A Fond Goodbye To I Bonds While Examining The Role They Actually Play In A Portfolio

seekingalpha04-21

Purchasing an I Bond before the May 1 reset assures a 4.77% return based on a combined fixed rate of 1.3% and the known inflation contribution.I Bonds have served me well since my first purchases in ...

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They also offer deflation protection, a solid return when the Fed suppresses all other rates, and a chance to defer taxes.Quirky advantages like avoiding \"phantom\" taxes and paying future taxes in depreciated dollars make I Bonds superior to TIPS.I Bonds are in essence a separate asset class that diversifies and serves a portfolio in many ways.   DNY59After much thought, I'm going to buy one more I Bond before the end of the month. That will be it for me. I'm not selling, never have, but no more buying either. I'm standing pat. In 2030, my first I Bond purchases will start rolling off. I'll turn 86 that year. The last to roll off will be in 2054, and I will probably have to leave it to others to handle it. My future heirs will get a one-page set of instructions, while there is plenty of time for them to ask me follow-up questions and for me to respond with answers which still make sense. Over the next two years, I will have my stepson \"Deliver\" the two $10K Gift Box Bonds I had him buy for me. At the same time, I will \"Deliver\" the Gift Box Bonds I bought for him. It feels a bit like saying a fond goodbye to old friends. What tipped the scales for one more I Bond buy was the present 1.3% permanent fixed rate as well as the assured one-year inflation numbers, 3.94% for April through September 2023 and 2.94% for October 2023. through March 2024. March, the last of six monthly CPI numbers, was just reported on Wednesday, April 10. Combining the fixed rate of 1.3%, the first six months of an April purchase produces a 5.27% annualized return (the small difference from the inflation number being due to monthly compounding). The next six months will produce a 4.27% annualized return. The combined annualized return is 4.77% for the full-year ending in March 2025. That's a bit less than the one year T-Bill yield of 5.18%, but it comes with other virtues. Having all the above information is like being able to buy (or not buy) an ETF or stock index at its year-ago price with assurance of receiving its return for the past year. This 100% visibility of the first year's return is one of several quirks in the way I Bonds work which set them apart from other investments. All the small details in the way I Bonds operate are very favorable to the investor. Before deciding whether to buy or not buy, you should make a strong effort to understand the workings of these quirky little details. The above numbers should be sufficient to enable you to decide whether you wish to buy before the upcoming I Bond reset on May 1, or whether you want to buy it at all. I don't have a strong opinion as to whether the fixed rate will go up or down slightly, but my personal preference is to buy before the end of April, ideally several days before so that there is no risk of your purchase sliding into May. The present numbers are good enough. I Bonds Understood In A Larger Context I Bonds have served me well over the years since my first purchase made in 2000. My source of funds was the sale of a few stocks as I realized that everything was likely to be dragged down by the inevitable approaching crash of the dot-com market. The permanent fixed rate at the time was 3.6%, the highest it would ever be, much too high, as the Treasury quickly realized. I Bonds looked like a good place to hide from a market crash, and were they ever! My initial I Bonds bought in October 2000 have more than quadrupled in value to $42,028 for each $10K bond. The limit then was $30,000 annually as against $10K currently plus an additional $5K as part of your tax refund. I went all in. They enjoyed a second moment of glory in 2022 as inflation reached 9.1% and those first I Bonds were yielding just under 13%. Over the entire not quite 24 years that initial I Bond investment has yielded well over 6%, not quite the expectation for stocks but better than ordinary bonds. They were thus fully present when their role as an insurance policy against inflation came to its crisis moment, and I could congratulate myself on having had foresight. Was it really foresight? In truth, all I did was to jump all over a good thing when I saw it. The bigger and tougher question is whether I Bonds can really amount to a form of insurance which protects you against inflation? In honesty, they had no impact whatever on the way inflation played out for me. To do so, I would have had to sell an I Bond to realize the cash. I wasn't about to reduce a major fixed income asset for walking around money. What I realized was that I Bonds were not so much inflation protection as a separate asset class. What they did was provide a small fixed income anchor to my portfolio, which at that point was just stocks and cash in money market funds. Owning I Bonds made me feel diversified, albeit in a somewhat eccentric way that no other asset class did. Although I still used the term \"inflation insurance\" in several articles introducing I Bonds to newcomers, I continued to rethink the implications of their broader impact on my portfolio. They were a great new thing to invest in, but not exactly the great new thing everyone, myself included, had thought they were. I kept buying them and putting them away, but in my view they belonged to a new and different category within my portfolio. After 2000, I have continued to buy I Bonds every year despite the fact that the Treasury