The new rates for I Bonds came out last week, and I think many people, including myself were quite surprised that the fixed rate portion went from 1.20% to 0.0%. The inflation rate went up to 2.42%, for a composite rate of 4.84%. I think most people were expecting it to drop fairly significantly and the inflation indexed portion to go up, but I don’t think too many people thought the fixed rate component would go to zero. As I have explained previously about I bonds, the total rate is the fixed rate plus 2x the semiannual inflation component plus the semiannual inflation rate x the fixed rate.
Here’s how the composite rate for I bonds issued May 2008 - Oct. 2008 was set:
Fixed rate = 0.00%
Semiannual inflation rate = 2.42%
Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.000 + (2 x 0.0242) + (0.0000 x 0.0242)]
Composite rate = [0.000 + 0.0484 + 0.0000000]
Composite rate = [0.0484]
Composite rate = 0.0484
Composite rate = 4.84%
So what does this means for I bonds purchased now or in the next 6 months?
For many people I would surmise they have become less attractive, because if you purchase I bonds when they have a higher fixed rate (or any fixed rate, as it is now 0%), you are guaranteed a certain minimum fixed return in addition to whatever the semiannual inflation rate. However, the inflationary rate went up to 2.42%, so the composite or total rate of return is currently 4.84%, which is not too bad, considering that most high-yield savings accounts currently return around 3.0% or less. But that rate is only guaranteed for 6 months and then the rates will change again. If the inflation rate portion begins to trend down, and your fixed rate is 0%, your returns could end up dropping significantly. So, now may not seem like a great time. Remember, you are required to hold them a minimum of 1 year (really 11 months if you purchase them at the end of the month), and you lose 3 months interest if you cash them in before 5 years. So, if you were to cash them in after 1 year, your effective rate would be 0.75 x 4.84% (although your real rate will depend on the change in November 2008 as well) = 3.63%, which is still not too bad and still better than most liquid investments such as high yield savings accounts. Even though you will have to pay tax on the earned interest, it is deferred until you cash it in, which is also better than most liquid investments where you will pay tax on the earned interest every year.
What’s my take?
I still think I bonds can be a good high yield alternative to savings accounts, even after you look at the puzzling change in the fixed rate. One explanation to the change could be that the U.S. Government is trying to peg the I bond rate entirely to inflation, which may not make them as attractive in the future, although when inflation may start coming down is anyone’s guess. I bonds have averaged a 4.5% return over the last 10 years, and even with the change in the fixed rate to 0%, this is still the case. They are appropriate for a medium range investment, something you will not need for at least a year, and preferably 5 years so you don’t lose any earned interest. They are also tax-free if used for education, which is another positive. I recently started buying I bonds on a monthly basis, in small amounts, and am going to continue to do so. As the rates change over the future semiannual (6 month) periods, I will evaluate my strategy.
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