Inflation News: October I Bonds Will Return More than Top 1-Year CDs

The Labor Department released the September Consumer Price Index (CPI) numbers on Friday, and with these numbers, the next Series I Savings Bond inflation component can be computed. This allows us to calculate the earnings for I Bonds purchased this month and redeemed from October 2018 to January 2019. Sometimes I Bonds compare favorably to 1-year CDs, and that is the case this time. The rise in gas prices after the hurricanes caused the CPI to surge. Friday’s report showed that the CPI-U increased by 1.24% in the last six months (an annualized rate of 2.48%.) The 2.48% rate should be the I Bond inflation component that will be announced at the start of November. If an I Bond is purchased in October, you’ll get the current rate of 1.96% for six months before the 2.48% takes effect. The result is a good deal when compared with current 12-month CD rates. I’ll explain the details below. But don’t forget the low I Bond purchase limits. Maximum purchases per year and per social security number is $10,000 at TreasuryDirect and $5,000 in paper bonds purchased with IRS tax refunds.

Before I review the details of my I Bond rate calculations, Friday’s inflation report is also important for other reasons. It’s used by the Social Security Administration to determine the cost of living adjustment in 2018. Also, inflation is a major factor in the Fed’s decision on rates.

Social Security Benefits Will Rise 2.0% in 2018.

The recent hurricane-induced surge in inflation gave a boost to the Social Security cost-of-living adjustment (COLA) for 2018. According to ssa.gov, “Monthly Social Security and Supplemental Security Income (SSI) benefits for more than 66 million Americans will increase 2.0 percent in 2018.” That’s the highest level since 2012. Last year, the adjustment was only 0.3% and in 2016, it was 0%.

Impact on the Fed’s Rate Decision

The Fed cares more about core CPI which excludes volatile food and energy prices. Core CPI increased only 0.1% in September. Over the last 12 months, core CPI increased 1.7%. The Fed’s main focus is on the personal consumption expenditures (PCE) price index excluding food and energy. The Fed’s target for the PCE is 2%. Since the Fed began increasing rates, the PCE has fallen from just under 2% to 1.3%. So the latest inflation data probably won’t have much impact on the Fed.

November I Bond Inflation Rate Should be 2.48%

I’ve done the calculations based on these latest CPI numbers, and the I Bond inflation component taking effect in November should be 2.48%. The I Bond inflation component is added on to the I Bond fixed rate to derive the I Bond composite rate. The fixed rate is currently 0%, and it probably won’t change much if at all in November. We won’t know the November fixed rate until Wednesday, November 1st.

If you buy I Bonds before the end of October, you can know the rate of return you'll receive if you redeem the I Bonds between October 2018 and January 2019. The interest rate for the first 6 months will be based on the current inflation component (1.96%). The next 6 months will be based on this new rate (2.48%). After that, it'll depend on future inflation numbers. The current fixed rate component of 0% will stay the same for the life of the bond. Below are the details of calculating the expected rate of return.

I Bond Rates of Return for October 2017 Purchase

From Treasury Direct I Savings Bonds FAQs:

the inflation rate announced in November is the change between the CPI-U figures from the preceding March and September.

All previous CPI-U numbers are available from this government webpage. The CPI-U for March 2017 was 243.801. Based on Friday’s release, September 2017 CPI-U was 246.819. This is an increase of 1.24%. The annualized version of this is 2.48%.

If you buy before November, you'll receive the current I-Bond fixed rate of 0% for the life of the I Bond. The inflation component will be added to this rate and will change every 6 months. The current inflation component is 1.96%, and the composite rate is 1.96%. Here's an estimate of the return for the next year:

• 1.96% from October 2017 through March 2018
• 2.48% from April 2018 through September 2018

I Bonds increase in value on the first day of the month. So on November 1st, you'll earn the interest for the full month of October. So for maximum return, it's best to buy I Bonds near the end of the month and redeem them early in the month.

If you redeem an I Bond before 5 years, you lose the last 3 months of interest. So based on this and the above numbers, if you buy an I Bond on October 31, 2017, the value of the I Bond on October 1, 2018 would be about 1.60% higher. For 11 months, this comes out to an annualized yield of about 1.75%.

Below is an estimated annualized return for I Bond redemptions from October 1, 2018 to January 1, 2019. It is assumed you will buy the I Bond at the end of October 2017 which gives you almost an extra month of interest. This effectively reduces the 3-month penalty to 2 months.

• 1.75% (11mo) redeem on 10/1/18, 6mo of 1.96%, 3mo of 2.48%, and 3mo of 0% (penalty)
• 1.81% (12mo) redeem on 11/1/18, 6mo of 1.96%, 4mo of 2.48%, and 3mo of 0% (penalty)
• 1.86% (13mo) redeem on 12/1/18, 6mo of 1.96%, 5mo of 2.48%, and 3mo of 0% (penalty)
• 1.90% (14mo) redeem on 01/1/19, 6mo of 1.96%, 6mo of 2.48%, and 3mo of 0% (penalty)

The highest guaranteed rate would be an annualized return of 1.90% for about 14 months. Note, it's best not to wait until the last day of the month to buy I Bonds at Treasury Direct. In 2011 I described my experiment in seeing how late in the month I could buy an I Bond. I found you should make sure the purchase is no later than the second to last business day of the month.

Compared to CD Rates

As you can see, the above rates are just above the best 1-year CD rates that are nationally available. If you have to worry about state income tax, the I Bond becomes even a better deal since I Bonds are exempt from state income tax.

Unfortunately, an exact comparison between I Bonds and long-term CDs is not possible. The reason is that the I Bond inflation rate changes every six months. For this short period of time from now to before November, we know the I Bond inflation rate for 12 months. We can only guess about the I Bond inflation rate after that. The best we can do is to make an estimate of the future inflation rates.

One way to estimate future inflation rates is to use the historical average. In 2014 I calculated the average I Bond inflation rate since the I Bond program began in September 1998. That average was 2.57%. This takes into account the period in 2009 when the I Bond inflation rate was negative. Since the composite rate can never be negative, I used zero for this period in calculating the average.

If the I Bond inflation rate average 2.57% over the next 5 years, an I Bond purchased today will compare favorably to 5-year CDs purchased today. The best 5-year CD rate that’s nationally available is currently 2.60% APY at Mountain America Credit Union.

If you have older I Bonds, you probably have I Bond fixed rates much higher than 0%, and if you're fortunate enough to have purchased I Bonds before 2001, you probably have fixed rates over 3.00%. So those I Bonds are especially good deals in today's environment.

Remember the $10,000 Annual Purchase Limit

Don’t forget that the annual purchase limit is $10,000 (excluding the purchases using your tax refund). Also, remember that the Treasury ended offering paper savings bonds at banks. However, it did double the annual purchase limit at Treasury Direct (see post).

I Bond Features

Below is a summary of the I Bond features. More information is available at this Treasury I Bond page:

• Can't be redeemed within 12 months of issue date
• Lose 3 months interest if redeemed within 5 years
• Interest is composed of fixed and inflation-based rate
• Fixed rate remains for life of bond
• Inflation-based rate changes every 6 months after issue date
• New rates announced every six months on November and May 1st
• Federal tax can be deferred on interest until bond is redeemed
• Interest is exempt from state and local tax
• Some or all interest is tax exempt when used for educational expenses
• $10,000 maximum of I Bond purchases per year (excluding purchases using your tax refund) - total was $60,000 before 2008 (Treasury's press release).

For more details about the purchase limit, please refer to the Treasury Direct's FAQ on the new purchase limit.