation spikes up even higher over the next twelve months or so and the investor needs the money before the new rate kicks in. In that case, it will turn out they could have done better in one-year-ish TIPS, since (A) they would not lose the last three months of interest and (B) TIPS are now paying meaningfully positive real interest rates, whereas the “fixed rate” on I-Bonds is still 0%. (And yes, I’m frantically straining to create a scenario where the “almost” makes a difference, given the huge value of the optionality at present.)

And what if things go the other way? What if the Fed has their way and inflation drops ever so muchly? Well in that case, an investor who can hang on for fifteen months will get the full 8.2%ish for the next twelve months and will only sacrifice the muchly lesser inflation-linked interest in the final three of those fifteen months. And then they can roll their merry way into TIPS or any other investment, depending on whether they care about inflation protection or merely liked the ridiculously high government-guaranteed interest rate. In other words, the ability to sell before accruing known low inflation is valuable optionality just as surely as is the ability to buy before accruing known high inflation.

Oh, but about that third caveat? The strict limits on I-Bond purchases still apply. So the lovely optionality the government is handing out for almost-free is only available in limited quantities.

[1] 8.2% is a bit higher than 4.81% + 3.24%. This is because I-Bond interest capitalizes/compounds after the first six months, so the math looks like: (1 + 4.81%) * (1 + 3.24%) – 1 ≈ 8.2%. Notably, inflation itself also compounds, and the total rate of inflation from October 2022 through September 2023 was also about 8.2%, as you can see on any news site today.

[2] Yes, I know options are not really that simple. (Though at-the-money, deliverable, European options on an underlying without a dividend basically are.)

[3] For what it’s worth, an investor can also be the seller of options. On average, this is a winning strategy…but as rational risk/return theory would imply, that is because it is risky. In particular, the potential gain for an options seller is limited to the original sales price (or “premium”), whereas the potential loss may be unlimited.

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