Dedicated to Deposits: Deals, Data, and Discussion

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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