How To Improve The Yield On Your I Bond

You may be buying the wrong kind of inflation bond. Here are two ways to get the good stuff.

Inflation bond: the ultimate protection against the rising cost of living. If you know what you’re doing, you get a real yield of 1.9% on these U.S. Treasury securities. If you don’t, you’ll get a lousy deal, a bond paying 0%.

Why on earth would people buy a 0% bond when the 1.9% alternative is right at hand? Because they follow the advice of naïve personal finance commentators.

The naïfs are in love with I bonds. These are savings bonds that track the cost of living. There are negatives: They have a purchase limit of $10,000 a year, they have restrictions on early redemption and they can’t be put in a brokerage account.

Worst of all, I bonds have a 0% real yield. Your interest consists of a nothingburger return plus an inflation adjustment. In purchasing power, you break even.

Smart money is going into the other kind of inflation-adjusted Treasury bond, called a TIPS (Treasury Inflation Protected Security). TIPS have no purchase limit, no restriction on your ability to get out early, and no trouble going into your brokerage account.

Best of all, TIPS have a positive real return. The ones due in five years pay 1.92% annually. In purchasing power, you gain 9.6% over the five years.

I can forgive the experts who were gushing about I bonds back in January. At the time, the five-year TIPS had a real yield of -1.6%. At 0% for the real yield, the I bond was clearly the better buy, apart from the inconveniences attached to getting and holding the thing.

Since then there has been a bond crash. Yields on marketable bonds have shot upward. The yield on I bonds hasn’t budged. There is no excuse for recommending an I-bond purchase today.

I bonds can be held for 30 years, after which they stop accruing interest. You can’t cash them in during the first year. In years two through four, a redemption comes with a penalty equal to three months of inflation adjustments. After the five-year mark you can cash in whenever you want, collecting your full 0% return (that is, full recompense for inflation).

Where to get those TIPS? You have two options. One is to own a bond. The other is to own a bond fund. There are pros and cons to each.

For the bond, arrange with your bank or broker to submit, close to the deadline, a non-competitive tender at the next auction of five-year TIPS. The tentative Treasury schedule, to be finalized on Oct. 13, is for the auction to take place on Oct. 20.

At Fidelity Investments there is no fee for an auction order placed online; the maximum buy is $5 million. Other financial institutions have similar deals.

TIPS yields could go up or down over the next two weeks. If they go up, hurray. If they go down a lot, you could choose not to participate.

If you hold that bond until it matures, you are certain to collect the return set at the auction. If you cash in early by selling in the secondary market, you could be looking at either a windfall capital gain or a windfall loss, depending on whether interest rates go down or go up. That’s a fair bet, but selling would mean getting nicked by a bond trader, who will pay slightly less than the bond is worth. I’d recommend a direct bond purchase only if there’s a pretty good chance you can stand pat for five years.

The alternative is to own shares of a TIPS bond fund. Two I like are the Schwab U.S. TIPS ETF (ticker: SCHP, expense ratio 0.04%) and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP, 0.04%). The Schwab fund has bonds averaging 7.4 years until maturity; the Vanguard portfolio’s average maturity is 2.6 years. A 50-50 blend of the two funds would give you the same interest-rate excitement as a single bond due in five years.

The advantage to the funds is that they are very liquid. The haircut from trading is typically a penny a share round-trip (that being the bid/ask spread), a tiny percentage of a $50 stock.

The disadvantage to the funds is that you can’t nail down what real return you’re going to get between now and October 2027. The funds keep rolling over proceeds from maturing bonds into new bonds. The portfolios never mature.

What that means: You could wind up doing better or worse with the funds than you would have with a single bond due in five years. It depends on what path interest rates take. Again, it’s a fair bet, but you may not like this kind of uncertainty.

I’ll now address two supposed benefits to I bonds: that you can’t lose money and that you can defer tax on the interest.

Can’t lose? Only in the sense that an ostrich with its head in the sand can’t lose. Savings bonds are not marked to market. You can’t see your loss.

Buy a $10,000 I bond today, and you become instantly poorer. If you plan on staying put for five years, your investment should now be valued at $9,100. That’s all your future claim on the U.S. Treasury is worth, given where TIPS yields are. If you have the sense to get out at the earliest possible date (12 months from now), then the damage is less, but it’s still damage.

The other supposed advantage to I bonds is the deferral of income tax on the inflation adjustment. This is not the bonanza you may think it is. Our current tax law is set to expire at the end of 2025. After that, tax rates are going up.