A Framework for Investments: Applied to iBonds
I recently wrote about a simple framework for evaluating investments that considers pricing, cash flow, and financing.
In addition, due to the current volatility of the stock market and elevated inflation, I’ve been a big proponent of iBonds.
Let’s take another look at iBonds through the context of this framework.
Pricing
The price of iBonds is static due to how they’re purchased. We can buy up to $10,000 a year for a set rate that is adjusted every 6 months.
Technically, we can buy another $5,000 using our tax returns, but that’s a bit too niche for most.
We can then view this as pricing is irrelevant in evaluating the value here.
Cash Flow
More importantly, as a bond instrument, we want to look at the offered rate for iBonds, which we’re considering as the “cash flow”.
In this case, the combined rate of iBonds is the fixed rate, which has been abysmally close to zero, and the variable rate which is pegged to inflation.
As we’ve all no doubt noticed and heard about, inflation has been off the rails recently, and thus the variable rate has been surging.
iBonds actually take twice the stated rate as the variable rate, so using the May 1st number: 4.81% * 2 = 9.62%.
9.62% variable rate + 0% fixed rate is how we get to the current combined rate of 9.62%.
In fact, inflation has barely missed a beat and has continued to stay elevated.
It’s reasonable (though not guaranteed) to assume that iBonds will pay at least 9.62% for the year which due to the properties of iBonds come untaxed!
Unlike standard interest that is normally taxed through the 1099 form.
Financing
Unfortunately for us, financing rates or the rates that banks will charge consumers for loans have also been increasing as the Fed raises rates to attempt to tamp down the aforementioned inflation.
Luckily for us, markets can often react slowly and rate changes take time to work through the system.
Especially a system that has been far too used to easy money over the last decade.
As a result, if we wanted to arbitrage the difference in rates, we can!
For example, let’s take a 24-month personal loan which Wallethub indicates for May (data is a bit delayed!) is at 9.58%.
On the surface, this seems pointless as we’d have to borrow 10k at 9.58% to gain a 9.62% interest rate through the bond netting a mere $4. We’d also have to hope that inflation stays elevated enough over the next 24 months that the iBond continues to pay out at least 9.62% for this to apply.
However, this disregards the fact that iBonds pay out for 30 years, so assuming that the offered rate stays 9.62% for the next two years, we effectively pay nothing and have the option of owning an asset that will continue to pay out for the next 28 years.
The deal gets even sweeter if we’re able to acquire better financing as other sources like FRED indicate an 8.73% borrow rate.
I’ve personally been offered and have seen cheaper personal loan rates around the 6% range or even less!
Putting it all together
We can ignore iBond pricing given that it’s a static number every year but must consider that it has variable interest rates alongside the available financing rates.
If we’re able to assume that iBonds will continue to pay out at least 9.62% for the next 24 months, then it becomes quite attractive to finance a purchase.
Not financial advice, but I personally think that recent inflation numbers indicate that the next period’s iBond rates will be similar and inflation will prove quite sticky resulting in elevated rates (though probably not as high) for the next few years.
If we’re able to get any financing rate lower than the iBond interest rate, we can collect the spread and enjoy pure arbitrage.
Assuming that the iBond continues to be held, the internet earned is tax-deferred till we decide to sell. Beyond the spread arbitrage, we should also consider that once the loan is paid off, the iBond will continue to pay out for the remainder of its 30-year life.
