What on Earth is a Series I savings bond?
crossposted from: https://blog.rossry.net/series-i/
(Not investment advice, of course.)
Summary: The Series I savings bond is a US government bond offered to US citizens, with purchases limited to $10k per person per year. It pays interest set by a formula based on the official inflation rate, with a built-in lag. If inflation from November ’21 to March ‘22 follows historical patterns, bonds purchased in December ’21 and redeemed after 15 months will pay ~4.62% interest annualized. If inflation is higher (as it has been recently), the bonds will pay more; if it’s lower, they will pay at least 3.26% interest when redeemed after 12 months.
All of those potential rates are a percentage points higher than any other bond that is even remotely as safe; this is because of the way the inflation adjustment rule works. Specifically, the inflation adjustment for the next six months is set based on what inflation was in the last six months. As a consequence, a Series I purchased between now and April 30 will pay its first 5-6 months of interest at 7.12% annualized (so 3.56% in 6 months), and then reset to some other rate that will depend on future inflation. If you don’t want to stay invested after that, it’s possible to redeem the bonds after 12 months.
If getting ~3-6% annualized interest on $20k of a US government bond is a thing that you want, then this might be the best way to do it.
(1) What is it?
The Series I savings bond is a US government bond that is offered directly to US citizens, with purchases limited to $10k per person per year. (Apparently, there’s a way to purchase an additional $5k using your tax refund, but it’s difficult and I’m going to ignore that.) You can’t sell or transfer them to anyone else, though any time after 12 months you can redeem the bond to get your money back, with interest.
It’s a US Treasury bond, so it’s almost literally the safest investment in existence (in terms of “will I get paid back with actual US dollars?”). Despite being an extremely safe investment, it pays a few percent a year. This is relatively unusual for very safe investments (citation required).
Why does the bond pay so much more interest than other government bonds? The Series I is specifically designed as an “inflation-protected” investment, which means that instead of paying a fixed interest rate, it pays a fixed “base” interest rate plus an extra interest rate that’s based on the official inflation rate (specifically, inflation in CPI-U). The base rate will be 0% in all relevant worlds, so we’ll ignore it.
Time-varying derivatives are difficult for many people to understand, and so Treasury wrote the rules on this one so that investors would mostly know what they were getting up front (and would have the option to redeem if they didn’t like it). The specific rule is: every six months, Treasury announces what the last six months of inflation was, and Series I bonds will pay that much for the next six months.
If you think it would make more sense to pay that inflation over the same period it actually happened, you’d be right, but then the bond would be harder for many people to understand what they were getting. The lagged rule isn’t very different if inflation changes slowly and people hold their bonds for many years, so you can imagine why Treasury might have chosen to set it up this way. And because of the $10k/person/year limit and the prohibition on transfers, they don’t have to worry about some hedge fund buying hundreds of millions of dollars of them to extract profits from the way the rule is written.
But because of the lag, if you had just observed a lot of inflation in interval 1, then you could purchase a Series I bond at the end of interval 1, get paid the interval-1 inflation rate during interval 2, get paid the interval-2 rate during interval 3, and decide at the end of interval 3 whether you wanted to get your money back or get paid the interval-3 rate during interval 4, and so on.
This is particularly relevant now because Treasury announced that inflation from March ’21 to September ’21 was 3.56%, and so Series I bonds purchased this month will pay 3.56%/6mo in their first 5-6 months, then the inflation from those months during their second 6 months, then give their holders the option to keep going or get their money back.
This post is not financial advice, but I find this bond to be more interesting than any other way of lending money risklessly (i. e., directly to the US government), and you might too.
To be more precise about the details:
Treasury announces their official estimate of Sept->Mar CPI-U inflation on May 1 and their official estimate of Mar->Sept CPI-U inflation on November 1 each year (e. g., Nov 1, 2021). CPI-U estimates are available on FRED, run by the St. Louis Fed.
The Nov 1, 2021 announcement gave a 3.56% inflation rate.
Bonds purchased in month M change the rate of their inflation-linked component on the 1st of M and M+6. On the rate-change date, the 6mo rate changes to the most-recently announced official estimates of 6mo CPI-U inflation. (e. g., bonds purchased in December change their rates on June 1 to the rate announced on May 1, and on December 1 to the rate announced on November 1.) Before the first rate-change date, they use the most-recently-announced rate.
If the fixed + interest-linked components sum to less than 0% (because of CPI-U deflation), the interest rate is 0% instead.
Interest compounds semiannually.
You can redeem your bonds starting 12 months after you purchased them. If you do so before holding them for 5 years, you get 0% for the last 3 months of interest.
I don’t know how long it takes from submitting for a redemption until you receive your cash. I would guess that it’s shorter than a 1-month credit-card cycle, and so it would be reasonable to treat Series I bonds past their 12-month window as nearly as good as cash in your bank account, and to be willing to count them towards “emergency expenses” funds. You’d want to check this before relying on it, though.
(2) The numbers
Okay, let’s run the numbers.
