I Bond, iBonds, i-Bonds or Series I bonds.

Top 118. Nov 18, 2005 6:29 PM

» pbradford6 - Mixed Feelings on I bonds

The following is a negative report on the most recent I bond rate. I have been buying I bonds as an alternative to purchasing Long Term Convalescent Insurance. I thought using inflation index saving bonds was a conservative/practical means to avoid purchasing long term care. With the purchase of another $60,000 my wife and I will have about $340,000 ear marked for medical emergencies or long term care. Do any of you have comments either positive or negative about my strategy?

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Stupid Investment of the Week
Inflation-adjusted savings bonds are a bad idea

By Chuck Jaffe, MarketWatch
Last Update: 10:13 AM ET Nov. 18, 2005

BOSTON (MarketWatch) -- At the start of November, Ray F. in Edmond, Okla., read a story about changes to savings bond rates and decided that he needed to get in on a deal.

The I-bond -- the inflation-adjusted version of a savings bond -- had seen its interest rate kicked up to 6.73%, about 50% better than what Ray received when he bought his first I-bond back in the summer of 2001. So Ray dumped his old bond, paying a three-month interest penalty in the process, to buy the newest version.

In the process, Ray became part of a growing crowd to make a Stupid Investment of the Week.

The redemption of old bonds for new ones is not the sole problem. Instead, it's the I-bond itself; under new rates announced by the Bureau of Public Debt on Nov. 1, the inflation-protected savings bond may look attractive but it's a bad investment idea.

Stupid Investment of the Week highlights conditions and characteristics that make an investment less than ideal for the average consumer, in the hope that showcasing danger in one situation makes it easier to spot elsewhere. While obviously not a purchase recommendation, neither is this column intended as an automatic sell signal, as there are times when dumping a problem investment simply creates new problems.

For the I-bond, this is particularly true, as it is the current configuration that is the real problem. Investors like Ray -- who did not want his full name used because he's embarrassed to have made a silly blunder -- should not unload bonds purchased under the better terms of the past, because those outstanding older issues can only be replaced by the lesser terms of today.

The trouble with newly issued I-bonds is the very attractive 6.73% rate of return.

That looks terrific until you consider that the rate is a composite, with two distinct parts. There's an inflation rate that changes twice a year -- and which most observers believe will decline in the not-too-distant future -- and a fixed rate that stays in place for three decades. The fixed rate is the important part because it amounts to the bond's "real return" after inflation.

On Nov. 1, the fixed rate was dropped to 1%. Ouch.

By comparison, Ray's bond from the summer of 2001 carried a fixed rate of 3%. (His biggest mistake was in not recognizing that an I-bond purchased in 2001 -- with its better inflation kicker -- adjusted on Nov. 1 so that it actually has a current yield of 8.73%, two full points better than the bond he bought with the proceeds of his sale.)

"The headline number skyrocketed versus six months ago, but the fixed return component -- what you actually get after inflation over the time you hold that bond -- was cut," explains Greg McBride, senior editor at BankRate.com.

"This is a lot like your boss saying 'You got a raise of $100 a week but, by the way, your medical insurance premium is going up $120 a week.' It's not much of a pay raise when your net pay declines, and it's not much of a good deal in I-bonds with the real return getting smaller."

(On Nov. 1, the Treasury also cut the rate on the traditional Series EE bond to 3.2%. Int May, after a decade of hyping the value of a market rate on the EE bonds, the Treasury fixed the rate of return on the traditional bonds for 30 years. The change to a fixed rate -- especially in a rising-interest-rate environment -- is damaging enough that an investor could conclude that all savings bonds currently deserve Stupid Investment of the Week status.)

While it's too early for statistics for sales of the new I bonds, officials at the Bureau of Public Debt acknowledge seeing investors looking at the wrong number.

"It's definitely a frustration here that people are looking at the headline rate and not looking at the underlying values," says Stephen Meyerhardt, a spokesman for the savings-bond program. "They're not making a decision based on the fixed rate is, they're just seeing the 6.73 number, seeing what they could get on a CD and then making a decision based on that, rather than on the value of the I-bond over time against inflation."

McBride noted that the I-bond return numbers can be misleading. The I-bond must be held for five years to avoid forfeiting three months worth of interest. The highest-yielding five-year certificate of deposit currently yields about 5%, "and while that looks bad compared to the 6.73 of the I-bond, that five-year CD will beat the I-bond easily if inflation runs at 3.5% or less over the next five years."

