The Federal Reserve continues to slash short-term rates, so right now looks like a good time to take a second look at Series I Savings Bonds since they are not directly tied to such rates and also offer protection from inflation.
I-Bonds Quick Summary
- Series I Savings Bonds (also known as I-Bonds) are investments that have very low risk (backed by the government) and offer to pay interest in two parts: a fixed rate + a variable rate indexed to inflation. The fixed rate is known when you buy, and the variable rate changes every 6 months.
- You must hold them for at least 1 year. If you redeem within the first 5 years, you lose the last 3 month’s worth of interest. They stop paying interest after 30 years.
- Interest from savings bonds are subject to federal income tax, but are exempt from local and state income taxes. For people that live in states with high income taxes, this can make them more attractive. They also have some special exemptions when used for educational purposes. See this Tax-equivalent Yield Calculator.
- As of 2008, you can only buy $5,000 of paper I-bonds and $5,000 of online I-bonds per Social Security Number, per year. However, many users report still being able to buy up to $30,000 at a time online.
- More info at TreasuryDirect.
Currents Rates and Predictions
Currently, the fixed rate portion of I-Bonds is 1.2%. If you buy a bond now, you will also be guaranteed an variable interest rate of 3.08% for the next 6 months, for a total interest rate of 4.28%.
After that, the rate will adjust every 6 months based on the previous 6 month’s worth of inflation data. The next adjustment will be in May, based on September-March 2008 data. Currently, we have September-February, so let’s use that to make an educated guess. Using the prediction method explained here:
Sept 2007 CPI-U was 208.490. Feb 2008 CPI-U was 211.693. 211.693/208.490 = 1.015363, or a semi-annual increase of 1.536%.
Total rate = Unknown fixed rate + 2 x Semiannual inflation rate + (Semiannual inflation rate X Fixed rate)
If we assume a fixed rate of the current 1.2%, we get
Total rate = 0.012 + (2 x .015363) + (.012 x .015363)
Total rate = 1.2% + 3.09%
Total rate = 4.29%
Now, looking at oil prices, I’m guessing that inflation is probably going to tick upwards some more in March. If we use August-February data, the variable rate would be around 3.37% (total rate 4.57%). Either way, I think it is a fair bet that the variable portion will stay around 3.1% if not higher.
Buying I-Bonds as a 12-month CD
Given these predictions, we can have an idea of what our interest earned will be if we buy now. There is one last “trick” with I-Bonds, and it is that if you buy at the end of the month, you’ll still get all the interest for the entire month as if you bought it in the beginning of the month. Let’s say we buy at the end of March (this week!), hold for the minimum of one year, and pay the 3-month interest penalty. You’ll be able to sell on March 1, 2009 for an actual holding period of 11 months.
We will get 4.38% for 6 months, and ~4.3% for 3 months taking in account the penalty. That’s equivalent to an annual rate of 3.56%. Now, if you live in a state with 9% state income tax, your equivalent yield gets bumped up to 3.9-4.05% depending on if you fully itemize your state income taxes.
Given that you can also find a traditional bank CD that pays around 4% APY currently, this rate is competitive but not a screaming deal. But if you are in the market for some inflation protection and your time horizon is more like 2-7 years, there is low downside and good upside as you can always decide to hold it longer than 11 months if inflation continues to climb and the Fed is unwilling to raise interest rates due to economic recession. I am currently considering buying some of these to hold my emergency funds for this reason, but the lack of liquidity for the first 11 months is a concern.
Buying I-Bonds as a Long-Term Investment
If you want long-term inflation protection and are willing to stray from the ease and convenience of mutual funds or ETFs, I-Bonds might also be a good option. The fixed rate of 1.2% is relatively low historically, but in the current environment it’s actually very good. Other low-risk inflation-indexed products are trading at a negative real yield right now. The next update to the fixed rate will be in May. Given the current rush towards similar products, people are betting that the fixed rate is going to drop even further.
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Great post, because Zvi Bodie wrote a book called Worry-free Investing for those who are [rightly!] concerned about managing inflation through their retirement.
Zvi recommended TIPS …. but, I-Bonds look similar … another alternative are Inflation-Protected MUNI’s.
I bought I-bonds online last Thursday. I heard about the $5K limit, so first I tried $35K, and got an error stating that I can buy up to $30K, so then proceed to buy the max $30K with no problem.
Now the hard part is to convince my wife to buy some for her.
could you post the pros and cons of using these for college funds?
Everyone needs to make sure they know that you must hold I bonds 5 years or you’ll forfeit 3 month’s interest when you cash them. If your horizon is <5 years you may be better off in CDs or other short term savings vehicles.
Ibonds are a great diversifier and addition to emergency funds. I use them as a “last resort” and keep them on hand locked in a safe.
Todd – my understanding is that the growth on Ibonds is tax free if they are used for higher education. (I have some for my children to balance stock invested in 529 plans). You can’t just use the growth, however. You have to use the principal and growth. If you want a stable, simple, slow growth savings plan for college Ibonds can give you this. Beware that the 5 year rule still applies if college is getting close.
What do you all think about the Inflation protected mutual funds such as Fidelity Inflation-Protected Bond Fund (FINPX) or the Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX). Their expense rations are 0.45% and 0.20%. I think you can trade in and out without penalty but you need an initial investement >2500. Their quoted rate of return is >5%. What am I missing?
it is because of these security types that the cpi inflation rate is used and is completely bogus. can you imagine what these rates would be if they factored in real inflation?
Hi- I used I bonds a few yrs back and the limit was $30k online + $30k paper as far as i can recall (definitely $30k online since i invested online). One question that intrigued me- the interest accrued every month is not compounded or am i missing something? i.e. if you buy $10k, yor principle remains $10k for the 30 yr period and your interest just hangs out in the account unlike savings accounts where accrued interest is used as future principal or compounded. am i totally off base in my understanding of how I-bonds work here? I actually owned and the interest each month was always based on original principal i.e. it’s really a bond! and this was a concern to me if you’re looking to save long term and not use coupon or interest as income.
Another benefit of I-Bonds: They are tax-deferred until renewal. If you compare the after-tax compounded return of a tax-deferred investment versus the after-tax return of a non-deferred investment, you’ll see a big difference. And unlike TIPS, there is no risk of loss of principle.
If you need a long-term, zero-risk, savings vehicle, I-Bonds seem to me like the way to go.
thanks for the info. much easier to understand your post rather than the US Treasury website!
Buy gold and silver; government paper is a waste!
PB – I bond interest is compounded semi-annually based on the issue date. See http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_ifaq.htm