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Update on Series I Savings Bonds: Six Months of 0% for All Existing I Bonds

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Update 5/01/09: Treasury issues new fixed rate of 0.10%.

The Labor Department released the CPI numbers for March, and with this info, we can now calculate the I Bond inflation component that starts on May 1st. Last month I had predicted a negative inflation component with an annualized rate of about negative 5 percent. I was close. I've calculated that the actual annualized I Bond inflation component for May will be -5.55%. 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. From the Labor Department's CPI-U table, September 2008 CPI-U was 218.783, and now we know March's CPI-U (212.709). So the annualized rate can be calculated: 2*(212.709-218.783)/218.783. This equals -5.55%.

The negative 5.55% is by far the lowest inflation component since the I Bonds were started in 1998. The next closest occurred in May 2002 when it was positive 0.56%. The drop in gas prices over these 6 months was surely a big reason for the deflation. There wasn't as much deflation for the year. In that case the CPI-U only decreased by 0.4%. Nevertheless, according to the Treasury, this was the first 12-month decline since 1955.

So what does this mean for I Bonds?

Existing I Bonds

All I Bonds that have been purchased will have a period of six months with zero percent interest rate. The composite rate is equal to the sum of the fixed rate and the inflation component, but only if the sum is zero or higher (the composite rate can never go below zero). The highest that the fixed rate has been was 3.60% in May 2000. So this means all I Bonds will experience six months of zero percent. The start of the six month period depends on when you purchased the I Bond. Here's a table that shows when the six months of 0% interest rate begins:

I Bond Purchase Date When the 6-Month Period
of 0% Begins
-------------------- -----------------------
May November May 2009
June December June 2009
July January July 2009
August February August 2009
September March September 2009
October April October 2009

The good news is that this is a good opportunity for those with I Bonds from 1 to 5 years old. Redeeming those I Bonds that are less than 5 years old incurs a 3-month interest penalty (the last 3 months). So if you redeem an I Bond that you bought in May 2006 on August 2009, you'll lose interest that the I Bond earned in May, June and July. But since that interest is 0%, it doesn't matter.

For those interested in I Bonds for the long term, it may be better to live with the six months of zero percent. Remember, some I Bonds are still earning over 8% due to the current high inflation component. So for the long-term, the I Bonds are still not a bad deal, especially if you have I Bonds with fixed rates of over 3% (those bought before 2001).

Buying I Bonds before May 1st

If you buy an I Bond this April, you can still earn a decent rate for one year. You'll 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%.

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 3%.

The other nice I Bond feature is that the interest is exempt from state and local tax. The federal tax will be based on the interest when it's redeemed, so you won't have to worry about that until 2011.

The big downside of the I Bond is that you can only invest a maximum of $10,000 per social security number per year ($5K online and $5K paper at a bank). So compared to a 2.50% 1-year CD, you'll make around $50 more with this I Bond for a $10,000 investment.

Buying I Bonds after May 1st

The composite rate won't be known until May 1st when the Treasury announces the fixed rate. Unlike the inflation component, the Treasury keeps its method of determining the fixed rate secret. If the Treasury does make a large increase to the fixed rate, 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. You'll probably have to suffer 6 months of zero percent. But if inflation starts to become an issue, the future inflation components combined with a high fixed rate could provide some nice returns (with no risk).

The current I Bond fixed rate is only 0.70%. It has been under 2% since November 2002 (see its rate history). So in my opinion, it's time for the Treasury to make a significant bump in the fixed rate. With a -5.55% inflation component, I doubt the Treasury will offset this with a fixed rate above 5.55% to make a positive composite rate. The fixed rate has never been higher than 3.60%. However, could the Treasury at least raise it to above 2% or 3%? The Treasury did the offset the other way. In May 2008, it lowered the fixed rate from 1.20% to 0% when the inflation component was a high 4.84%. The fixed rate improved a little last November, but it remained very low at 0.70%. So if the Treasury wants to be fair, why not do the offset in reverse and give us a decent fixed rate of at least 3%? With only a $10K cap, it's not going to give the banks much competition for our savings. And it will give responsible small-time savers a little help especially as concerns about inflation grows.

My hope is that the Treasury will raise the fixed rate to over 2%. However, as I mentioned in my last post, 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 importantly, they slashed the purchase limit from $60K per year to only $10K per year. Based on this history, my guess for the fixed rate is between 1% and 2%.

For more information on I Bonds, refer to my March post for a summary of the I Bond features, and for the official information, refer to the Treasury Direct website.

Edit 5/04/09: Corrected example of when to redeem an I Bond: Redeem on August and not July.


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Comments
15 Comments.
Comment #1 by Anonymous posted on
Anonymous
My Guess:

The fix rate will be between 0.7 and 1.0%.

I can not see the treasury giving higher that 1.0%.

1
Comment #2 by Robert (anonymous) posted on
Robert
I can see the Treasury ignoring the CPI trend from September to December. Looking at just first three months of 2009, the inflation will amount to about 1.5% for the semi-annual rate. The semi annual composite target for the last 5 years has always been around 2.5-3%

So I would expect 1%-1.5% but no more.

