I Savings Bonds – the best kept secret

I am a strong proponent of loading up on I Savings Bonds issued by the US Government treasury. In treasury’s own words

I Bonds are a low-risk, liquid savings product. While you own them they earn interest and protect you from inflation.

  • Sold at face value; you pay $50 for a $50 bond.
  • Purchased in amounts of $25 or more, to the penny.
  • $10,000 maximum purchase in one calendar year.
  • Issued electronically to your designated account.

In addition to the inflation component I bonds also have great tax advantages. They are exempt from state and local taxes. For states with high state taxes, I’m looking at you California and NYC, this is a big deal. You can also choose to account for taxes on an accrual basis. In simple terms this means that you can defer paying federal taxes till the bond matures (30 years). In this respect the I bond acts like a 30 year term CD. Cd’s typically max at out 10 years, so 30 years is a huge bonus.

The I bond rate has two components, a fixed rate component as well as Inflation linked component. Again straight from treasury direct,

The I Bond earnings rate is a combination of two separate rates; a fixed rate and an inflation rate:

Fixed Rate:

  • Announced each May and November
  • Applies to all bonds issued during the six months period beginning with the announcement date.
  • Remains the same for the life of the bond

Inflation Rate:

  • Announced each May and November
  • Based on change in the Consumer Price Index for all Urban Consumers (CPI-U)
  • Is combined with the fixed rate to determine the earning rate of the bond every six months

Here’s how the composite rate for I bonds issued May 2012 – October 2012 was set:
Fixed rate = 0.00%
Semiannual inflation rate = 1.10%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

Composite rate = [0.0000 + (2 x 0.0110) + (0.0000 x 0.0110)]
Composite rate = 2.20%

An I Bond’s composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in March 1999 changes every March and September.

Currently in the low rate environment expect the fixed rate component to be set at Zero for a while!. Interest is accrued monthly, compounded semiannually and there is no penalty if you hold the bond for 5+ years. You have to hold the bond for a minimum of a year. If you withdraw money within the period 1-5 years you are charged a penalty equal to the last three months of interest.

I also consider I bonds as a great alternative to short term high yield checking accounts. For example the current composite interest rate is 2.20% which is valid only for 6 months. So the actual interest rate for 6 months is 2.2/2 = 1.1% . Lets assume that in the worst case that the interest rate for the next 6 month period will be 0.0%. So on 100$ investment the interest gained will be:

  • Interest 1st 6 months = 100*1.1% = $1.1
  • Interest 2nd 6 months = 102.2*0% = $0
  • Total = $1.1

Since the minimum period you have to hold the bond is a year, the shortest period you can hold the bond is a year and 1 day. So if you redeem on day 366, you lose the last 3 months of interest which was equal to zero anyway. So your worst case return = 1.1% for a year. That’s a great deal.

Where do you get a one year CD for 1.1% that is exempt from state tax? This is also the worst case return, if inflation is non zero (which is more probable) , the next six month rate will be non zero and you will get higher that the 1.1% modeled above!

References:
Treasury direct I Bonds Resource Center
Interest Rate Calculations at Savings Bonds Advisor
Performance of I Bonds vs Inflation @ E-piphany Blog

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s