realized its early rates had been too generous and trimmed them severely. From time to time, I did a little arithmetic on how my overall I Bond portfolio was actually doing. Those first bonds from 2000 and a couple of following years kept growing into such a large position that the lower yielding additions up to the $10K annual limit were very slow to pull down the aggregate yield. By 2010 every time I checked the total portfolio yield continued to exceed 2%. On the one hand, I was just paying up a bit for an insurance policy that still had plenty of time to come into play. On the other hand, it was like adding to a position in NVIDIA (NVDA) which I had originally bought at a cheap price (I hadn't, alas). Nvidia, of course, has an entirely different purpose in a portfolio with much higher risks and potential returns. Starting in 2008 with the Mortgage Backed Securities Crash a new phenomenon appeared with I Bonds. In full pants-wetting mode the Federal Reserve stepped on Treasury rates and continued to suppress rates for a decade and a half. Tough luck for retirees and income investors, eh? No need to buy any more I Bonds, right? However, I decided to take another look at some simple math. No retirees or other income investors liked the Fed's suppression of rates on safe investments, but it turned out that I Bonds actually produced a decent return. It had nothing to do with the fixed rate. Between 2008 and 2022 sixteen of the annual fixed rate resets were at exactly zero - that's half the time - and the other 16 fixed rate resets averaged $0.25 (that's a quarter, the price of a haircut in my childhood) with no reset above $0.50. Inflation averaged a bit above 2%. That was 2% more than the Federal Reserve was allowing you to enjoy from short-term Treasuries. This continued until fiscal and monetary policy simultaneously went wild with the pandemic and serious inflation (surprise! surprise!) came back with a vengeance. I Bonds were ready for that too. It became increasingly clear to me that I Bonds were not simply an insurance policy against inflation. Between 2008 and 2022 they actually turned inflation into an ally, using it as the source of a decent safe return when all other sources of safe return were being suppressed by the Fed. I had empathy for the many investors who were forced to seek income by going further out on the risk curve. When actual significant inflation returned with numbers that got everybody's attention, I Bond investors again looked at inflation with a combination of concern and pleasure as their I Bond portfolios cashed in on inflation big time. The huge rush to buy I Bonds which backed up Treasury processing for days in 2022 had much to do with investors seeking excellent short and medium term returns that beat T Bills. I Bonds served as a great place to park cash. My I Bond articles suddenly attracted tens of thousands of readers. They were interested in the hot new thing. As for using them to counteract the rising cost of living, I never considered selling an I Bond to rescue me from the rising CPI, nor did I hear from any others who did so. In practical terms I Bonds did not serve as protection from inflation at all aside from making you feel good. What consumers actually did included things like going out to dinner less frequently as restaurant prices doubled, or at least (as I did) going to restaurants with better value. I noticed that fine dining restaurants substituted inferior versions of ingredients (canned tuna for a Nicoise salad?). I struck those restaurants from my list. I became a pioneer of opting out of absurd tip suggestions. Inflation was their problem, not mine. I Bonds had nothing to do with it. What were I Bonds for? The incredible rush to I Bonds around the peak in June 2022 when the inflation rate was 4.81% made it clear that I Bonds weren't and had never been what we thought they were. That kind of search for short-term yield has never been my game, but it reinforced the view that with I Bonds inflation can actually be your friend. So what are I Bonds for? For the several years when ordinary Treasuries of all durations paid so little that I wouldn't buy them as a matter of principle, my I Bond portfolio became my one minuscule fixed income position. It was in effect its own asset class. I Bonds Versus TIPS, And The Winner Is.... Inflation protected bonds were created in 1997 as a response to requests by bond investors who lived with the memory of what inflation had done to both stocks and bonds during the 1970s. Thanks to the late great Daniel Kahneman, we know that recent events have disproportionate impact on investor thinking. For more than fifty years, the 1970s inflation has been the most recent huge and extended event to afflict the markets. TIPS were aimed at large and institutional investors, who would presumably be able to deal with their complexities. I Bonds were created in 1998 as the poor man's inflation-protection vehicle and came with a number of highly specific rules, simple enough that once you master them, dealing with I Bonds doesn't require a huge amount of thought and strategizing. At least it seemed that way at first. In actuality, some of the rules can have results very profitable for thoughtful investors. In several cases, these I Bond rules make them superior to TIPS. The one great advantage of TIPS is that you can buy a lot of them... if you want to. I Bonds are bought and eventually sold within the Treasury site. Because you can't trade I Bonds, it's easy to manage them with a few simple decisions. At any given moment, you know exactly what you have. You know how a few numbers will change with the semiannual inflation reports which are updated on May 1 and November 