Need a little help...

[lghbob]

I own I bonds, and am very happy with them, as the ones I bought in 2001 are paying 8.4% and the ones I bought in 2003, are paying 6.56%
I know that my minimum payouts during deflation (ie. 0% CPI) will be 3.4% on the older account and 1.6% on the other account.

So here's the question... As I am expecting high inflation, in the coming years, I wondered what the interest rates would be at higher levels. It's so high, I feel like I've done something wrong in the calculations. I used a 5% CPI and a 10% CPI to calculate the return, and my original 3.4% and 1.6% base to make the full calculation.

Here's what I come up with... @ the 10% rate, a return of 33.8% and 33.2%

At the 5% rate , a return of 21.8% and 18.4%

This seems very high, but I can't see where I made my mistake.
The formula is: (Issue base rate )plus (2 times the CPI) plus the (base rate) plus the (CPI).
Help?

[Philip Brewer]

You've missed a divide by two on the inflation part.

The formula is complicated by the fact that they want to do the calculation twice a year, but express it in terms of an annual rate. So, they take the six-month inflation rate and then double it (to get an annual rate), but then divide it by two (by applying it for just half the year).

For practical purposes, though, you can get very close by just adding the annual (CPI) inflation rate to the fixed rate. Over a calendar year it will come out almost exactly right.

I assume you've seen the Treasury's page on I bond rates, but I'm including the link for other people who are interested in the details:

http://www.treasurydirect.gov/indiv/...esandterms.htm

[lghbob]

Phil... I guess I'm not good with numbers. I'm pretty sure that the interest rat that I calculated is wrong, but I still can't figure out why... I think it's because I'm putting the decimal in the wrong place. Anyway... here's the formula that the Fed uses

Here's how the composite rate for I bonds issued Nov 2008 - Apr. 2009 was set:

Fixed rate = 0.70%
Semiannual inflation rate = 2.46%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0070 + (2 x 0.0246) + (0.0070 x 0.0246)]
Composite rate = [0.0070 + 0.0492 + 0.0001722]
Composite rate = [0.0563722]
Composite rate = 0.0564
Composite rate = 5.64%

Now... here are my figures to be plugged in:
Fixed rate = 3.4% (my base year)
Semiannual inflation rate = 10.0% (my est for high inflation in a year or two)

Sorry to beat a dead horse, but I'm truly trying to understand... Trying to make a decision on what to cash in, and when.

[Philip Brewer]

Originally Posted by lghbob

Semiannual inflation rate = 10.0% (my est for high inflation in a year or two)

Are you really thinking that we'll see semi-annual inflation of 10% (i.e. annual inflation of over 20%)? If so, then you may be doing the calculation right. If, on the other hand, you're expecting an annual inflation rate of 10%, then the semi-annual inflation rate would be about 5%.

If you're still puzzled, let me know and I can work out an example for you.

[lghbob]

Phil... thanks for the come back...
My understanding of the semi annual rate is basically the CPI as of either May 1st or November 1st... the two dates when the rate is changed. If the CPI is the same, then the same number would be used both times, and there is no place where it is divided by two. On the fed page you linked, there is a chart of the semiannual rates for the period since the beginning.
The Fed provides a saving bond "Wizard, where you van plug in your bonds. In my case, my older bonds are currently showing an 8.4% APY, which, when I do the math myself, "does" come out to that number.
When the inflation rate is low, the numbers don't show the dramatic interest rates, but when we get to higher inflation, the formula makes the numbers look pretty good.
The "semi annual" number is listed that way, because of the revaluation twice a year.
Thanks for having the patience to answer so many questions...

[Philip Brewer]

Originally Posted by lghbob

My understanding of the semi annual rate is basically the CPI as of either May 1st or November 1st...

Okay, that's wrong--but it's easy to be confused about, because the rate keeps changing and the semi-annual rate will sometimes be quite close to the annual rate.

You can find the raw data here (link the the Bureau of Labor Statistics site). Click on the PDF for November and look on page 3. You can see that the annual inflation rate for the 12 months ended October 2008 was 3.7%. To get the semi-annual rate you can (roughly) add up the "percentage change from the preceding month" for the six months through October. If you do that you get 2.5%. (The official calculation uses the raw data and also adjusts for compounding which is why they get 2.46%.) But the point is, that's the inflation for just six months, not a full year. Since they want to turn that into an annual rate, they multiply by 2.

The "semi annual" number is listed that way, because of the revaluation twice a year.

Right--but it's also just half a year's inflation: The inflation in the six months before the revaluation date.

You can get very close to the right number just using the annual inflation rate, but then you mustn't multiply by 2, because the number is already a full year's inflation.

[Xin Lu]

Well, semi annual inflation rates of 10% have happened in the past. Lets hope it doesn't happen again. Meanwhile, I am also very happy with my I-bonds. It's unfortunate that they cut the limit so much.

[Philip Brewer]

Right. I was just making sure I understood. If you use full-year inflation rate and then multiply by 2 you get the wrong answer.

[starshard0]

So based on that, are bonds worth buying at this point?

[Philip Brewer]

Originally Posted by starshard0

So based on that, are bonds worth buying at this point?

It's a tough call. New bonds don't offer much of a real return--just 0.7% over inflation. But you have to compare that to other investments, many of which are going to offer less than inflation over the next year or two.

There are a couple rules to be aware of. First, you can't cash in an I bond until you've held it a year (unhandy if you really need the money). Second, if you cash it in before you've held it five years, you pay an interest penalty of 3-month's interest. Because of those, I don't recommend that you go hog-wild buying I bonds.

Having said that, though, I think they look very interesting as a place to put a little money every year. Once you've been doing that for 5 years, those first bonds can be cashed in without penalty. In the meantime, just keep an eye on I bond rates--if they go up a lot, you could potentially come out ahead cashing the bond in early, paying the penalty, and then buying a new I bond.

I've written several posts about I bonds for Wise Bread:

http://www.wisebread.com/tips-and-i-bonds
http://www.wisebread.com/savers-suff...all-what-to-do
http://www.wisebread.com/i-bond-rates-go-to-zero
http://www.wisebread.com/new-rate-se...-savings-bonds