Series I bonds offering a huge fixed rate of 0.9%

The Treasury Department has announcement the widely expected fixed rate for Series I Savings Bonds for the new issuance period from May 1 to October 31, 2023 at a whopping 0.9%. It’s not sarcasm. Although few would be likely characterize 0.9% as “huge” for a bond, this is significant for the Series I bond.

This is the highest fixed rate offered by the Series I bond since 2007:

A fixed rate in this territory becomes attractive from a long-term perspective. Indeed, all I bonds, regardless of their date of issue, earn interest at the current variable rate determined by the change in the CPI. The difference between the I bonds issued from one year to the next is the fixed rate. Clearly, bondholders should prefer higher rates.

Notice in the table below how the fixed rate at issue has an impact on the attractiveness of the bond. The blue line is again the fixed rate that has been fixed for the I-bonds issued on the dates on the x-axis. The orange bars represent the yield that each of these I bonds has earned over the past 6 floating rate months. For example, I bonds issued in 2020-21 would have yielded 6.5% over the last 6 months, while I bonds issued in 2003-2004 would have yielded 7.5-7.5%. This is due to differences in the fixed rate. If the I bonds issued between May 1 and October 31, 2023 with the fixed rate of 0.9% had been able to earn the previous floating rate (which they cannot), the potential rate that these bonds could have earned would be by 7.4%. Solid fixed rate I-bonds are powerful savings instruments.

We are not surprised by this new higher fixed rate. We predicted this in our last article on I-bonds on March 5, titled I-Bonds: Long Term Buy Opportunity Ahead. This was our expectation:

…we should expect the May I-bond to offer fixed rates of 0.7-0.9% with floating rates of 2-2.4% for a composite rate of 2.7-0.9% 3.3%.

We were right on the fixed rate. In fact, we received a lot of criticism for our predictions. To be clear, we don’t have access to the methodology the Treasury uses to set the fixed rate. But we have discussed the implicit methodology of pegging the rate to a function of real rates as determined by the markets. Our methodology has proven useful.

However, our expectations for the floating rate were too conservative. The new variable rate for I-bonds is 3.38%. We have been open to the possibility that inflation could remain sticky. Here is what we said:

There are two months of CPI data to be released before the May adjustment. We can only guess what inflation will do in these months. But one thing indicating a higher CPI is the spot price of copper, which has a consistent track record as the leader of the CPI.

Although inflation was higher than our base scenario, this does little to change the investment thesis. I-bonds have a place in our portfolio for liquid inflation protection. With fixed rates above 0.9%, we will begin the process of rolling over (redempting and reissuing) our existing I-bonds into new I-bonds to earn this higher long-term fixed rate. As a reminder, there is an annual contribution limit of $10,000 per person for Series I bonds which applies to “rollover”.

Looking ahead, we don’t know if the new fixed rate in November will turn out to be higher or lower than the current rate. This will depend on several factors which we will monitor and publish in the future. But the probability is not particularly strong. The fixed rate would be expected to rise if the average real rate for the next 6 months is higher than the previous 6 months. For this to happen, inflation expectations will have to fall, nominal rates will have to rise, or a combination of both.

Next week, we expect the Fed to raise the Fed Funds rate by 25 basis points. This is supported by market expectations that assess a 90% probability of 25 basis points as of 4/28. While further rate hikes are possible, we are now sensing for the first time this cycle of hikes that the Fed may end after May. We will continue to assess our position with incoming data.

The market is already convinced that a pause and rate cuts are imminent. The near-term forward spread expects nearly 200 basis points of rate cuts. Fed funds futures forecast an 80% chance of easing by the end of 2023. While we think that might be too aggressive, it’s clear that the rate cap is near.

With nominal yields slowing, it depends on inflation expectations. Below is the break-even inflation rate over 7 years, to represent inflation expectations. Inflation expectations and energy prices are closely correlated. For inflation expectations to fall, energy prices would have to remain stable or weaken. This is an important unknown to consider.