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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.
The interest rate on Series I bonds is reset biannually - in each May and November - and is composed on two components.
The first component is a fixed rate. On May 1, 2008, the Treasury reset the fixed rate at ZERO for bonds purchased through April 30, 2008 (down from 1.2% during the prior six months and 1.3% during a year ago, and 1.4% eighteen months before that). 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, 2008 will never have a fixed component for the life of the bond. Bonds purchased prior to May 1, 2008 will 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 variable rate for all outstanding Series I bonds (previously purchased and new purchases) is 4.84% APY (or two times the actual six-month increase). The CPI-U increased from 208.490 to 213.528 from September 2007 through March 2008, a six-month increase of 2.42%.
As a result, the APY effective interest on newly issued Series I bonds has been set at 4.84% through October 30, 2008. Previously issued bonds (except those that have reached their final 30-year maturity) will earn their original fixed rate plus the 4.84% variable rate.
Information on the history of the fixed and variable
components of Series I Bonds is available here.
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.
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.
A Note on Series EE Bonds:
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 1.4% 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, Bestcashcow strongly recommends avoiding new Series EE bonds.
What to Look for:
One significant advantage of Series I bonds 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 environments,
especially one accompanied by high short term interest
rates).
Unlike 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.
Avoiding Pitfalls:
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.