A $10,000 Series I bond purchased on Wednesday, December 15, 2021 and redeemed on Thursday, December 15, 2022 will be worth approximately:
The last term is only 3.5/6 of the 6-month inflation because if you redeem your bonds before 5 years are up, you don’t collect the last 3 months of interest. But if the inflation rate is low, then that probably isn’t bad, and if the inflation rate is high, then you probably will wait and redeem later. (The second term is only 5.5/6 months because you collect the rate only from December 15 to June 1.)
Let’s check the case where the inflation rate follows historical trends.
CPI-U[Sept′21] was 274.31, and from 1983 to 2020 it went up in a ruler-straight 2.62% annualized (so 1.3% per 6-month period). So if we assume that inflation will go back to the pre-2020 regime, then the bond will earn 3.26% in the first 5.5 months, and 0.76% in the next 3.5 months, then 0% for 3 months, for a total of 4.04% over 12 months.
Bloomberg highlighted the 7.12% “annualized” rate in their reporting, saying vaguely that “after that [the rate] will rise or fall depending on inflation”; this is somewhat misleading because that’s the rate you’d get if 3.56%/6mo inflation continued and also you held for 5 years and so didn’t give up 3 months for early redemption.
Still, 4% is a lot more than your bank account will give you on a Certificate of Deposit! It’s more than 7 times what this ~1-year Apple bond yields, and more than 16 times what this 1-year US note yields. I won’t say that it is an objectively ‘good’ or ‘bad’ investment, because what people want from investments is different from person to person for completely legitimate reasons—but if you have a Social Security number and are already investing some of your money in safe bonds, this is a very, very safe bond that pays nontrivially more interest that whatever other safe bonds you’re investing in.
In fact, it’s somewhat better than that. The CPI-U number for Nov′21 is already out, and it’s 277.984 -- up 1.3% in just two months from Sept′21. It would be somewhat irresponsible to extrapolate that rate to the next four, but even if we assume the next four months will be at the old 2.62%/yr rate, that would mean a 6-month inflation of 2.17%, meaning your 12-month investment earns 4.57%, or holding it for 15 months will earn 4.62% annualized.
You can form your own opinions on whether you think something happened around January 2021 that started causing more CPI-U inflation than there had been for the ~40 years prior, and whether it will continue to have that effect, and for how long. (If you think the inflation will continue to be higher, that’s better for the bond.)
In fact, it’s somewhat better than that because, as I mentioned, you can choose whether to:
redeem the bond at 12 months, and get 6 months of the initial rate plus 3 months of the next rate,
redeem the bond at 15 months, and get 6 months of the initial rate plus 6 months of the next rate,
hold the bond for another 6 months (meaning 21 total) and get 6 months of the just-announced rate for another 6 months, or
keep doing the last step until you decide to stop.
The analysis in the last two sections was just assuming that you always took the first option, but actually by the time you have to choose, you’ll already know what the “next rate” will be, and so you can choose to keep holding it to get that rate for a few more months (and also keep the rolling option open) or get your money back.
It’s even better than that if we look at the April 2022 vintage, because those bonds will use the Mar′21->Sept′21 rate for their first six months (from purchase to October 1, 2022) before switching to the Sept′21->Mar′22 rate (from October 1, 2022 to April 1, 2022).
If you think that this means you should be able to have a pretty good estimate of the first two inflation periods by that point, you’d be right. It will also mean that you’ll know the officially-announced rate for period (plus two bonus months of FRED data) when deciding whether to redeem before you start your six months of earning .
April 2022 will also be the last vintage that starts with the 3.56% rate from Mar′21->Sept′21 (and is the one that maximizes the look-ahead optionality), so it seems likely that it will be an interesting thing to check in on come April.
I suppose you could value the ladder of chained redemption options if you plugged in a model for inflation volatility, but that’s more work than I feel like doing in this post, so I’m just going to call it a free roll on top of the expected rates above.
The $10k/person/year limit means that this year’s December vintage is use-it-or-lose-it, and so the immediate question is whether you’d prefer to have $10k of your savings in this, instead of whatever else you might put it in before the end of the year.
I won’t even try to say whether the Series I is a better investment than stocks or ETFs on stocks—it would be a reasonable guess that stocks will return more than 4.6% over the next year, but they come with risk. On the other hand, it seems pretty easy to say that it’s worth using it to replace a different bond (or bond ETF) that returns less, if that was part of your portfolio, up to whatever concerns about the 12-month lockup.
Another opportunity is that, if you hold stocks or ETFs at e. g. Interactive Brokers, you can borrow money against them at the benchmark rate plus 1.5% or less (in a Pro account), which currently means 1.58%. Borrowing short versus lending long is the risky direction (the benchmark rate can go up), but it would take a lot for it to move 3%.
If you’ve already margined as much as you’re comfortable, and don’t have a different way to borrow money that costs less than 4.6%, and don’t have any other bonds to substitute away from, and don’t want to substitute from your leveraged stocks into this bond, then maybe it’s not good for your situation.
Not financial advice! Not investment advice! I probably got more than one thing wrong in my math! But when I saw the headlines about “7% risk-free return”, I couldn’t not run the math, and I found the answers sufficiently interesting that I thought others might as well.
If I did get something wrong in my math, please do let me know in the comments.