I-Bonds Headed For a Plunge In Yield

Bottom Line: Yield is going lower. I would not buy I-Bonds until the fixed yield reaches high 2s or low 3s. An article written by Jeff Brown is posted to my blog. This article appeared in "The Record" out of Hackensack, NJ on 18 Apr 2006.

"After extolling the benefits of inflation-indexed U.S. Savings Bonds for years, I'm doing an about-face: Stay away.

Because inflation has been tame in recent months, new I bonds going on sale May 1 are likely to yield as little as 1 percent to 1.4 percent, while you can easily make three times as much in a certificate of deposit at a bank.Even the I bonds that are available until the end of April are a bad deal: They currently pay a generous 6.73 percent, but they will drop after you own them for six months to the rate that will be set May 1. That means you'd probably make only about 4.1 percent over the next 12 months.

To make matters worse, you'd pay a penalty equal to the final three months' interest earnings if you redeemed the bond after a year, cutting your yield to 3.7 percent or so. Again, that's less than the 4.5 percent you could get on a 12-month CD that could be redeemed penalty-free.

To understand all this, you have to know that I-bond yields come in two parts. First is a fixed yield that, once set when a batch of bonds is first offered, stays the same for those bonds' 30-year life. Currently, it's 1 percent.

That is added to a variable yield, which is adjusted every six months to match the inflation rate. After a big run-up in oil prices last summer and fall, the variable rate was set at an unusually high 5.73 percent on Nov. 1.Together, the two parts give the 6.73 percent being earned on the Nov. 1 to April 30 I bonds. That's an annualized rate over six months, the bond owner gets half that. It is paid for the first six months you own the bond. Then the variable rate adjusts to the rate set on May 1 or Nov. 1, whichever was most recent.

The problem now is that inflation has been all but non-existent during the past five months, says savings bond expert Daniel J. Pederson, author of "Savings Bonds: When to Hold, When to Fold, and Everything In-Between."

There is one more month's inflation data to be included in the calculation for the May 1 rate. Nonetheless, the variable rate set May 1 could well be zero, he said.

"That means that if the government doesn't change the fixed rate, which is currently 1 percent, you could end up with an I-bond rate of 1 percent," he said.

Pederson estimates there is a 50 percent chance the government will raise the fixed rate to attract investors to I bonds, but he doesn't expect it to go any higher than 1.2 percent to 1.4 percent.

The other type of Savings bond, the EE bond, doesn't look like a very good investment either, Pederson says. It currently pays 3.2 percent, and he expects no change May 1. EE yields stay the same for 20 years.

Isn't the I bond useful for anyone?

Well, some long-term investors might give it a look. Though I bonds might be stingy in the short run, they do guarantee returns that will always beat inflation by a margin equal to the fixed portion of the yield. I bonds thus offer a good way to assure that your money retains today's buying power no matter how high prices go. And the government guarantees you'll never lose principal.

Pederson suggests that long-term I bond investors postpone purchases until May 1 on the chance the fixed rate will be raised. That would mean giving up the 6.73 percent rate you could get for six months on bonds bought before May 1. But over the long run, you'd come out ahead with a higher fixed rate.

Remember that I bonds are no good for people who need steady income, since you don't receive the interest earnings until you redeem the bond.

An I bond cannot be redeemed until you have owned it for 12 months. And if it is redeemed within five years of the purchase, the owner loses the final three months of interest earnings.

Savings bonds can be bought at many banks, or online at http://savingsbonds.gov. The maximum annual investment is $30,000 for bonds bought at a bank, plus $30,000 for those bought online."