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Series I Savings Bonds Considerations for the Short Term and Long Term

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The Series I Savings Bond currently has a composite rate of 5.64%, and it's available through April 2009. This rate is much higher than you can get now with any CDs, but it's not really that good of a deal. There are reasons why you may be better off waiting for May when the new I Bond rates are announced.

To understand why buying an I Bond now may not be a good idea, it's useful to understand how I Bonds work. 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 (last 3 months)
  • Interest is composed of fixed and inflation-based rate
  • Fixed rate remains for life of bond (up to 30 years)
  • Inflation-based rate changes every 6 months from issue date
  • New rates announced every six months on November and May 1st
  • I Bond rate can never be negative
  • 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, per SSN ($5K online and $5K paper) - total was $60,000 before 2008 (Treasury's press release).
The important feature to note is that the I Bond rate is composed of a fixed rate and an inflation rate. The inflation rate changes every 6 months from the issue date. Currently, the fixed rate is only 0.70%. The current inflation rate is 4.92%. If you buy an I Bond now, you'll only get the 4.92% inflation rate for 6 months. The inflation rate for the following 6 months will be the rate announced in May.

Based on the deflation that we experienced late last year, the I Bond inflation rate in May is very likely to be negative. You don't have to worry about the composite rate going below zero, but it could be zero. So if you plan to only hold the I Bond for one year, you'll likely earn 5.64% for the first 6 months and 0% for the second six months. There's a 3-month penalty if you redeem before 5 years, but since this is the last 3 months, this won't matter. So this results in a one-year rate of 2.82%.

2.82% for one-year is very respectable in today's rate environment. The effective interest rate could be pushed up a little higher if you buy the I Bond near the end of the month and redeem it at the start of the month. This could push the annualized rate for 11 months to just over three percent.

Another advantage of the I Bond over a CD is that the interest is exempt from state and local taxes. The federal tax can be deferred until the bond is redeemed, but this won't help you much if you only plan to hold the bond for a year.

A big downside is the $10,000 purchase limit ($5,000 online and $5,000 paper). So compared to a 2.50% CD, you'll make around $50 more with a 3% I Bond for a $10,000 investment.

I Bonds for the Long-Term

There is one reason you may want to wait and purchase the I Bond after April when the Treasury announces the new rates. We'll know the inflation component after the government announces the CPI-U numbers on April 15. As described by the Treasury, the inflation rate announced in May is the change between the CPI-U figures from the preceding September and March. The government will be announcing the March CPI-U numbers on April 15.

We can estimate the March number and come up with a likely I Bond inflation rate for May. Here are the CPI-U numbers since September as listed at the Labor Department's CPI-U table:

Month CPI-U
September 2008 218.783
October 2008 216.573
November 2008 212.425
December 2008 210.228
January 2009 211.143
February 2009 212.193
March 2009 ?

Note how much the CPI-U went down last year. It started going back up in January, and I would estimate it'll go up again for March. So if we assume the increase in March matches that of February, this will give a March CPI-U number of 213.243 which is still way below September CPI-U of 218.783. This results in a negative annualized inflation rate of about -5.06%.

As you can see, it's very likely we'll have a negative I Bond inflation rate in May. We know how this will affect I Bond purchases today, but what about those after April? It depends on the Treasury's decision on the fixed rate. If the Treasury doesn't substantially increase the fixed rate, the composite I Bond rate for new purchases starting in May will likely be zero percent (composite rate can't be below zero).

It's possible that the Treasury could raise the fixed rate to give a composite I Bond rate of at least a little above zero percent. That would create a good opportunity for those planning to hold I Bonds for the long term especially if you want to use I Bonds to a hedge against rising inflation. The current fixed rate is only 0.70%, and the fixed rate since 2002 has been under 2.00%. The highest it has ever been since the I Bonds started in 1998 is 3.60% in 2000 (see its history). It's possible that the Treasury could raise the fixed rate to at least the level we saw in 2000.

I'm not too optimistic about the Treasury substantially raising the I Bond fixed rate in May. In the last several years, the Treasury has made the I Bonds much less competitive. The fixed rates have been disappointing, and most imporantantly, they slashed the purchase limit from $60K per year to only $10K per year. With an inflation rate that is a negative 4 or 5 percent, the Treasury may see no reason to offset this with a high fixed rate. A 4% fixed rate may still result in a zero percent composite rate. So from that perspective, the Treasury may decide to keep the fixed rate close to where it's at now. I hope the Treasury decides to help the small-time savers by making a substantial increase to the fixed rate, but I think it's likely there won't be much change. The Treasury keeps their process of determining the fixed rate secret, so we'll have to wait to May 1st for them to publicly announce the rate.


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Comments
14 Comments.
Comment #1 by Anonymous posted on
Anonymous
I would be shocked if the fixed rate was over 1% on May 1st.

I just dont see the treasury doing this.

I believe the best deal would be buying the bond on March 31st and selling on March 1st, 2010 earning over 3% for a 11 month and a day term.

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Comment #2 by Anonygal (anonymous) posted on
Anonygal
Am I right to assume that IBonds are not suitable for seniors who use interest for income? Isn't interest only available when bond is cashed in?

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Comment #3 by Banking Guy (anonymous) posted on
Banking Guy
Yes, I believe you only receive the interest when the I Bonds are redeemed.

