i-bonds

While Waiting for Rates: I-Bonds

Philip Brewer — Mon, 28 Feb 2011 13:00:09 +0000

Your short-term cash in a savings account or money fund isn't earning much yield. You could earn a bit more by locking your money up for a longer term, but that could be costly if your money is still locked-in when rates eventually do rise—and especially costly if inflation goes up.

If only there were some instrument that paid a reasonable return, provided some inflation protection, and still gave you access to your money if rates went up.

As you'll have guessed from the title, there is: the series-I savings bond.

The I-Bond provides excellent inflation protection, by paying a rate that consists of a portion that's fixed for the life of the bond, plus a portion that changes every six months based on recent inflation. A bond you buy right now will only pay the inflation rate, because the fixed portion is zero. However, there'll be a new fixed rate announced May 1st.

The I-Bond does this while providing considerable flexibility for you to decide how long you want to leave your money in. If it's providing a good return, you can choose to leave your money in for 30 years. Alternatively, you can take your money out any time after one year has passed. If it's been less than 5 years, you forfeit the last three months interest payments—but since rates are so low, that's not much of a penalty.

Four Scenarios

There are four scenarios that you need to consider: interest rates might stay low or they might go up; at the same time the inflation rate might stay low or it might go up. Let's look at each of those in turn, and see how the I-Bond works in that scenario.

Rates stay low, inflation stays low

This is basically the situation we've been in since the financial crisis began. The I-Bond is an adequate investment, keeping you even with inflation.

Your best move: Hold your bonds. With low rates, you probably can't do better elsewhere anyway.

Rates go up, inflation stays low

This seems like the least likely scenario, but if this is what happens, you'd be okay.

Your best move: Cash in your bonds and then invest in something paying the new higher rates. You'll have to give up three month's interest—but since inflation is low, that wouldn't be much.

Rates stay low, inflation goes up

This is generally the worst situation for the saver, but the I-Bond does a reasonably good job of protecting you, and you can't do much better elsewhere anyway. (People who locked in their money at low rates without inflation protection, on the other hand, are screwed.)

Your best move: Hold your bonds and keep up with inflation.

Both interest rates and inflation go up

In this scenario you're protected from the inflation, but you're not earning the new higher rates.

Your best move: Cash in your bonds. You'll pay a penalty, but it will be small (as long as you do it early, before you'd earned much of the new, higher inflation adjustment). Then reinvest at the higher rates.

Take Your Time

Probably the best move overall is to adopt this strategy gradually. For one thing, since you can't get your money out for the first year, you don't want to put in any money that you might need during that time. In any case, you're only allowed to buy $5000 worth of savings bonds per year anyway.

If you make a modest investment into I-Bonds each year, all but the most recent batch will be available to cash in anytime that's the right move. And, once five years have passed, some of them will be available to cash in with no penalty.

In fact, once you reach that point, you can start thinking of your savings bonds as part of your emergency fund. They can be cashed in at any bank, so they're almost like cash. (But they're more secure than cash, because if they're lost, stolen, or destroyed, you can get them replaced.)

If you want to invest larger amounts, consider TIPS. They're currently paying higher rates. (However, they don't have the feature of allowing you to cash them in early.) I wrote an article comparing TIPS and I-Bonds a while ago.

See the Treasury's site on I-Bonds for all the details on current rates, how the rate is calculated, how to buy them, etc.

It's entirely possible that interest rates will stay low. In fact, the Fed is pretty much promising to keep rates low for "an extended period." That's assumed to mean at least six months, but it could be much longer than that. I-Bonds are a reasonable choice while you're waiting—and after May 1st, depending on what the Treasury sets as the new fixed rate, they might get better.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

New rate set for series I savings bonds

Philip Brewer — Mon, 03 Nov 2008 20:07:11 +0000

Every six months, the Treasury sets a new fixed rate for series I savings bonds. After tracking close to the rate on the Treasury's other inflation-indexed bonds during the Clinton administration, the rate was cut sharply starting in 2001, culminating in an interest rate of zero for the past six months. Today, though, the Treasury announced the new rate for the next six months: 0.7%

That rate isn't as bad as it sounds, because you get that plus inflation. Adding in the adjustment for inflation, the total annual return on a bond purchased this month will be 5.64%. (That's an annual rate that will apply for the next six months. A new rate, based on inflation, will be calculated every six months--but the 0.7% fixed part of the return will remain in effect for the life of the bond.)

There are several good features of the I Bonds. You can defer taxes on the interest until you cash the bond--up to 30 years. And, if you use the money for education expenses, you may not have to pay taxes on it at all. In addition, if there's deflation, your investment is protected to the extent that its value won't fall below the face value of the bond.

As an alternative to the series I savings bond, consider TIPS--Treasury Inflation Protected Securities. They pay a market rate determined at auction, rather than a fixed rate determined by the Treasury. Currently, they're paying as much as 3.25% (plus inflation). Obviously, that's a lot better than 0.7%. There are several downsides, though. In particular, new bonds are only issued on specific dates (although you can buy one at any time through a broker). Also, TIPS have a specific maturity date, and you can neither cash them in early nor hold them longer, the way you can with a series I savings bond. In addition, their protection from deflation isn't quite as good. (For more info, see my previous article about TIPS and I Bonds, and for information on the mechanics of buying them, see my article Treasury bills for ordinary folks.)

