Series I Bonds 2023 Decisions

Series I Bonds generated a lot of attention when their annualized rate reached a high of 9.62%. Unfortunately,  purchases of these bonds is limited to $10,000 per tax ID number, per year. With 9.62% rates, we couldn’t get enough of them, and naturally, as 2023 is a new year, many people are wondering if they should buy more.

The short answer is yes (assuming funds permit), but the decision isn’t as clear as when they were at 9.62%, and is trending towards a possible ‘no’ in the future. That said, when considering Series I Bonds we should always be evaluating the merits of holding them as we are presented with new information.

The difference between not buying, and selling

If we consider ultimate conviction in a strategy, you might decide that if you wouldn’t buy something, you should short (or sell) it. A caveat in the Series I Bond equation is that selling newly acquired bonds comes with a loss of 3 months of interest, which could be punitive enough to encourage holding, rather than selling. However, a point may come where selling, with penalty is superior to holding.

Opportunity Value

The decision to buy, hold or sell comes to a comparison with opportunity value. And while we should consider that punitive loss of interest might tip the decision to holding, there is also a scenario where the scarcity of Series I Bonds (limited to $10,000 per tax ID) encourages us to hold even if slightly less efficient than selling in the short term.

The Math

Series I Bonds have two components, a fixed interest rate, set for the entirety of the 30 year bond,  and and variable interest rate that adjusts every 6 months based on CPI-U inflation data. They are a Treasury Bond, therefore they are exempt from State tax, and are high credit quality.  To decide on buying, holding, or selling we need to compare with a similar risk investment, which would be a different Treasury issued bond.

At time of writing, the highest T Bill yield is found at the 6 month duration. This yield is 4.846% annualized. The yield curve beyond 6 months drops down gradually to 3.660% for a 30 year treasury bond. The current yield for a Series I Bond is 6.89%.  We need to keep in mind that we are comparing a fixed rate on the other Treasury bonds, and the Series I Bond rate will reset in May 2023.  We must speculate as to that rate, but it is possible that it lowers from current levels. We will examine this shortly.

Series I Bond Yield Mechanics

Variable interest, guaranteed for 6 months

As we examine these Series I Bond, we need to keep in mind that interest rates are locked in for 6 months. Therefore, if we wanted certainty on the rate, it would be better to wait until just before the inflation related reset is announced, which occurs on May 1st and November 1st each year, as our ability to predict a year of income increases as we are closer to the announcement of the upcoming date.

Calculating the next rate, can we see the future?

We are told the rate is calculated from CPI-U, which is publically available from https://www.bls.gov/news.release/cpi.t01.htm what we find interesting is that CPI-U is a trailing 12 month average figure. As such, mathematically it becomes easier to ‘box in’ a predicted value. To examine this, let’s first show how the 3.24% rate was derived from CPI-U, and then use predictions to see where the next amount might be.

“Consumer Price Index for all Urban Consumers (CPI-U). The CPI-U increased from 287.504 in March 2022 to 296.808 in September 2022, a six-month change of 3.24%.” Therefore, we can see a lag in data. In order to announce the November rate of 3.24% the Treasury Department looks at a 6 month period ending in September. 

It is interesting to note that the 3.24% appears to ignore the months between March 2022 and September 2022. It simply looks at the percentage change in CPI-U that was 287.504 in March, and became 296.808 in September.

How can we predict future Series I Bond Rates with unpublished CPI-U?

There are two paths here, one is to consider fundamental factors that could be quantified, such as mortgage rates, whereas another is technical, to consider what bounds of probability a number could be within.

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From the technical perspective, if we look at 2022 and how the November rate of 3.24% was derived, we could look at the period that is known, such as March to August. While we know that the reference rate is March to September, knowing August would allow us to narrow in to a monthly change.

Here we can see that the while the reference period of September to March yielded a 3.24% rate, we were gravitating towards this in the months leading up to September. If we look at the month to month change:

Here we can see that July and August were quite significant from a disinflation perspective, and actually became slightly deflationary on a month to month basis.  If we were to look at August and apply a ‘worst case’ from the reference period, such as the increase that occurred in June vs March of 1.40% increase vs the prior month, our Series I Bond Rate would be as follows:

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Therefore it is possible that inflation would have been announced at 4.68%, in which case the Series I Bond would offer a whopping 9.78% rate when considering that they have a 0.40% fixed component. Any prediction based on technicals will lack precision. And in the case of Series I Bond rates our variables are time and inflation.  In a simplified view, we could look at the 6 month reference period as a binomial tree:

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Here we can see that between March and September 2022 CPI-U changed from 287.504 to 296.808. But from a predictive perspective, being able to guess the rate in September from August seems easier than trying to do so from March. 

This is because each month we can move up and down the tree. In this case, we see that July 2022 inflation rates cooled significantly when compared to the increase between May and June, if they had not, and the path had continued in a similar pattern, it is more feasible to see a higher September rate, as illustrated below:

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Therefore, in some ways we can hone in on what an expected range for inflation might be based on the historical average monthly change, and consider the probability of movement using standard deviation and a bell curve.

‍Let the upside go up

With the Series I Bond decision, we are making a choice to buy a product that is illiquid for 12 months, and loses 3 months of interest if sold within the first 5 years. As such, we are agreeing to be locked into a product with a variable interest rate, and one that we might find unattractive as inflation slows.  Therefore, we aren’t going into this speculatively in the hope that inflation (and therefore our Series I Bond rate) will rise, but rather that it will not fall sufficiently to be an inferior choice.

To examine this, we need to consider an equilibrium price for the bond. If we were to use 4.846% as our comparative rate for a T-Bill, we need to know what our breakeven price for a Series I Bond would be. This raises a question about how to discount for the penalty component.

Scenario: pseudo-equilibrium at 4.846%

You buy Series I Bonds today, and ‘somehow’ the annualized 12 month rate becomes 4.846%. For simplicity, the T-Bill rate is also 4.846%.  However, if you were to sell the Series I Bond at the earliest opportunity (after 12 months) you would forfeit the trailing 3 months of interest. We can see the cost of that by reverse engineering a 4.846% rate from the current 6 month rate of 3.24%:

With the current issue of Series I Bonds guaranteeing 0.40% annually, and a known rate of 3.24% for the first 6 months, the variable rate that would be required to drop the yield from the current amount of 6.89% to 4.864% would be 1.21% in the May 2023 announcement.

In order for that to happen, CPI-U in May 2023 would be announced at 300.399 (vs 296.808 from the reference period). It is worth noting that the most recent figure released (December 2022) lists CPI-U at 296.797, which is lower than the reference period of September 2022, thus increasing the probability that a May 2023 figure will be lower than previous reference periods, and a rate closer to 1.21% is not unlikely, though indicators suggest it might land somewhere between the current rate of 3.24% and 1.21%.

That said, we should keep in mind that there are several months until May 2023, and that inflation is likely to experience change on fundamental factors rather than technical ones.

Pricing the penalty

One advantage of the penalty is that it removes the trailing 3 months of interest, therefore, assuming the bond owner has sufficient resources, they should not be selling a bond where losing 3 months of interest is overly detrimental. IE, the reason to sell is that the interest rate has declined to the point of insignicance. If we use the 1.21% rate example, the monetary impact per $10,000 unit of Series I Bonds would be a loss of $71 of interest.

Therefore, if we have the ability to buy a T-Bill at 4.8460% yield, we wouldn’t want to acquire a Series I Bond if we knew with certainty that it would also yield the same amount, because of the penalty element, but we should also keep in mind that the penalty element isn’t substantial, and if we do find that we have the opportunity to exchange the Series I Bond for a T Bill by incurring the penalty, a calculation at that point in time would allow us to decide on holding vs selling.

Timing the sale by knowing what you are earning

The annualization method of the Series I Bond can be confusing. We should keep in mind that if we were were earning 1.21% for the second 6 months, returns would trail the T-Bill rate, and in essence, the annualized rate is being carried by the overly generous first 6 months. The 12 month lockup on these Bonds prevents us from exiting and forces us to accept much lower rates.  However, while we can sell after 12 months (subject to penalty) we also have the ability to hold a little longer to see what rates are to be announced.

Since there are purchase constraints on the bonds, the decision to sell would be best made after seeing what you are being offered in the next 6 months (IE month 13 of the holding period) rather than being based on the month 7-12 rate earned.

Conclusion

Forecasting CPI-U for a particular date is challenging, but should become easier to predict as the gap between today and that date narrows. A decision to purchase Series I Bonds far away from the next 6 month announcement date increases the variability in the annualized rate, but the alternative is to hold until just before the announcement, and doing so carries a cost where you would earn less for this period of time. Therefore, if the current 6 month rate is sufficiently attractive, it is suggested that we purchase the bonds, but when doing so we know that we may reverse course if CPI-U declines in the next 12 months, and the interest rates become unattractive.

Therefore, as of now (February 2023) we believe that Series I Bonds are a buy. In May 2023 they may become a hold, or a sell, or possibly remain a buy. The decision becomes easier as we trend closer to the announcement of the forward 6 month variable rate. Also, in order for this to be a generic ‘buy’ decision it assumes that the individual has exhausted any high cost debt options, sufficient liquidity, and resources to not be forced into selling for cash flow purposes. It's very hard to say anything is an absolute 'yes' or 'no' without knowing the individuals underlying circumstances.