1. TIPS, on the other hand, are subject to unhappy surprises. Owning TIPS is a bit like walking through a mine field without metal inserts in your boots. Even in Vietnam, the government provided you with metal inserts. From 2015 through 2021, while the Fed suppressed all durations of safe Treasuries TIPS were sold at issue to yield a -0.56% real rate. This meant that if you bought and held to maturity (as many investors actually did) you were paying the Treasury 0.56% annualized to hold your money! I don't get it. I never did. Didn't they have mattresses under which to hide cash and a Glock? Inflation began to build in January of 2022 with higher rates soon following. This should have been the year TIPS outperformed I Bonds. For two and a half years, whenever I had written about I Bonds, I could point out that their zero percent real yield sounded bad but actually beat the real yield on everything else, including TIPS. It was a close call on May 1, 2022, zero again for I Bonds versus -0.01% for TIPS. Over a few months, the real yield on TIPS climbed strongly to 1.89%. So TIPS turned the tables and crushed I Bonds, right? Nope. Sorry. I Bonds, still at zero real yield, once again trounced TIPS. The trouble with TIPS is that, unlike I Bonds, they trade every day. Their poor performance stems from the fact that they are in some ways like ordinary bonds, which are priced inversely to interest rates. Their real return went up rapidly, but interest rates, thanks to the Fed, also ran up rapidly enough to sink the value of ordinary Treasury bonds. It turns out that the elements it shares with ordinary non-inflation-protect bonds make up the larger part of TIPS performance. Here's what it looks like on a chart from 2022 comparing both the long-term Vanguard Inflation-Protected Securities Fund (VIPSX) and the Vanguard Short-Term Inflation-Protected Securities Index Fund ETF (VTIP) to the Vanguard Total Bond Market Index Fund ETF (BND).   Seeking Alpha YChartsWhat you see in the chart with wonderful detail is that the ordinary bond aspect of the longer duration Vanguard Inflation-Protected Fund was pulled down hard by the same force that pulled down the Total Bond Market ETF. Sorry, TIPS holders, sometimes you just can't win for losing. In the long run, of course, individual TIPS held to maturity will return exactly the real yield promised at the point of issue plus inflation. That's assuming, of course, that you didn't pay a premium or needed to sell at some earlier moment. Another disadvantage to TIPS is that the accrued inflation component is also subject to being dragged down if the inflation rate goes negative. In short, TIPS do not fully share the deflation protection provided by I Bonds. While you will receive the initial assured yield at maturity you will not be assured of it if you wish to sell earlier. You must take what the market provides. I Bonds, on the other hand, have full deflation protection. While the inflation rate may go negative for a six-month period, you will have no deflation reduction to less than zero. That period's fixed yield will be reduced by the amount of deflation, but only once and only to zero. You will in practical terms be compensated by the reduced prices you pay for goods and services. This deflation projection may seem a minor and unimportant matter, but while the probability of a Deflationary Black Swan outlier is pretty low it is quite possible and could lead to an enormous disaster. The United States has not had sustained major deflation for almost 100 years, long enough that most people can't remember how deflation works, but you can't be certain that it will never return. In the Great Depression of the 1930s stocks at their worst lost 90% of their value while ordinary bonds earned about 6% for the decade. Two prescient financial tycoons, Arthur Lee Loomis and his partner and brother-in-law Landon Thorne, made large fortunes by loading up on high quality bonds. More important, however, was the fact that the prices of goods, services, and assets like real estate fell as much as 80% at the low point. That 6% coupon return on bonds was the least of it compared to the several hundred per cent increase in the buying power of money. The latter part of the 19th century was largely deflationary despite spectacular growth thanks to the success of Eastern bankers in keeping currency based on the gold standard (no silver, no greenbacks). Businesses just had to keep in mind that borrowed money had to be paid back in more valuable currency. Will such a deflationary period happen again? Probably not because too many entities, including the Federal government, benefit from inflation, but you never know for sure. Once deflation gets going, it's very hard to stop it. Ask Herbert Hoover. FDR finally got us out of it by fighting and winning a global war, which achieved full employment the hard way. Hitler did pretty much the same a decade earlier, but the long-term outcome wasn't good. Events like extreme deflation are pretty much beyond the control of ordinary people, but owning ordinary bonds would be extremely helpful for individuals, as would the deflation hedge provided by I Bonds. One last disadvantage of TIPS is that the inflation component of TIPS is subject to a \"phantom\" tax every year unless it is held in a tax-advantaged account. The word \"phantom\" is a usage meaning that you must pay tax on the income annually despite the fact that you do not actually receive it until the bond reaches maturity. Over the long term this produces a bit of a drag on TIPS returns and may be very inconvenient to an income investor. I Bonds give you the opportunity to avoid this problem by electing to defer taxes until