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US Treasury Series I bonds are inflation indexed savings bonds and provide a good alternative for protecting the value of your capital in rising interest rate environments. The Bureau of the Public Debt is the only seller of these bonds so you are unlikely to learn about them through your bank or broker.
Series I bonds are issued by the U.S. Treasury at face value and have a maximum duration of 30 years. These bonds can be sold any time after five years without penalty, and between one and five years after purchase with a loss of the most recent three months interest.
Series I bonds are now issued in both paper and electronic format. Whereas the Treasury previous limited annual purchases by a single individual to as much as $60,000 per calendar year, new rules limited purchases to $5,000 in each format, for a total of only $10,000 per calendar year.
The interest rate on Series I bonds is reset biannually - in each May and November - and is composed of two parts.
The first component is a fixed rate. On May 1, 2009, the Treasury reset the fixed rate at 0.10% for bonds purchased through October 30, 2009 (down from 0.7% in the previous six months, but up from a zero fixed rate component a year ago; in the two years previously, it had run between 1.2% and 1.4%). The fixed rate applies to all bonds purchased in the defined six-month period and does not change during the life of the bond. Since changes to the fixed rate do not affect previously purchased bonds at the reset date, bonds purchased after May 1, 2009 will always have a 0.10% fixed component. Bonds purchased prior to May 1, 2009 will also have the fixed component offered at the time purchased, plus the variable component.
The second component is a variable rate calculated on the basis of the change in the Consumer Price Index for Urban Consumers (CPI-U) during a six month period ending one month before the rate setting date. The US fell into a deflationary environment in October 2008. As a result, the variable rate for all outstanding Series I bonds (previously purchased and new purchases) is -5.56% APY or two times the actual six-month CPI-U change which fell by 2.78% from September 2008 through March 2009. In the six months previously, the CPI-U had increased by 2.46%.
Information on the history of the fixed and variable components of Series I Bonds is available here.
As a result of decline in the variable rate, the APY effective interest on newly issued Series I bonds has been set at 0% through October 30, 2009 since the rate cannot be negative. Since previously issued bonds (except those that have reached their final 30-year maturity) will earn their original fixed rate plus the -5.56% variable rate, all of these bonds will also earn nothing through October 30, 2009.
Whereas in principle, series I bonds provide strong protection in inflationary environments, they earn nothing in disinflationary environments. Moreover, they are backwards facing and are likely to earn a significant negative component after the reset on November 1, 2009. Series I bond should therefore be avoided for the foreseeable future.
While Series I bonds are state and local tax free (and federal tax deferred), they are not as liquid as other state and local tax free instruments. The rates on the Series I bonds is also roughly equivalent to short-term tax free municipal bonds and variable rate notes. Those in lower tax brackets will find Series I yields to be significantly inferior to those offered by online savings accounts, Money Market funds, and short-term CDs.
I Bonds can be used for education and college expenses. All interest earned on I Bonds is Federal tax exempt if the money is used for college tuition within 12 months of the I Bond being cashed out.
One significant advantage of Series I bonds, when held over long periods, is that they are state and local tax-free and federal tax is deferred until redemption.
Since interest on Series I bonds is calculated on the basis of the month in which they are purchased (and not the day), there is an advantage to purchasing these bonds at the end of the month and selling at the beginning of the month.
Series I bonds provide strong protection against inflation that shows up in the CPI-U (conversely, these are not good instruments to own in a deflationary or disinflationary environments, especially one accompanied by high short term interest rates).
Unlike Treasury Inflation Protected Securities (TIPS) , the interest payment on these bonds change and the principal is not adjusted. Therefore, these bonds will not depreciate in value in a deflationary environment; rather, your rate will be reset to the lower rate.
The biggest pitfall is the lack of liquidity in these bonds. These bonds cannot be sold within less than 1 year of purchase, and are therefore substantially less liquid than online savings accounts, auction rate securities, and money market funds. Moreover, there is a forfeiture of three months' interest if you sell between one and five years of purchase.
If you opt for paper, as opposed to electronic bonds, they should not be lost (they, however, are not bearer bonds). They are most easily redeemable by being physically presented to a savings and loan institution. Most online banks will not redeem these bonds for you.
Prior to May 2005, Series EE bonds were similar to Series I bonds in their rate resetting provision, except they were set to earn 90% of an average of the prevailing 5-year Treasury rate. Since May 2005, Series EE bonds purchased in May 2005 and thereafter will earn a fixed rate of return set at purchase. The rate for EE bonds purchased between May 1, 2008 and October 31, 2008, as well as for all previously purchased Series EE bonds, has been set at 2.8% for the life of the bond. Since Series EE bonds no longer provide the function of protecting against a rising interest rate environment and since the interest rate is not competitive with US Treasury bonds of comparable durations, Bestcashcow strongly recommends avoiding new Series EE bonds.