Inflation plus 0.7% isn't a great rate, but given that there's a real danger of the economy tipping toward either inflation or deflation (or first one and then the other), these bonds may be a good buy.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

TIPS and I-Bonds

Philip Brewer — Sun, 02 Sep 2007 11:32:27 +0000

There are risks in any investment. The market might go down--or the market might go up, but your investment might go down anyway. The company that issued your stock or bond might go bankrupt. Even cash has the (virtually certain) risk that it'll be worth a bit less next month due to inflation. There are a couple of investments that eliminate almost all these risks: TIPS and I-Bonds.

Having just talked about gold as an investment, I thought this might be a good time to talk about these other inflation hedges.

In some ways these securities are pretty similar. They're both issued by the US government and they're both indexed to the Consumer Price Index. Although the details of inflation adjustment are quite different, the results are pretty similar.

They don't eliminate all risks, of course. The calculation of the CPI could understate inflation (it probably does, although not by a lot). The inflation rate that matters to you--the rise in costs of the goods and services that you buy--could be higher (or lower) than the government's calculation, even if the goverment's number fairly represents the average inflation faced by the average person. The US government could collapse. Overall, though, these investments are about as safe as cash and offer a higher return.

TIPS (Treasury Inflation Protected Securities)

These are a lot like other treasury notes and treasury bonds. They're sold with a face value of $1000, and the interest rate is determined in an auction. Individual purchasers can skip the auction process and just buy at the auction price (which guarantees you the same return as the investment professionals whose bids won the auction).

The interest rate is usually pretty low (currently running around 2.3% to 2.4%), which is not as bad as it sounds, because it is paid on the inflation-adjusted face value of the bond. An adjusted face value is calculated for each day and is announced monthly when the new CPI numbers are released. For example, the face value of the 3% 10-year TIPS that was auctioned in 2002 was 1158.80 on September 1st. As long as inflation continues, the face value will go up--and the interest payments, calculated as a percentage of face value, will go up as well.

At maturity you get the final adjusted face value. The face value won't go below $1000, giving you some protection against deflation as well.

If you have to sell before maturity, though, you're not guaranteed the face value. The price will depend on current interest rates and current inflationary expectations.

I-Bonds

These are savings bonds, rather like ordinary savings bonds. They're sold in various denominations, from $25 to $10,000. They also pay a fixed rate plus an inflation adjustment, but the calculation is different. Instead of calculating an adjusted face value and then applying the fixed rate to that, the treasury calculates a "composite earnings rate" that combines both parts. The composite rate is calculated every six months, based on the inflation rate of the previous six months.

The fixed part of the rate is determined by the Treasury twice a year. It applies to all bonds sold for the next six months, and remains in effect for the lifetime of the bond (30 years).

You can't cash in an I-Bond in the first 12 months after you buy it, and if you cash it in after less than five years, you lose 3-months of interest.

After-inflation return

Back when inflation-adjusted bonds were new, they paid a pretty good rate. If you'd bought one in 2000, you could have gotten a 10-year TIPS that paid 4.25% over inflation. Until about 2003, you could generally get 3% over inflation. Since then, the rates have dropped, mostly because interest rates in generally are lower now.

One way to think about the rate on a TIPS is that it should be exactly the same as the rate on an ordinary treasury security of the same maturity minus the expected inflation between now and then. So the rate on a TIPS goes down anytime the expected inflation rate goes up, plus it goes down anytime other interest rates go down.

The rates on I-Bonds used to be reasonably competitive with the rates on TIPS (from 1998 until 2001 they were 3% or higher). Since then, though, they've fallen quite low. The current fixed rate on an I-Bond is just 1.3% over inflation.

Tax Considerations

One reason to consider I-Bonds, despite the very low rate, is that they've got the same tax advantages of other savings bonds. You can choose to pay taxes on the interest every year (if, for example, you're a child with almost no income who will owe no tax) or you can chose to wait and pay taxes on the income only when you cash in the bond. Further, if you use the money to pay for certain kinds of education expenses, you don't need to pay taxes on it at all.

TIPS, on the other hand, have a unique tax problem: you not only owe taxes each year on the interest that you get, you also owe taxes on the increase in face value due to inflation (even though you don't actually get that money until the bond matures). Some people consider this a big deal, and don't recommend that you buy such bonds except in a tax-sheltered plan such as an IRA or a 401(k). Personally, I don't see how it's much worse than the tax treatment of a mutual fund where you're reinvesting the dividends, where you still owe taxes on the dividends and the capital gains, even though the money has been reinvested in the fund.

The interest on TIPS and I-Bonds, like all US Treasury interest, is exempt from state and local income taxes.

Info on:

TIPS
I-Bonds

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: