Inflation and Future Series I Savings Bond Rates
The Labor Department released the September CPI-U numbers today, and with these numbers, the next I Bond inflation component can be computed. The new I Bond inflation component that will be announced in November should be 1.76%. This number is added on to the I Bond fixed rate to derive the I Bond composite rate. As I show below, this can make for a good short-term deal as compared with today's CD rates. For the long-term, the value of the deal will depend on what you think of the government's CPI-U that's used to determine the I Bond inflation rate.
Government's CPI vs "Real" Inflation?
I'm sure many will claim a 1.76% inflation rate is much lower than what most people have experienced in the last 6 months. One problem with the CPI is that it includes price changes on many big ticket items and occasional purchases. The American Institute for Economic Resarch (AIER) has developed an inflation index called the Everyday Price Index (EPI) which measures the changes in prices of goods and services people buy frequently. This includes many essentials like food, gas, utilities and medical care. So big ticket items like TVs and PCs (with prices that always keep falling) don't impact the EPI. The AIER hasn't come out yet with the EPI changes for September, but for August the AIER showed a big difference between the EPI and CPI:
So far this year, everyday prices have increased 4.2 percent, three times the 1.4 percent increase in the seasonally adjusted CPI over the same period.
Long-term EPI changes haven't been radically different that CPI changes, but the EPI increases are larger than CPI increases. According to the AIER overview of EPI:
From January 1987 to December 2011, the CPI roughly doubled: it increased from 100 to 202.9. During the same time, the EPI increased substantially more - from 100 to 234.5. This translates into an inflation rate of about 2.9 per year on average for the CPI and 3.6 per year on average for the EPI.
This shows that the inflation that most of us see is indeed higher than the CPI reported by the government. However, it also shows that the CPI-U increases over the long-term are not radically different than "real" inflation that is being measured by the EPI. So the inflation component of the I Bond may be a little below the "real" inflation that you see, but it probably won't be radically lower than the "real" inflation.
I Bond Rates of Return for October 2012 Purchase
If you buy I Bonds before November, your I Bond will have a fixed rate of 0.00% and an inflation component of 2.20%. Thus, the composite rate is the same as the inflation rate of 2.20%. This rate will remain in effect for six months until April 1, 2013. The I Bond inflation component that the Treasury announces in November will take effect for your I Bond (purchased this month) in April. That will remain in effect for six months. Since we know the November I Bond inflation component, we can compute the I Bond return for the next year for I Bonds purchased in October.
the inflation rate announced in November is the change between the CPI-U figures from the preceding March and September.
All previous CPI-U numbers are available from this government webpage. The CPI-U for March 2012 was 229.392. The September 2012 CPI-U was 231.407. This is an increase of 0.878%. The annualized version of this is about 1.76%.
If you buy before November, you'll receive the current I-Bond fixed rate of 0.00% for the life of the I Bond. The inflation component will be added to this rate and will change every 6 months. The current inflation component is 2.20%, and the composite rate is 2.20%. Here's an estimate of the return for the next year:
- 2.20% from October 2012 through March 2013
- 1.76% from April 2013 through September 2013
I Bonds increase in value on the first day of the month. So on November 1st, you'll earn the interest for the full month of October. So for maximum return, it's best to buy I Bonds near the end of the month and redeem them early in the month.
If you redeem an I Bond before 5 years, you lose the last 3 months of interest. So based on this and the above numbers, if you buy an I Bond on October 31, 2012 (best not to wait to the last day), the redemption value of the I Bond on October 1, 2013 would be 1.54% higher. For 11 months, this comes out to an annualized yield of about 1.68%.
Below is an estimated annualized return for I Bond redemption from October 1, 2013 to January 1, 2014. It is assumed you will buy the I Bond on October 31, 2012 which gives you almost an extra month of interest. This effectively reduces the 3-month penalty to 2 months.
- 1.68% - redeem on 10/1/13, 6mo of 2.20%, 3mo of 1.76%, and 3mo of 0% (penalty)
- 1.69% - redeem on 11/1/13, 6mo of 2.20%, 4mo of 1.76%, and 3mo of 0% (penalty)
- 1.69% - redeem on 12/1/13, 6mo of 2.20%, 5mo of 1.76%, and 3mo of 0% (penalty)
- 1.70% - redeem on 01/1/14, 6mo of 2.20%, 6mo of 1.76%, and 3mo of 0% (penalty)
Note, it's best not to wait until the last day of the month to buy I Bonds at Treasury Direct. You probably want to give yourself at least two business days to ensure they are officially purchased before the end of the month. I did an experiment last year to see how close to the end of the month one could wait (see the middle of this post).
I Bond Purchases AFTER October 2012
We won't know the I Bond fixed rate until November. However, it's very likely to remain zero percent in this interest rate environment. So the worst case composite rate will be 1.76%. If inflation increase over the next 6 months, the May 2013 I Bond inflation component may be over 2.20%. That could make an I Bond purchase after October a better short-term deal.
Validation of Above Calculations
To validate the rates that I calculated for a late-October I Bond purchase, I plugged numbers into the TreasuryDirect Savings Bond Calculator. I assumed a $100 I Bond purchased in October 2011 and redeemed on October 2012. The calculator gave me a total present value of $103.08. In my October 2011 I Bond post, I calculated that "if you buy an I Bond on October 28, 2011, the value of the I Bond on October 1, 2012 would be about 3.07% higher." As you can see, it's very close. I assumed the 3-month penalty applies to the last 3 months which must be the case based on the calculator.
Remember the $10K Annual Purchase Limit
It's important to remember that the annual purchase limit is $10,000 (excluding the purchases using your tax refund). Also, remember that the Treasury ended offering paper savings bonds at banks. However, it did double the annual purchase limit at Treasury Direct (see post). So if you earn 1.70% APY for 14 months on $10K, the total dollar amount of interest is about $198. As a comparison, a $10K deposit into a 1.15% CD would return about $134 in 14 months. So you won't make that much more with the I Bond. Nevertheless, I Bonds have some nice features that CDs don't have such as being exempt from state and local income tax.
I Bond Features
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
- Interest is composed of fixed and inflation-based rate
- Fixed rate remains for life of bond
- Inflation-based rate changes every 6 months after issue date
- New rates announced every six months on November and May 1st
- 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 (excluding purchases using your tax refund) - total was $60,000 before 2008 (Treasury's press release).
For more details about the purchase limit, please refer to the Treasury Direct's FAQ on the new purchase limit.
Social Security COLA for 2013
The CPI numbers that were released today can also be used to calculate the Social Security cost-of-living adjustment (COLA) that takes effect in 2013. According to the Social Security website, the increase will be 1.7% for 2013. The I Bond inflation component is based on CPI-U, but the Social Security benefit changes are based on CPI-W and it's based on a different time period. According to the government:
It is based on the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of the last year a COLA was determined to the third quarter of the current year.
As the AIER described, "Seniors who rely on their Social Security checks to cover everyday expenses - food, utilities, gasoline, and medical care - may find that a 2013 increase of 1.5-1.7 percent will fail to keep pace with rising prices."