As a conservative investor, I have a ladder of CDs and bonds which are continually maturing, freeing cash to be rolled over into the most advantageous interest-yielding instrument which is non-callable and has zero default risk. These are:
Treasuries, which have duration risk.
TIPS, which have both duration and inflation rate risk.
CDs, which have no risk if held to maturity, significant sacrifice of interest if redeemed before maturity.
I-Bonds, which have no duration risk if held more than one year, sacrifice of 3 months interest if sold before 5 years and inflation rate risk.
If inflation is higher than predicted, the inflation-adjusted TIPS and I-Bonds would have an advantage over fixed yield instruments.
The bond market predicts inflation by the spread between the Treasury and TIPS of the same duration. The bond market is very confident that inflation will be under 2.5% for the next 5 to 10 years.
Wells Fargo predicts that inflation will be 2.4% in January 2024.
Statista predicts a similar path.
|Maturity||CPI Statista||Inflation Statista|
The bond market expects that the Federal Reserve will cut interest rates as quickly as possible. The combination of this expectation, the banking crisis and gradually falling inflation has led the yield curve to drop suddenly.
Because of this expectation, I am looking at 5 year durations or even more. I clearly recall how interest rates dropped suddenly in 2020. The “transitory” high inflation in 2022-2023 may be an opportunity to lock in higher yields before the Fed cuts again. The inverted yield curve means that every year longer duration yields less.
TIPSwatch.com has a good discussion.
What about I Bonds? We are going to get a reset on both the fixed and variable rates for the U.S. Series I Savings Bond on May 1. The variable rate will probably fall to a range of about 3.2% to 3.5%, down dramatically from the current 6.48%. The fixed rate looks likely to hold at around 0.4%, I think, or just a bit higher. [end quote]
I agree with this assessment. Does it make sense to buy a I-Bond with the intention to hold it for 5 years when a TIPS with a 5 year maturity yields 1.2% (plus inflation)? The benefit of the I-Bond is the flexibility of the holding period. Return of principal is always assured with an I-Bond, which isn’t the case for a TIPS which is sold before maturity. On the other hand, if interest rates fall, the TIPS could yield a capital gain, which the I-Bond cannot.
If the market’s expectation of inflation is correct, secondary-market CDs are yield more than TIPS. (Data from Fidelity.)
|Maturity||New CD||Secondary CD||TIPS||Secondary CD minus TIPS||CPI Statista||Inflation Statista|
If inflation remains higher than the market’s expectation the picture changes. The Fed has been wrong about inflation’s tenacity before and they may be again.