I am going to miss that 8% yield from my bonds purchased in 2000 and 2001.

1
Comment #3 by Anonymous posted on
Anonymous
Even with a six-month hiatus from interest, I-bonds -- particularly those terrific early issues, with 3.6% yields over the CPI -- remain outstanding investments.

Even though, for the applicable period, there is a substantial deflationary component, the I-bond retains its full principal value -- unlike a TIP, which can go down in value during deflationary periods. That's a pretty good deal.

1
Comment #4 by Anonymous posted on
Anonymous
I guess it does not matter how big the federal deficit becomes if the governement can loan money at 0% interest !!!

1
Comment #5 by Doug (anonymous) posted on
Doug
Unlike I-Bonds, TIPS never pay zero percent interest, and there's no silly $10K/yr limit.

And like I-Bonds, TIPS guarantee full principal at maturity.

1
Comment #6 by Anonymous posted on
Anonymous
Funny (not) how the Gov't calculates inflation using the Core CPI when inflation is high (thus ignoring true effects of fuel, food etc), yet now, when we are in a low period (but surely not zero @ the core level, well, they factor-in every last dunsbious factor. Of course, if this blog's readers haven't figured it out yet...it's my opinion that the Fed (via giving virtually free money to banks, and others, are trying to close every conservative investment (e.g. CD's, I/EE bonds(...thus I see a pattern of attenpting to *force* money back into the stock market (IMHO). Nice!

1
Comment #7 by Anonymous posted on
Anonymous
I am sorry that Robert will miss his 8% on his bond.

He could have purchased a 10 year CD paying 8.10% at Capitol One in May of 2000.

1
Comment #8 by Bozo (anonymous) posted on
Bozo
To: All
Re: CDs versus I Bonds +/or TIPS

I've yet to see any definitive studies showing that I Bonds or TIPS beat CDs in tax-deferred accounts. Admittedly, I do a lot of rate chasing, and keep a fairly tight ladder of CDs. Over the past 2 1/2 years, my CD ladder has beat I Bonds handily. Same for TIPS, except when the real rate of return nudged over 3%.

I'm not a big fan of TIPS funds (too volatile for retirement planning), and the opacity of the TIPS secondary market is a bit scary.

Just my $.02

Bozo

1
Comment #9 by Anonymous posted on
Anonymous
To anonymous poster of 4:19 AM:

My thoughts exactly! Every word of it. Including trying to force us conservative savers into the stock market looking for a decent return. Only to vanish and never be seen again.

Many unfortunate people do not have time on their side to wait for a rebound.

1
Comment #10 by gaelicwench (anonymous) posted on
gaelicwench
With all the hoopla that was made when the I bond first came out about 11 years ago, why even bother. Banks certainly don't stand to benefit from selling them.

Makes one wonder if the Treasury is in the back pockets of the banks to keep both fixed and composite rates down low. No one will invest in the I Bonds, go with other investments that banks themselves sell and...VOILA!

Cynical? You bet! I put absolutely nothing past financial institutions nowadays.

1
Comment #11 by Anonymous posted on
Anonymous
If the FEDs continue to flood the money supplies at every level of investments, it is obvious that something is definitely wrong here.

If interest rates are near zero, then what is the point of saving?

If hyper inflation is on the horizon, then again, what is the point to save when the purchasing power will decline?

My thinking is that there is something very wrong here.
Low interest rates create false sense of security for near future.
High interest rates not backed with real growth, will make our savings worthless, regardless of the interest rate received in future.

FEDs should leave the rates to be dictated by the market conditions and not interfering artificially with bogus rates.

1
Comment #12 by Anonymous posted on
Anonymous
I have 1.20% Fixed rate i-bond.

Am getting 6%+ right now, no way I am cancelling till the 0% kicks in.

Bond was issued in April 2008. Ill check the treasury direct website to see when the 1.20% Fixed rate will kick in and will shop rates at that time to see which is better.

1
Comment #13 by vladimir (anonymous) posted on
vladimir
Once again, you all (y'all in Texas) forget about tax deferral and state taxes.

Yes, in Texas we pay no taxes except federal, but deferral is why I like I bonds.

I will cash them out when my tax rate is lower than now or none. Probably, when I am no longer working...

1
Comment #14 by Anonymous posted on
Anonymous
I have to nitpick about the example of cashing in your I bond during the months of 0% interest.

The interest for a month is paid on the 1st of the following month; that's why it's advantageous to buy near the end of the month, when you'll earn that full month's interest.

In your example, to surrender the 0% interest for May, June, and July, you'll want to redeem early in August. If you cash in during July as stated, you'll lose the interest from April.

1
Comment #15 by Anonymous posted on
Anonymous
Worse than you thought:

As of May 1
WASHINGTON (Dow Jones)--The U.S. Treasury Department set a zero percent earnings rate Friday for its Series I savings bonds bought from May through October 2009.

The earnings rate includes a fixed rate, set at 0.1%, and the annualized rate of inflation over the next six months, which was -5.56% between September 2008 and March 2009. The earnings rate is never less than zero.

1