I-Bonds and Inflation May 2011

Starting May 1, 2011, I Bonds (the “I” stand for inflation) will be yielding a composite rate of 4.6%. That rate is great when compared to the yields currently available on bank and mutual fund money market accounts or CDs.

All bonds purchased between May 1, 2011 and October 31, 2011 will earn 4.6% for the first six months you own them.

(UPDATE: The I Bond composite rate effective from November 2011 through April 30, 2012 is 3.06%, down from the previous six month period, but still better than most "short term" alternatives.)
How the Rate is Determined

The I Bond’s composite rate (yield) is made up of two parts:

1. The fixed rate that’s established arbitrarily by the Treasury which remains in effect for the life of the bond (that fixed rate is currently 0%)

2. The inflation-adjusted rate which is set by a formula that measures inflation over defined consecutive six-month periods (the current inflation adjustment is 4.6%). This rate is reset every six months, and moves up and down based on the previous six-month measuring period’s rate of inflation. This inflation adjustment is added to the fixed rate to get the composite rate for each succeeding six month period.

So, when we add the 0% fixed rate and the 4.6% inflation adjustment, we get the current 4.6% composite yield. That rate remains in effect until the next inflation adjustment takes effect. That pattern continues every six months for the life of the bond. The composite rate can never go below 0%, so even if we experience a prolonged period of severe deflation, the I Bonds will still help protect the future spending power of your investment.

I Bond Advantages

I Bonds offer a number of advantages that taxable money markets and CDs don’t, including:

1. They’re very flexible. They can be redeemed anytime between one and 30 years. (There’s a loss of the last three months of interest if you redeem them prior to five years.)

2. They’re risk free. You can never lose money and they’re backed by the full faith and credit of the United States Treasury.

3. They’re free from state and local taxation. If you live in a state with an income tax, and/or a city with an income tax, your after-tax return is even higher with I Bonds when compared to conventional taxable money market accounts and CDs.

4. They’re tax deferred. Even though you buy I Bonds with taxable funds, they’re tax-deferred until you choose to redeem them or when they reach final maturity in 30 years. This is a great way to increase your tax-deferred space.

5. They can be tax-free. If you use your I Bond proceeds to pay for qualifying educational expenses for yourself, your spouse or your children, all of the accumulated interest can be tax-free if you meet the then-current income limits.

Purchase Limits

I Bonds do have purchase limits. An investor is limited to purchases of $10,000 per year per Social Security number ($5,000 in paper I Bonds and another $5,000 via Treasury Direct). A couple can thus purchase twice that amount ($20,000), and if they have trusts, they can buy another $10,000 ($5k paper and $5k via Treasury Direct) for their trust(s).

How to Purchase I Bonds

You can purchase I Bonds at any bank that’s an agent of the Federal Reserve. After filling out the paperwork for the purchase and present it to the bank, you’ll receive a dated copy of the order form. That receipt will serve as your proof of the actual purchase date in case there’s any problem with the issue date when you receive your bonds in the mail.

To purchase your I Bonds from Treasury Direct, open an account and link it to your bank account. Once that’s done, you can buy and sell I Bonds online. When you buy, the Treasury takes the money out of your linked bank account, and when you redeem all or a portion of your I Bonds, Treasury deposits the money into your linked account.

Purchasing Strategies

You can purchase I Bonds anytime during the month, up to and including the final business day of the month. (Note that Saturday and Sunday are not considered business days by the Federal Reserve.)

I Bonds only carry the month and year of purchase as their issue date, not the exact date you purchased them. So even when you purchase your bonds at the end of the month, you’ll still get the same issue date that you would have gotten had your purchased your I Bonds on the first day of the month. And, you’ll earn that full month’s interest, since interest for the month is credited to everyone who owns the bonds on the last day of the month. Therefore, there’s no advantage to buying early in the month unless that’s more convenient for you.

In my opinion, I Bonds are once again an attractive option for money that’s sitting in low-yielding money market accounts, CDs or perhaps even short-term bond funds.