The I-bond might be useful to investors is as a short-term interest-rate play, where it is sold after the mandatory 12-month holding period. If the inflation rate stays fairly high when rates are re-set in May, a buyer could beat the average 12-month CD, even after paying the interest-rate penalty.

Says Dan Pederson, author of "Savings Bonds: When to Hold, When to Fold and Everything in Between:" "You get that 6.73 for the first 6 months and then say the rate drops to 4% for the next 6 months. You are averaging 5.35% for the year. If you cash it in then, you give up three months of interest, which is about 1.35%, so you net 4 percent after the penalty.

"If you have a money market fund at 2 percent, the I-bond could help you double up."

But to make that work, you will need to track bond rates closely, and hope the unknown future rates aren't worse than you expect.

The only guarantee you get is the 1% above inflation, fixed, and the three-month inflation penalty if you change your mind in the first five years.

Says McBride: "When you are looking at a financial instrument and the only thing that is guaranteed is ugly -- 1% fixed for 30 years -- you're really asking for trouble if you go ahead and invest in it."

-- posted by pbradford6

Top 119. Nov 18, 2005 8:21 PM

» bamala - Re: Mixed Feelings on I bonds

In response to Mixed Feelings on I bonds posted by pbradford6:

For me I-bonds are a holding place for cash I don't want to invest just yet. In that case, my goal is to make a decent short term gain without risking the principle and I'd like the gain to be tax free. (The author of the article failed to mention the state tax bennie.) That's the I-bond for you. When I do investment planning I use the current I-bond rate, minus 3 month's interest, as my risk-free rate because it's the best I've been able to find. For long term I would think you need to aim for a higher fixed rate portion of the bond -- but still it's inflation protected and state tax free and the principle is not at risk so I still don't see how you can lose -- you will just not see the big gains those gambling in the equity markets might experience.

-- posted by bamala

Top 120. Nov 19, 2005 5:19 AM

» pbradford6 - Re: Re: Re: Mixed Feelings on I bonds

In response to Re: Re: Mixed Feelings on I bonds posted by Kirk:

Thanks to Bamala and Kirk; I appreciate the feed back.

-- posted by pbradford6

Top 121. Dec 21, 2005 9:03 PM

» bamala - No mention of I bonds

So did anyone else notice that BB didn't mention I bonds in his last newsletter? Tomorrow's WSJ has an article by David Wessel predicting that Bernanke will be cutting rates in 2006. The recent PPI is lower than expected. I suspect that there will be an increase on the fixed portion of Feb's I-bond rate. 1.5%?

-- posted by bamala

Top 122. Dec 21, 2005 11:09 PM

» gadget767 - Re: No mention of I bonds

In response to No mention of I bonds posted by bamala:

The fixed rate can't change in February, only in May and November.

-- posted by gadget767

Top 123. Dec 22, 2005 7:13 AM

» bamala - Re: Re: No mention of I bonds

In response to Re: No mention of I bonds posted by gadget767:

Thanks for the correction!

-- posted by bamala

Top 124. Dec 22, 2005 8:56 AM

» bob90245 - Re: Re: I bond Question

In response to Re: I bond Question posted by Kirk:

Hmm... Maybe you meant to say this:

As my note above says, the ~~fixed~~ variable rate is constant for 6 months after you buy then is reset.

-- posted by bob90245

Top 125. Mar 8, 2006 9:41 AM

» bamala - Re: Fixed rate on I Bonds

In response to Re: Fixed rate on I Bonds posted by Thruhiker:

That sounds about right. And in practice, the fixed rate is increased when the variable rate (CPI) is low. And the fixed rate is decreased when the variable rate is high.

Now if you consider our incredibly high trade deficit and our incredibly high budget deficit you can see that there are really only two choices left for sustainability: raise taxes or inflate. I don't see any calls for tax hikes therefore we must be headed for an inflationary period. So that would mean the I-bond fixed rate will be decreasing. I'm going to say the next I bond fixed rate will be set to 0.9%. Any other predictions?

-- posted by bamala

Top 126. Mar 9, 2006 11:10 AM

» Kirk - PLEASE USE NEW FORUM ON NEW SITE

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We have a new discussion forum for I Bonds on our new site here.

This forum is now closed. Please use the new I Bonds forum for your discussion.

Also, please read my article on I Bonds HERE.

All posts after this one will be deleted.

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