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.