maturity. To compensate for these several disadvantages the real return fixed component of TIPS has historically been 50-75 basis points higher than the fixed return of I Bonds. If the idea of a phantom tax doesn't bother you much, just recall that it is paid in present dollars. Bear in mind that the inflation rate since 2000 averaged about 2.5%. Why does this matter when discussing taxes? I was a little surprised recently when some analysts suggested that I Bond holders who go way back like me might wish to start selling to cushion the tax payable at expiration. Don't do it unless you are forced to by personal circumstances. The I Bond rule on taxes is that you can sell at any point after a year, but you are not required to sell and pay your taxes until maturity at 30 years. There's a very good rationale for holding until then. You may well wonder what good it is to defer taxes if you will eventually be required to pay them anyway? It all comes down to the time value of money in an environment with even a modest inflation rate of 2.5%. The value of money is reduced by that 1.025% compounded annually by the simple equation which is used with a hurdle rate to show that the value of future corporate earnings must be similarly discounted. The answer is that deferred taxes are paid in devalued dollars. That 30 years of 2.5%+ inflation adds up to a 77% depreciation of what a dollar can buy, thus reducing your tax cost significantly in real terms. Real terms are the whole purpose of inflation protected securities, aren't they? If you are like me, you will enjoy having the last laugh in some small way on excessive government spenders. With TIPS, the government takes back with one hand a significant part of what they give with the other. The Treasury itself makes tremendous use of the deferred payment trick, borrowing billions which it promises to pay back in the distant future using depreciated dollars. No fools they. A Few Final Words A fixed income investor who doesn't bother to consider I Bonds because you can only buy in modest quantities is like individuals who won't pick up a fifty dollar bill on the sidewalk because it is small compared to their total stock portfolio. Investing starts with doing the little things right. When you learn about I Bonds, you improve your grasp of the entire investment universe with bits of insight that jump out of the analysis. Over 24 years of holding I Bonds, I have seen them perform well under three conditions, including one which I had not anticipated: 1. The one brief episode of inflation which the Fed initially underestimated. TIPS did much less well. 2. The single deflationary six-month period which demonstrated that deflation would have no impact on an I Bond portfolio, thus leaving you to enjoy the higher buying power of dollars. 3. The extended period in which the Fed suppressed rates for all totally safe income vehicles, while the modest but persistent 2% inflation return of I Bonds made them a helpful part of a fixed income portfolio. This came to me as an overlooked virtue of I Bond structure at a time when TIPS returns were miserable and sometimes negative. I Bonds, in my view, are both more and less than an insurance policy protecting you from rampant inflation. It's a rare person, I'm pretty sure, who sells an I Bond because the CPI has risen a bit. The main thing you get from holding a portfolio of I Bonds is a self-administered pat on the back from having a unique kind of diversification in your portfolio which never does badly, is risk-free, and provides both offense and defense in a variety of ways. I Bonds are actually a minor but extremely helpful asset class serving as both inflation and deflation hedges, helping you get through times when the Fed decides to suppress rates to the detriment of savers and retirees, and getting a last laugh of sorts by deferring taxes and paying them in devalued dollars. For me, it's time to declare victory and begin tidying up all my finances in a way that prepares things for my children. A perfect forecast for the next ten years would be helpful, but I don't really have one. The Fed's determination to push inflation down to 2% seems misplaced, as 3% is the 100-year average accompanied by good long term economic performance. Getting to 2% is most likely to produce another decade of overpriced stocks and bonds, with retirees and income investors struggling to produce income without taking more than an acceptable degree of risk. I Bonds would probably help. I would certainly not consider modest 3-4% returns as a reason to shun them. My confidence level for this forecast is fairly low, but definitely higher than the likelihood of runaway inflation barring a war or other disaster. Then again, as argued above, insurance to protect against inflation is not the only purpose of the I Bond asset class. Diversification within a portfolio needs to include assets roughly in proportion to the scale of the event they diversify against. There are a few reasons that my April I Bond purchase will be my last. My current I Bond holdings seem sufficient for the purposes they serve. Fed tightening has produced recent periods when it was possible to build a fixed income portfolio out of ordinary bonds and CDs so that there is less need to fill in with patchwork including I Bonds. My current financial task is the general process of tidying up my holdings for my future heirs.  Ask questions in your comments, and I'll try to respond to all of them. This article is the true overview I couldn't have written about I Bonds a decade ago. I probably won't write about I Bonds any more unless something new comes to mind.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2429933563"}