Student Loan Carry Trade – I Bond Update

While many of the Covid-19 economic stimulus and relief programs have now expired, an important one remains alive – student loan forbearance. Since March 13, 2020 the interest rate on eligible student loans has been set to 0% and payment requirements have been paused. This has helped millions of Americans – young and old – keep more money in their pockets to deal with the rising prices of goods and services. Currently, this pause is set to expire on August 31, 2022.

Back in May 2020 we first suggested that student loan borrowers could take advantage of a carry trade by investing their would-be loan payments in bonds yielding more than 0%. Several payment pause extensions later, we wanted to see how that trade worked out.

Missed Opportunity?
At that time we offered a few investment suggestions, but in retrospect missed a big opportunity: Treasury Series I Savings Bonds. These are bonds issued by the US Treasury that pay a fixed rate of interest for the life of the bond plus a variable inflation rate tied to the Consumer Price Index for all Urban Consumers (CPI-U) that changes twice per year. Through the end of 2021, bank loans and short-term corporate bonds produced positive returns while short-term Treasuries were a push. But at midyear 2022, due to the rapid shift in the Fed’s monetary policy resulting in higher rates, bank loans were the only fixed income asset that had eked out a positive total return between June 1, 2020 and June 30, 2022 (Figure 1).

Figure 1 – Comparison of Cumulative Returns

Source: Morningstar Direct

Treasury Direct I Bonds
But unlike two years ago, inflation is top of mind today. The Consumer Price Index reached 40-year highs of 9.1% in July 2022 compared to a scant 0.1% in May 2020. Since that time, the once obscure Treasury Series I Savings Bonds have become all the rage. These bonds, issued by the US Treasury, pay interest that’s adjusted semi-annually for inflation. In 2020, the Treasury sold $29 million in I Bonds per month, while in the first half of 2022 monthly sales averaged a whopping $2.9 billion (Figure 2).

Figure 2 – Gross Sales of Treasury Series I Savings Bonds (1/1/20–6/30/22)

Source: Fiscal Data

With a fixed 0% rate on student loan interest, I Bond purchasers would have earned a positive spread without taking credit, interest rate, or principal risk. Yes, there are some limitations on these bonds: They are illiquid for the first 12 months, redemptions in the first 5 years forfeit the last 3 months of interest, and purchasers are limited to buying $10,000 per calendar year per Social Security number. But in a high-inflation environment, they can be very attractive (Figure 3).

Higher Inflation, Higher Return
Taking the 3-month redemption penalty into account, the cumulative return for an investment in an I Bond purchased June 1, 2020 would have been +5.5% through June 2020 and +6.7% through August 2022 when student loan payments are scheduled to restart. With the benefit of hindsight, we really missed an opportunity. But for those interested, I Bonds issued before November 2022 will earn 9.62% for the first six months before the CPI-indexed rate adjusts (Figure 3).

Figure 3 – I Bond Composite Interest Rate (0% fixed rate + CPI-U)

Source: TreasuryDirect