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Comment #4 by Anonymous posted on
Anonymous
Savings Bonds are similar to zero coupon bond investments. You do not receive regular interest distributions like CDs. You only receive the interest when you redeem the bond. Savings bonds are more suited for investors who can sock the bonds away and expect to use the money in the far away future (such as for education, home purchase, gift to children, or some long term goal). If you wanted to receive periodic distributions, I believe the Series H/HH bonds offered that option. But I sort of recalled that that series no longer is available now, so that leaves only Series EE and I which are the accrual type of bond. Some of the other Treasury securities will provide periodic distributions (such as Treasury notes that pay interest every 6 months). You can get more information at this website.

http://www.treasurydirect.gov/indiv/products/products.htm

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Comment #5 by Anonymous posted on
Anonymous
Thank you for posting this information. It is very helpful!

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Comment #6 by Larry Ludwig (anonymous) posted on
Larry Ludwig
Great post!! I was researching into this and low and behold you have a post on it!

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Comment #7 by Anonymous posted on
Anonymous
The reduction to the maximum purchase amount was made because the Treasury said that most Savings Bond buyers only purchase "a minimal amount every year". They were pushing the big investors into the mainstream Treasury offerings. I think it is an overall effort to shrink the Savings Bond program so that the list of eventual buyers will be focused on those who buy it as gifts for others. My agency used to have a Savings Bonds payroll campaign every year. For the last few years, nothing was even mentioned about the program at all. The Series I bond was introduced in the 1980's to make the program more competitive with other securities offerings during the high inflation period in those years. Now the push to move people more into the regular Treasury securities (which had their minimum investment amount reduced recently). With so many people (especially globally) buying US Treasury securities, there is no longer any impetus to push this other US Treasury investment. I think with current deflationary trend and very low interest rate environment, the Government will not need to attract any new money into the Savings Bonds program for a long time, so the "guaranteed" rate will be very close to 0% for a while.

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Comment #8 by Anonymous posted on
Anonymous
Thanks for the great post, this was just what I was looking for!

But what about for those of us that purchased the IBonds last April? When will the 0% rates hit us, and when is the optimal time to sell in the short time (3 months after the 0% rate hits, right?).

What about the long term, should we expect a massive recorrection in the inflation rate, such that holding the IBonds through 6 months of 0% interest to be worth it?

Thanks again for this great information!

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Comment #9 by Anonymous posted on
Anonymous
I believe this statement: "So if you plan to only hold the I Bond for one year, you'll likely earn 5.64% for the first 6 months and 0% for the second six months" is not accurate. Wont you earn at least the .70% fixed rate component to the I-bond the second 6 months?

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Comment #10 by Banking Guy (anonymous) posted on
Banking Guy
If the inflation component is equal or more negative than -0.70%, the composite rate will then be zero percent. In this case the inflation component wipes out the fixed rate.

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Comment #11 by Anonymous posted on
Anonymous
To Anonymous who posted on 11:23 PM, March 24, 2009

I-bond rates for the inflation component adjust every six months. So if should be 0% this coming May, then you will only receive the base rate that was issued for those bonds back in April 2008. For those who bought bonds between May-October 2008, the base rate was 0%, so the inflation component will be all you can possibly earn for the life of the bond. It is best to sell the bond right after the first of the month because you will not earn interest if redeemed later in that month. If it is redeemed prior to that date, you essentially lose the interest for the entire month. You also want to redeem it when interest rates are low. Here is a calculator on another website to help you with estimating redemptions.

http://www.mymoneyblog.com/archives/2006/11/when-should-you-redeem-i-savings-bonds-a-calculator.html

Remember two things about these bonds. You CANNOT redeem them if held less than one year. You also will be penalized three months interest if redeemed in less than five years.

As for the future threat of inflation. If that should occur, then it might be a good deal to suffer the period of 0% interest now. But, you could also sell them and then repurchase new bonds later. I sort of don't think that Geithner will allow the bonds to be set to 0% this upcoming May because that would mean people who bought the bonds at the 0% base rate will be very annoyed with that impact on their long term savings goals. While it is true that 3 month Treasury bills are earning very little now, I don't believe the Treasury will allow that same thing to happen to Savings Bonds. Doing so, would lead to a floodgate of redemptions because people won't tolerate giving a bond to a child for their future college expenses that will earn virtually nothing when they need the money. I think the Treasury will come up with a base and inflation component figure that would not scare away bond holders. I purchased a lot of bonds back in the 1980's when the base rate was above 3%. I also bought a few last October when the base rate was 0%. The earlier bonds are earning a whole lot more than my later issued bonds and I am glad that I was able to buy them in larger quantities back then.

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Comment #12 by Anonymous posted on
Anonymous
To Anonymous who posted on 2:41 PM, March 25, 2009

The base rate of 0.7% would apply for the next six months (and for the rest of the life of the bond), but as BG said earlier, the inflation component may negate the base rate and you might end up with 0%, but you will never lose money (unlike the stock market) even if deflation becomes greater. It all depends on the announced inflation/deflation component rate. Series EE bonds will always earn something (albeit a smaller rate) because they don't have the inflation/deflation component.

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Comment #13 by Anonymous posted on
Anonymous
Here is an explanation regarding the interest rate adjustment for the I-bond. Your interest rate changes every six months depending on when you bought them, not when the Treasury announces a rate change.

http://www.bankrate.com/brm_c/news/DrDon/20070222_seriesI_bonds.asp?prodtype=chksav

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Comment #14 by Anonymous posted on
Anonymous
According to this blog, you should steer clear of I bonds.

"You would earn only the fixed rate for the period from May to November, which at the moment is just 0.7%, up from 0% for the previous six months. The fixed rate has been trimmed so severely over the past year that Dan Pederson, author of Savings Bonds: When to Hold, When to Fold and Everything In-Between, nixes I-bonds despite their current high interest rate. CDs are a better deal."

http://blog.kiplinger.com/kiptips/2009/01/steer-clear-of-ibonds.html

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