I Bonds Revisited

With interest rates remaining at very low levels, there are few options for earning any sort of a return on cash balances.

 Current yields:

Schwab Bank High Yield Savings                    0.40%

1 Year CD National Average                            0.46%

5 Year Treasury Note                                   1.85%

5 Year TIPS Note                                         -0.32% (plus inflation)

10 Year TIPS Note                                        0.70% (plus inflation)

Series I Savings Bonds                                4.60% (for the next 6 months)

One thing to consider for smaller balances is Series I Savings Bonds (“I Bonds”) issued by the U.S. Government.  The new rates came out May 1, and I was surprised to see that I Bonds are currently earning an annual rate of 4.60% for the next 6 months.  Please refer to my earlier blog posting “How to Make a Little More Money on Your Excess Cash (with a Bit of Work on Your Part)” or visit www.treasurydirect.gov for a more detailed description of I Bond features.

The earnings rate for I Bonds is a combination of a fixed rate, which applies for the life of the bond, and an inflation rate that changes semi-annually (think “I” as in “inflation”). The 4.60% earnings rate for I Bonds purchased through October 31, 2011 will apply for their first six months after issuance. I Bonds cannot be redeemed for 12 months after issuance, and there is a penalty of 3 months’ interest if they are redeemed before 5 years.  Purchases are limited to $5,000 per Social Security Number in electronic bonds and $5,000 in paper bonds, so a couple could purchase up to $20,000 annually.

If you act by October 31, you are in effect creating a 1 year CD with a yield of at least 2.30%.  For the next six months, I Bonds will earn interest at an annual rate of 4.60%.  The inflation rate will then reset.  Since the fixed rate is zero for the life of the bond, the earnings rate for the next 6 months will be the inflation rate.  If the semi-annual inflation rate stays the same at 2.30%, the earnings rate for the next 6 months will also be an annual rate of 4.60%.  In this case, you would earn about 3.83% for 1 year after factoring in the penalty for early redemption.  Even if the inflation for the second 6 months is zero, which is unlikely, you would earn a return of 2.30% over the next year versus 0.46% in a bank CD.

What if there is an emergency and you need the money?  Since you cannot redeem the bonds for 12 months, you need to leave some liquid cash on hand.  After 12 months, a penalty of 3 months’ interest is deducted from the redemption value.  But even after paying the penalty you would still be ahead of a bank CD, and considerably ahead if the change in inflation continues at its current level. In addition, I Bond interest is exempt from State income taxes and is tax-deferred until you redeem the bond.  Also, if you buy the bonds on the last day of the month, you still get interest for the full month.

All I Bonds have the same inflation component.  The only difference is in the fixed rate that each bond offers.  If the fixed rate increases significantly in the future, just redeem some bonds and pay the penalty.  Then buy some new bonds with the higher fixed rate (but remember the $10,000 annual limit on purchases for each Social Security Number).  After 5 years, there is no penalty on redemption. 

Another possibility is a short-term, high quality bond fund.  However, these do carry some interest rate risk.  For example, a popular short-term bond fund has a current yield of 1.41% and an effective duration of 1.85 years.  This means that if interest rates were to suddenly move up by 1%, the value of the fund would be expected to fall by about 1.85%.  This would wipe out over a year’s worth of interest, making it a less attractive alternative for cash balances.

Bill Hansen, CFA

May 13, 2011

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